A call for creative destruction
07 March 2013
The low base rate may be keeping companies aﬂoat, but at what cost?
We need to see capital and other resources reallocated from failing businesses to those that can make better use of them, says Nick Fenn, a partner of Beechbrook Capital.
When we have poor harvests, the cost of cereals goes up. That cost increase works its way through the supply chain to consumers and we pay more for our food. The same is true in relation to most other commodities in periods when demand outstrips supply. The same should be true of money. But it isn’t.
Western European governments generally adopt laissez-faire policies with regard to the prices of commodities (unless a strategically or electorally important domestic industry is threatened, in which case tariffs or other protectionist measures may be employed).
Money is treated differently. In response to the most recent liquidity crisis (i.e. a dearth of money in the bank system), governments and their central banks pumped vast amounts of newly minted money into the system at an artiﬁcially low price, largely by issuing guarantees that they probably couldn’t honour if called upon to do so. They then pressured banks to pass the new cash on to borrowers at a subsidised price. Compliant banks across Europe are making loans at real interest rates that are close to all-time lows and at odds with the market cost of money.
An obvious consequence of this is that struggling companies are beneﬁtting from artiﬁcially low interest bills. All but the very weakest can keep paying the coupon on their loans and so are not being forced to restructure, to make necessary changes to strategy or put themselves up for sale. Central bankers and politicians argue that this approach is necessary, ﬁrst to avoid systemic bank collapse (no argument from me there), second to ward off the evils of deﬂation, which has (wrongly, in my view) become a synonym for depression, and third to keep businesses out of administration and unemployment levels down. Those last two arguments deserve a closer look.
The idea that all deﬂation is bad is a modern one. There have been lengthy periods of price deﬂation in the past that have occurred simultaneously with economic growth, usually associated with advances in technology. The indiscriminate attitude towards deﬂation, usually accompanied by broadly drawn comparisons with Japan over the last couple of decades, is not particularly helpful. That kind of thinking inspired the policy response to the bursting of the TMT bubble just over a decade ago (the last pre-Lehman time that we “looked into the abyss”) and established the conditions for disastrous asset price inﬂation over the following years.
A desire to avoid churn of private-sector businesses is similarly misplaced. Of course, given the pitiful state of public ﬁnances that seems to be an inevitable feature of the universal suffrage, Western form of democracy (except in countries that have small populations and, ideally, vast amounts of oil), it is understandable that governments are desperate to try to minimise the attrition in the tax base and rise in welfare expenditure that come during a period of high insolvency rates. But that is to design policy to work around previous errors rather than to plot a course forwards.
Restraint on recovery
My view is that keeping failing businesses ticking over, rather than allowing the normal cyclical processes of creative destruction to play themselves out, is preventing the economy from moving fully into recovery mode. We need to see capital and other resources reallocated from failing businesses to those that can make better use of them. That isn’t happening fast enough, a few headlines from the retail sector notwithstanding. Bullying banks to lend at uneconomic rates of interest also ensures that they will fail to generate the returns required to cover the credit losses they will, of course, eventually incur. Warning them to “go easy” on borrowers means that they are stuck with battalions of staff nursing inefﬁcient loan books rather than recycling capital to borrowers that can generate some decent commercial returns with it.
This policy is also, incidentally, a slap in the face for savers, who constitute a large, but rather unco-ordinated, section of the population and are being doubly punished by near-zero rates on their deposits and miserly annuity rates.
Closer to home for those of us in alternative fund management, a less obvious implication of all this is that the wave of new lenders that might have been expected to ﬁll the void left by the partial retreat of newly cautious commercial banks has not materialised to the extent anticipated. There is a simple reason for that, in my view. New institutions (unitranche providers and mezzanine lenders, for example) setting up to address the widely perceived opportunity in European private debt are at risk of being crowded out by failed banks on governmental life support, particularly on the continent. The newcomers have to raise their capital in the private sector, where it is hard to come by and expensive; the cost of this capital has to be passed on to borrowers.
Given a vaguely level playing-ﬁeld, that would be ﬁne. That is wishful thinking, though: for EPO- and HGH-fuelled cyclists, read LTRO- and QE-drenched banks.
In the short term politicians can congratulate themselves, pointing out that no large banks have failed recently and that corporate insolvency rates are extraordinarily low for this point in the economic cycle. In the longer term, though, we may well see that an opportunity to reallocate capital away from underperforming banks and businesses towards those which might bring some much-needed drive to the economy (together with a sustainable boost to employment levels) has been largely missed. Low economic growth rates for years to come seem the likely consequence.