by Damon de Laszlo, ERC Chairman
In February we were anticipating the beginning of an escalation in the rate of bankruptcy. Central banks’ policies of raising interest rates in quantitative tightening are their tools for controlling inflation. Historically, this basically means bank loans become more expensive and more difficult to obtain, leading to business bankruptcies, which in turn reduce the demands on the economy by constraining expenditure and increasing unemployment, i.e. a recession.
The current inflationary problems can be laid primarily at the door of central banks’ easy money policies over the last ten years. This resulted in massive misallocation of investments by encouraging private borrowing along with business investment in marginal and non-profitable businesses. The enormous increase in so-called private equity investment over the period was also accelerated by the splurging of cheap liquidity.
Private equity companies are past masters in financial engineering. That is, taking over a business, arranging for it to take enormous debts which are then used to pay out private equity investors, leaving the company unable to expand its business and make productive investments. In the short term, the private equity industry can crow about its ability to increase dividends and share buybacks. Co-investors are happy to ignore the obscene pay-outs made to the masters of the universe running the banks and private equity groups. The idea of the central banks to reduce liquidity and hope that inflation will decrease slowly with a so-called soft landing was absurd but nevertheless suited the playbook of the City’s financial engineers.
The tech bubble, also blown up by cheap money pouring into the Californian technology miracle, is less private equity and more so-called venture capital. The early and exciting days of technology growth were financed by equity, but more recently private equity was replaced by debt and the biggest bank in the business, SVB, estimated to account for more than 60% of all deals this year, floundered, bringing into question US banking stability. SVB’s depositors have been underwritten by the Federal Deposit Insurance Corporation in a surprise move, but this will not stop a wave of bank tightening across Europe and the US. The collapse of SVB and Credit Suisse in the same month will add to the drying up of liquidity for European and US businesses.
Banking groupthink will do the job of reducing liquidity in the system much faster than actions by the central banks. Unfortunately, it is unlikely that the central banks will take notice and will continue to keep their foot hard down on the brake.
While headline inflation in Europe of 10.6% in October is falling steadily, we could come out at 7%ish in March. The easing of the disruption in the supply chains caused by the Russian invasion of Ukraine is helping bring this number down. Now the ECB has moved its sights to Core inflation, which excludes food and energy, which has moved up slightly from 5.6% to 5.7% as a result of strong wage growth and increases in companies’ selling prices. These pressures are already set to reduce dramatically as corporate bankruptcies take hold and unemployment rises.
At the same time, the Chinese economy is slowing as a result of US restrictions on exports to China that feed the technology investments, coupled with a slowdown in Chinese exports. Chinese exports are vulnerable owing to their dependence on the western retail sector, which had become overstocked as the supply chains improved after the disruptions caused by Covid.
As yet we have not seen a major problem in the property markets in the US and Europe. Here again, group thinking in the banking industry is likely to cause liquidity to dry up, particularly for the US and Canadian regional banks. The upward spiral of property prices is likely to turn down, leaving many loans uncovered.
At the risk of adding to the short-term gloom, it is interesting to note that the misallocation of capital has starved important infrastructure development in the West. The war in Ukraine has hugely increased the demand for ammunition. The so-called peace dividend has meant that businesses producing military equipment and munitions have been run down over recent years. Apparently, Nammo, a Norwegian munitions company, has been told it cannot expand its production because all the surplus electricity supply in its area is being used by TikTok, and this is their primary customer in the area. Norway is particularly attractive to data centres as it provides cheap electricity and the climate helps keep the data centres’ cooling costs down, i.e., they are a major contributor to global warming.
With tongue in cheek, one can only observe that the frivolity of social media is more important than the defence of the country and worries about global warming. It would seem joined-up thinking is beyond our political system to manage as it is fragmented by pressure groups.
Damon de Laszlo
28th March 2023