Chant of the Ever Circling Skeletal Family

According to media reports, the economy has been caught in a negative cycle of spending cut backs by consumers (who fear losing their jobs), which leads to fewer sales for companies providing goods and services, who then in turn must layoff workers, which leads to more cutbacks, fewer sales, more layoffs, etc. Down and down this vicious cycle spins (so the story goes) until we are all reduced to bony wraiths, dressed in rags, shuffling our shoeless feet in a bleak David Lynch tableau, muttering in unison “wall street crooks, wall street crooks…” Hence the obtuse reference to the obscure David Bowie song which shares its title with today’s blog.

Apocalyptic? Yes. Entertaining? It must be for some (why else would we hear so much about it in the media?). Reality? Not really.

My reasoning here comes from something I learned back in Econ 101 – the law of diminishing returns. In its most basic form, this concept suggests that, all else being equal, the output for each producing unit (an employee, for example), will decline once a certain number of producing units is realized. In other words, the additional return from adding new production will be in successively smaller increments. For example, if 5 workers can make 100 gizmos in an hour, one might expect that 10 employees could make 200 of them in the same time frame. However, that may not be the case. Why? Production could be dependent on available factory space and machinery, the speed of automated processes and so forth.

So how does this apply to news about consumers cutting back? Think about it. If a working person cuts back spending a bit due to concern over the economy, how much really could that person cut out of the monthly budget? 10%? Whatever the number, let’s assume that that same person (who still has a job) has adjusted spending a bit, but has been watching the TV (or his 401k statement) and thinks that further cuts are needed. How much could this person cut the second time? Unless this person cuts more (in percentage terms) than the first time, the impact on the economy will be less negative than before.

Same thing applies for companies firing workers. The first 10% headcount reduction for any given company would have a bigger impact on the economy than the second 10% would. Even though companies are reacting to fallen demand, they are probably cutting back a bit more than is necessary, just in case things worsen a bit. If this is true, then they are less likely to make additional cuts even if demand slackens a bit more. Perhaps this is why we are not seeing multiple waves of layoffs from any given company, outside of highly distressed industries.

A person who no longer has a job is likely to cut back spending more dramatically than a person who is just worried about that possibility. Even so, the incremental spending cuts (after the first ones) will have a smaller impact on the economy. Look at it this way – if 7% of the workforce is unemployed and each person cuts spending by 50% (for example), a 10% cut by the remaining 93% would actually have a bigger incremental impact on the economy. It’s also important to consider that spending cuts by employed people are largely driven by sentiment – something that could change much faster than changes in the actual economy.

All of these factors are impacted by the law of diminishing returns. Unless each successive wave of spending cuts and layoffs is bigger than the last one, its impact on the economy will be less than the previous one. This suggests that at some not-too-distant point, we could begin to see economic data that, at the margin, is less negative than before. This may be all the stock market needs to begin thinking about a recovery...