The last two decades of low interest rates have seen a vast increase in the world’s stock of assets, measured at market value, largely matched by a corresponding increase in debt. However, the increase has not raised global productivity growth, which has slowed as the asset glut has increased. This points to a core economic secret: large agglomerations of assets are a drag on growth, wealth and productivity, and lead to repeated financial crises through their obsolescence. Going forward, we must devise ways to move towards an asset-light economy.
The fashion for assets is not new. In the 1950s, the archetypal company was not some start-up – indeed, there were very few start-ups — but General Motors and General Electric, the heads of which, both called Charles Wilson, were known as Engine Charlie and Electric Charlie. GM had 576,000 employees in 1955, deployed in a network of huge automobile plants. When Engine Charlie opined that “What’s good for General Motors is good for America” he spoke no more than the truth.
The fate of General Electric in the last six decades, even more than that of General Motors, is illustrative of what went wrong with the Big Assets model. With 210.000 employees in 1955, GE was modestly less asset-heavy than GM. For the next quarter-century it flourished, growing by acquisitions carefully related to its strategic business and spinning off some businesses such as mainframe computers (sold to Honeywell in 1970) in which it found itself unable to compete effectively.
Then in 1981 “Neutron Jack” Welch became CEO. He disregarded such old-fashioned concepts as strategic fit, buying and selling assets and operations according to two criteria: whether they were #1 or #2 in their business and whether they added to GE’s earnings per share. The result was an unholy mess; GE divested many businesses in which it had built up a long and honourable track record and diversified into areas such as media and finance in which its top management completely lacked expertise (and quickly proved it by a series of spectacular blunders.) As an old and dear friend employed by the top-flight investment bank Kidder Peabody remarked when Welch parachuted in the former CEO of Illinois Tool Works to run the thing: “Just what this place needed: a good tool and die man.”
The result was unparalleled riches and, in the short term, media praise for Welch, but disaster for many of the operations GE bought and, in the long run, for GE. Cushioned by decades of funny money, the inevitable denouement has taken a very long time to happen; it is now 17 years since Welch left. However, make no mistake about it: Welch’s strategy of concentrating purely on the financial bottom line, without regard to the long-term strategy or the immense capabilities that had been built up, has destroyed or close to it one of America’s finest companies – and, by extension, one of the world’s.
Over the centuries, true innovation has not arisen in behemoths like the 1950s General Motors or Welch’s GE. Going back to the Industrial Revolution itself, its first great success Sir Richard Arkwright began as a barber and inventor of a new water-proof hair dye, the royalties from which enabled him to invent the water-frame for cotton spinning, opening his first factory in 1771 with capital of £12,000, less than $3 million in today’s money.
Throughout the Industrial Revolution, it was remarkable that the richest Britons were not industrialists but either landowners (the Duke of Sutherland) or bankers (the Rothschild and Baring families.) The richest industrialist, Sir Robert Peel, father of the prime minister and the largest textile manufacturer in Lancashire, was worth only about £1.5 million at his death in 1830 (equivalent to $350 million today.) The railways took more capital of course, but again the greatest fortunes were made by financiers. In any case railway/railroad building was largely a matter of copying the first successful model, the Liverpool and Manchester Railway, only 31 miles long and capitalized with 4,233 £100 shares, 1,000 of which were owned by the future Duke of Sutherland. In 1827, the market capitalization of the London Stock Exchange was only £49 million ($12 billion in today’s money) – the real money, over £800 million of it, was in government bonds.
Similarly, innovation in finance came not from giant behemoth banks but from medium sized houses with largely private ownership and very able people – as John D. Rockefeller said on J.P. Morgan’s will being read: “To think, he wasn’t even a wealthy man.” Only after the 1970s, with foolish new regulation in London and de-regulation in New York, did the behemoths come to dominate the finance business. Since the 2008 crash, there have been indisputable signs that, through “boutiques” and “hedge fund” pools of capital controlled by very small teams, the intellectual headquarters of finance is once again moving rapidly away from the trillion-dollar dinosaurs.
In the tech sector, the greatest innovation has always happened in small companies with small teams, not in the “dekacorns” financed by massive private equity cash injections. In that sense, the entire private equity and venture capital industry may be economically misguided – by throwing money at innovation, they are killing it. Certainly, it is remarkable that, at a time when equity finance for new companies is available in unprecedented quantities, the rate of U.S. company formation has fallen to half the level of 40 years ago.
Austrian economists should expect this. The unprecedented period of low interest rates has led to an unprecedented build-up of unproductive assets. Central banks themselves now have vast balance sheets, which in the case of the Fed will have led to losses with the gradual interest rate rises of 2018. Shadow banking continues to surge, with assets up 8% in 2016 to $45.2 trillion on the narrow measure – many of these assets are in China and are beyond the control of the Chinese or any other government. “Zombie” stocks, which cannot meet interest payments from EBITDA, are at record levels, around 12% of all listed companies worldwide. Real estate prices are at record levels, both residential and commercial, in many big cities all over the world.
The assets in this bubble are all rather unproductive. The Fed finances its bloated balance sheet by attracting deposits from the banking system, for which it pays relatively attractive interest rates that discourage the banks from making loans to productive industry. By and large, the “shadow banks” hold low-risk assets, but low-risk also implies low usefulness – there is nothing productive about the gigantic pile of government debt that has accumulated in the last decade, clogging up balance sheets everywhere. Zombie stocks, by definition, are companies that in a more rigorous world would have been put out of their misery, but in today’s sloppy environment, are using resources that could be better deployed in other areas. Real estate itself is productive of course, but high real estate prices merely mean you get less for the money – my house in unfashionable Poughkeepsie is larger and nicer than many people’s urban residences that are worth five or even ten times as much.
When the asset bases are so great, tiny returns on them can yield huge profits on an ordinary human scale. That’s why the LIBOR scandals happened. When LIBOR was developed in 1985 it was intended as a benchmark for the syndicated loans business, where a bank’s position would be at most a few billion dollars, so profits from manipulating LIBOR would be modest. A dodgy move of 1 “basis point” in 3-month LIBOR on a $5 billion loan portfolio would make a bank $125,000 and its perpetrator some fraction of that which was not worth risking jail for. However, once the derivatives market grew to full size, volumes outstanding were trillions rather than billions, so illicit profits for dodgy traders were 1,000 times greater. Now LIBOR’s replacement, SOFR, is probably as manipulable as LIBOR, but it is an overnight rate rather than a 3-month rate, dividing potential illicit profits by 90.
Nevertheless, reducing the volume of spurious, low-return assets in the system would reduce the profits available from manipulating those assets, generally unproductively. To the extent that resources are tied up in unproductive assets, they do not contribute to innovation and growth. To the extent that people are making good livings manipulating unproductive assets, they are not employed in the production of true wealth.
As this column has remarked before, it is likely that the current era of overleverage will result in a massive de-leveraging financial crash. Thereafter, it is to be hoped that the authorities avoid the temptation to jam interest rates at low levels. If real interest rates are allowed to remain high, then gigantic pools of assets will not be created. Banks will not leverage their balance sheets, real estate prices will remain low and zombie companies will be put out of their misery. In such an environment we may at least see the rebirth of true innovation.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)