Death Spirals

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03 11 2024 09 24 24

Death Spirals

The economic world and the natural world are full of mean reversion, by process of elimination. Something truly unsustainable either a) hasn't been started yet or b) has already gone out of existence. What's left is either stable or growing. But growth doesn't last forever; the stable processes you see are the result of something that looked like it was going through unstoppable, runaway growth until it reached some natural limit and slowed down. Continued growth does happen, but requires a lot of explanation to justify any level of extrapolation.

But mean-reversion doesn't necessarily last forever, either. The pre-modern economy was a mean-reverting one: good times tended to create enough of a calorie surplus to lead to population growth, which led to bad times through disease, famine, war, or revolution. Within that cycle, you'll have some institutions that tend to shrink when they're deprived of resources, but grow back to their natural extent later.[1] And some institutions are one catastrophe away from a death spiral.

Death spirals are worth thinking about and understanding because they're the mechanism by which almost-sustainable processes—whether they're companies, careers, civilizations, or species—finally die off. They're quite common, but take many forms.

A corporate death spiral happens when a company's financing options are limited to borrowing at greater than the company's cost of capital or issuing equity at a value below where the business could liquidate. Doing either of those things for an extended period cannot be sustained. Both of these practices are basically handing a growing share of the company's economics to whoever supplies enough cash to keep it in business for a little longer, which usually means it's a wealth transfer from existing investors to new ones, management, employees, and suppliers.

Death spirals can show up in other places, too, like schools. A school with a shrinking student body will have a harder time attracting professors, donations, and other students. It will also have fixed costs that have to be amortized over a smaller headcount. All of this feeds on itself: every year, budgets get trimmed, but typically not enough to offset the decline in revenue, so services get worse. Everyone who's still there would prefer to be somewhere else, and every additional departure serves as a reminder. It's extremely hard to turn this around, and a turnaround often means keeping the same brand name but applying it to a whole new institution (E.F. Hutton, Abercrombie & Fitch, and the Holy Roman Empire all did this; zero continuity with their previous incarnation other than whatever was necessary to ratify their use of the brand).

Polities face them, too, and for the same reason: a state with high pension obligations and slow economic growth is imposing an invisible head tax on immigrants, since those immigrants' taxes will fund future pension payouts. The number varies by state, but if you're considering a move from, say, Nebraska (pension liability per capita: $300) to Illinois ($17k) it's at least worth factoring it in. For the most part, there's a positive correlation between a state having unfunded pension liabilities and getting immigration from high earners for whom that extra liability doesn't make a huge difference; if the reason you're saying goodbye to Nebraska is because you finally landed that amazing job you've been angling for, the pension issue isn't going to make the final decision all that different.

But it does make a difference to lower earners. A trader doesn't have to worry about pension obligations, unless they're a discretionary trader in munis. A trucker does need to worry that they'll be squeezed by a higher tax burden and deteriorating services, and that by the time they realize this is a problem, they won't have the cash on hand to move. If taxes on high earners go up, the trader can move to Miami; the trucker is more likely to stay put.

And that's the key ingredient in a death spiral: if the biggest taxpayers are more mobile and the smallest taxpayers stay put, taxes will end up being effectively more regressive, even if on paper they're not.[2] This is also an important ingredient in company death spirals: the people who leave first are often the ones you really, really needed to stay, and every one of those people who leaves cuts off part of the social network of future prospective employees, in addition to leaving with whatever tacit knowledge they've accumulated.

When an institution is going through this, it doesn't stand still. But its incentive is to countersignal: death spirals are about perception catching up to reality, and it takes time to fix reality. That leaves perception as the lever. So it ends up being a useful heuristic for when someone has to come out and say what should be unquestioned—there are no plans to adjust the currency peg, the bank's liquidity position is strong, we've never had so many great applicants, etc.—it's usually a sign that things will reverse. They may even go through an extinction burst, where they're hyper-compliant with the narrative before they give in (during the 1992 Sterling Crisis, the UK defended the pound's value by raising rates from 10% to 12% intraday, and promised to raise them as high as 15%; they backed down and let the currency drop hours later).

In the long run, a statistical judgment on whether some process is sustainable or not means judging what's contained in not-yet-observed samples from the left tail of the bell curve. By necessity, there's never enough data to know for sure. But what you can estimate in advance is when something will reach the point of no return.

