by Damon de Laszlo, ERC Chairman
Contrary to initial projections, the pace of economic slowdown has been less pronounced as we approach the midpoint of the year. Western economies have proved much more resilient than anticipated. In 2020, it was becoming clear that the liquidity that had been poured into the world’s economy over the previous ten years was producing huge upward pressure on asset prices. Property prices everywhere were rising, stock markets were riding high, and a lot of money was chasing start-ups and IPOs, particularly in the technology sector, and Silicon Valley was having a gold rush. While inflation was beginning to appear, wage inflation, while anticipated, had not taken off, the huge amount of liquidity generated by quantitative easing was being absorbed by asset price inflation.
Central bankers were sanguine, while many economists were warning of the economic problems being stoked up by quantitative easing, central bank economists, who tend to spend their time looking at historical models, seemed to be happy that inflation was no longer an economic problem as it had not appeared on their radar in the last ten to fifteen years. Indeed, the lack of inflation was a big worry. What does not seem to have been factored into individual central bank models was the impact of China joining the World Trade Organization and becoming the world’s economic driver, supplying the West with manufactured goods. China’s industrialisation was extraordinary and will be seen as one of the major economic turning points of the 21st Century. The strength of China’s industrial economy weakened Western industry, holding down prices in most of the retail sector. This caused large parts of Western industrial production to move to Asia; manufacturers in the computer sector, luxury goods sector and even motor cars, migrated. To name but a few – Mercedes, Volkswagen, General Motors and Apple have major manufacturing plants in China.
The enormous build-up of debt in Western economies, encouraged by excess liquidity and historically low, moving to zero, then negative, interest rates thwarted central banks’ attempts to raise interest rates as it threatened the debt markets and, in particular, the structured debt market where borrowing at super low rates was used to gear the purchase of riskier debt instruments to boost yield.
The arrival of Covid and the measures taken to contain it, basically locking down economies, caused economic chaos. Governments, to a greater or lesser extent, paid for people to stay at home, except in the essential supply chain and service industries. The unprecedented situation caused a huge increase in government debt and a further increase in quantitative easing. These actions also preserved the debt structures that were in place and by and large protected businesses from bankruptcy. It also had a major impact on individuals’ finances, the savings rate massively increased as people were unable to spend their income. As we came out of the Covid restrictions in 2022, a rapid rise in private expenditure met massive disruptions to the global supply chains, causing prices to start rising rapidly.
Into this mix, Russia’s invasion of Ukraine, dislocating grain supplies and cutting off Russian energy, representing 40% of Germany’s requirement so bringing its industry to a near standstill, and enormously increasing inflationary pressures. Central banks have responded to the rapid rise in inflation by dramatically increasing interest rates at a faster rate than in the last 30+ years. Western economies in general have not yet reacted to the rapid rise in interest rates and the tightening of liquidity, as economies were already overstretched and labour was in short supply, compounding wage demands. While the inflation in basic foods and energy supplies caused by Russia’s invasion is dissipating, and we are beginning to see lay-offs, particularly in the technology sector, the full impact of economic tightening has not yet caused the large sectors of business that are over-borrowed to get into trouble.
The economy has been much more resilient than anticipated and bank tightening, which is now increasing rapidly, has not yet had a major impact, it feels as though this is a dam ready to burst. The backlogs created by supply chain dislocation are dissipating and the growing reluctance of banks to lend money will start to meet declining order books, certainly by the fourth quarter.
The wave of defaults and bankruptcies has been postponed but will not go away, particularly in the face of central banks continuing to tighten. While the next six to nine months can be regarded with pessimism, there is underlying the economy, in general, a major move by well-run resilient businesses to reindustrialise. As companies take advantage of automation and implement new computer systems, we can expect a huge revival in productivity and general prosperity. Western companies have been enormously disadvantaged by the misallocation of capital, caused by the private equity industry and Asian competition, both of whose influences will decline in the economic downturn.
Damon de Laszlo
16th May 2023