by Damon de Laszlo, ERC Chairman
There is considerable reason to be optimistic as I mentioned in my last Daberiam, but that should be applied to the latter part of this year running into next year.
Today, however, the stock markets are running hot, and there seems to be an over-optimistic view of the world. Western Central Banks are very cognisant of the easing up on inflation too quickly, this happened in the last inflationary bubble, and there seems to be a lot of comment about a soft landing, i.e., inflation continues but declines, but general business and employment remain reasonable. This short-term optimism is probably misplaced as Central Banks will continue to keep the pressure up. The Fed is still forecasting an increase in interest rates, as is the Bank of England. This will be followed by the ECB. While they are predicting an increase in interest rates, it might be at a slower pace, but good employment figures and the lack of current economic pain will reinforce the Bank’s determination to increase interest rates.
What is not being generally discussed is liquidity. The banking system and the stock markets are awash with cash created during Covid, Central Banks are holding huge quantities of government and other debt, all of which need to be unwound. The draining of liquidity which this entails has started and has to some extent been mitigated by people running down their savings built up during Covid. Also, better-run businesses have considerably more cash reserves than normal. As liquidity is reduced there comes a point, usually quite suddenly, when there is a so-called liquidity crisis. There is a gradual increase in companies getting into financial difficulties, usually starting with ones that have been run on a profligate basis. These go bust initially and the blame is laid on incompetent auditors, who then defend themselves by claiming fraud.
This has been seen in Europe, the UK and the US. The nervousness that this creates in the banking industry means that borrowing and/or rolling over loans will soon become a lot more difficult, leading to an escalation in the rate of bankruptcy. In easy money periods, banks advertise and encourage borrowers. When money tightens, your best friend at the bank suddenly doesn’t return calls. This serves to facilitate the process of creative destruction, named by the famous economist Schumpeter, which is good in the longer term, but painful and frightening in the short term. The misallocation of assets and resources over the last ten years or so, encouraged by Central Banks’ profligacy, is a major contributor to inflationary pressures and has also depressed productivity.
Low rates of interest encourage reliance on borrowing. Buying new plants and machinery is hazardous and unpopular with shareholders and produces an initial hit to Profit & Loss accounts. Low interest rates also discourage businesses from working on raising their profitability. Making a commercial 10% return on assets looks good if the interest rate is 2 or 3%, but as interest rates rise, business profits must genuinely rise to keep ahead of the interest rate hurdle which investment has to overcome.
Europe and the UK also suffer from the government’s almost total lack of understanding of business productivity. As the bureaucracy rises, productivity declines, while the job of Government is to create a stable environment in which entrepreneurs can operate, the bulk of government expenditure today has been diverted away from Police, Law Courts, front-line hospitals, medicine and schools into layer upon layer of management that provide comfortable employment under the government umbrella, where accountability is minimal.
The difficulty in Britain in developing and expanding a business is caused by the endless rules, regulations and planning requirements, bringing every decision to a near grinding halt and enormously increasing the cost of running a business. This sand in the works also inhibits public services.
An interesting example reported today in the Financial Times is that education colleges in England, which for the past three decades have been formally independent of government, allowing them to finance capital projects through private loan finance, were last November re-classified as part of the Public Sector. Apparently, they are now subject to strict government lending restrictions and are barred from taking out commercial loans. The Association of Colleges has pointed out that the Treasury is likely to be reluctant to lend to them as it is trying to reduce the government deficit…… Their reclassification has already stalled many projects for new facilities, along with leaving poor infrastructure and dilapidated buildings unattended to.
While the rate of increase in inflation has declined and, in a fair number of areas such as energy prices have dropped dramatically, the underlying trend is still well over 5%. The British government and Brussels, along with their advisors, seem to have little understanding that capital investment leads to improved productivity and indeed has set a course of a dramatic rise in Corporation Tax and a major reduction in Capital Allowances. This combination will produce a massive disincentive to invest in productive resources, particularly for publicly quoted companies. The manufacturing sector is where productivity improvements can reduce costs and help push down inflation. While the financial sector, which is not really interested in productivity and capital expenditure, is less affected by this combination. The US is in a better place and the Chinese economy, like it or not, is set to grow fairly rapidly in the near future.
Damon de Laszlo
20th February 2023