  1. This mostly applies to cities, which tend to be where ancient ones were, in part because water-based transportation determines which areas are easy to settle and in part because settlements create denser land-based transportation networks that make the city a better destination for trade and immigration. But it also works on a country level: China occupies roughly the same area it did in 1760, for example; half-of-China and 110%-of-China are equally non-viable. So at a species level, some strategies keep on working and get reimplemented over and over, like the crab. ↩︎

  2. It would be hard to collect this data, but Raj Chetty could do it: you could measure the effective incidence of a tax hike by looking at which earners relocate. The efficacy of higher income taxes in New York and New Jersey can only truly be measured by looking at how many people relocate from the Upper East Side to Miami in response. ↩︎

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The WSJ has a good look at how companies like Uber and Lyft are incorporating ads ($, WSJ). They have an audience that's probably between tasks and generally high-income, so it's a good demographic, but they're also competing against whatever electronics riders bring with them. As with many ad-supported businesses, the natural equilibrium is that if the core service was worth doing without ads, it's worth doing more cheaply with mandatory ads. But that's tricky for a service that's mostly designed around convenience, i.e. saving users time. So the right move for these companies is probably to use ads as a price hike: if the opportunity cost of being bombarded with ads between meetings is that you miss a blessed fifteen minutes to catch up on email, you'll probably pay for Uber Black. And if not, Uber will be happy to monetize your slightly cheaper ride just as well as the more expensive one that you're no longer paying for.

Healthcare and Insurance

The Diff spends comparatively little time on healthcare because it's a complicated topic where progress is expensive. But GLP-1 agonists have been a promising new category that seems to meaningfully impact health. Part of the problem is making them, and part of it—another reason writing about healthcare is tricky—is the question of who pays and how. Fortunately for pharma companies, they've been able to argue that weight loss drugs should be covered by insurance since they reduce future claims ($, Economist). One of the reasons that healthcare is so contentious is that it’s politically unpopular to make sick people pay the full cost of their care, but it’s also politically unpopular to make anyone else do it for them. But that also means that medical advances can ease political logjams. If they reduce the total burden of healthcare costs (still an "if," but a high-probability one) they get rid of one more endlessly-debated tradeoff.

Transition Economics

Saudi Aramco reported 25% lower earnings this year, but also raised their dividend ($, FT). Aramco's status as a public company is a way for Saudi Arabia to both gradually reduce its reliance on oil and share credible data on just how hard it would be to undercut them if anyone were tempted to do so. For the former, it absolutely makes sense to pay out a high dividend—it's basically a way to slowly liquidate the company, perhaps eventually by replacing equity with debt. It also puts them in an awkward position. Saudi Arabia, as a country, wants to have a future that isn't dependent on a single deeply unpopular industry. Saudi Arabia, as the largest shareholder in the fourth most valuable business on earth, has an incentive to indicate that the cash from oil and gas will keep flowing for a long, long time.


Options-selling investment vehicles are getting popular again. This is always tricky to write about, because two things are true:

  1. Over long periods, writing options does produce decent returns.
  2. Over shorter periods, particularly the ones where there's a lot of options-selling from people who don't fully understand the bet that they're making, these strategies sometimes blow up, and tend to all blow up together.

When there's systematic writing of options, one result is that it's cheaper for other investors to take highly levered positions with controlled risk; you can make a levered long investment paired with a put, or, equivalently, buy a call option. And the VIX is a standard proxy traders use to measure how worried other traders are; a low-VIX environment is one where more leverage feels safer. So these strategies tend to go through a cycle, where when they work, they gather assets, which makes them work better (if you're an options seller, you have an immediate mark-to-market gain when someone else sells more of the same options you sold). And then, there's a swift reversal.

Strategic Investments

The WSJ has a piece interviewing the head of one of Nvidia's venture groups ($, WSJ). Nvidia's investment strategy has been tricky to model ($, Diff): on one hand, they do have better information that most investors about who's applying AI well and who isn't. On the other hand, they're writing checks to companies whose big expense is buying Nvidia's own hardware. But on yet another hand, that hardware is scarce, and Nvidia isn't raising prices as aggressively as it could, so to the extent that there's any circular logic it's less about Nvidia converting cash on hand into sales, and more about Nvidia converting sales that would happen anyway into a markup on their venture investments. The article floats yet another possibility: Nvidia is making these investments in order to better track demand for its products. In mid-2022, they were missing estimates and writing down inventory, because chip demand is so hard to predict, especially when it's been growing. By investing in companies that are going to be ordering chips at scale, but not for a few quarters, Nvidia gets a better view of what those quarters will look like.