The Bear’s Lair: 24 years of Schumpeter

The Sears bankruptcy, and the Schumpeteran creative destruction in the shopping mall sector that will follow, feels like it has been coming for a long time – and it has. Ever since the Fed went off track from sound monetary policy in February 1995, ultra-low interest rates have created new unproductive investment and postponed necessary bankruptcies. In 2019, if the Fed stays on its current path, we will enjoy 24 years of Schumpeteran creative destruction – all at once. With good management the experience should be highly invigorating.

“Capitalism requires the perennial gale of Creative Destruction” wrote Joseph Schumpeter in his 1942 “Capitalism, Socialism and Democracy.” Well, since the Fed meeting of February 23, 1995, that gale has been an intermittent breeze, at most. Indeed from 2009-15 it was a flat calm. Interest rates have for nearly 24 years been set artificially low, almost always far below a neutral rate (of about 2% above the rate of inflation) or where the free market would have set them without Fed meddling.

Consequently, fixed asset prices, primarily stocks and real estate, have soared far above their equilibrium level and investment has been misdirected accordingly. The Dow Jones Industrial index, which passed 4,000 for the first time on that fateful Fed meeting day in 1995 (a mid-market, not a bear market value) should be around 10,900 today, if it had increased along with nominal GDP. Instead, it is today 25,200, making the stock market 130% more overvalued than in 1995. Most important, creative destruction that should have occurred has been prevented, because it has always been possible to get new financing, often at a negative real interest rate, by which the failing asset has been artificially propped up.

You can see the effect of this in the Sears example. Sears’ bankruptcy did not come out of the blue, far from it. The company began selling off pieces of itself as far back as 1992, spinning off its Allstate insurance subsidiary and its Dean Witter brokerage business. In 1993, Sears discontinued its famous catalogue, doubtless saving a great deal of money on distribution infrastructure but also losing vital know-how. That infrastructure and know-how was to form a central part of the business of Amazon, founded just a year later.

Probably the best sign of Sears’ impending demise came in 1996, when it sold its Prodigy web access business, at the very cutting edge of the most exciting new development in decades, for a mere $200 million, having spent over $1 billion together with IBM over the previous decade in building it up. Thus, by the middle 1990s at the latest, Sears was a dying business, spinning off and closing operations even when market developments suggested they had an exciting future potential.

With Sears having been in liquidation mode for half a decade, a proper Schumpeteran process would have shuttered it in about 1998. Its continued existence for the subsequent two decades has been thoroughly unprofitable and economically damaging. If you had bought Sears stock when hedge fund genius Eddie Lampert took over Sears in 2003, you would have lost 96% of your money by October 15. Lampert never figured out a way to make a decent operational return on Sears; he simply kept it going by asset stripping and repeated rounds of leverage, using the over-inflated credit markets, where money was always available and credit risk was always grossly under-priced.

Had Sears closed in 1998, its closure’s market signals for the shopping mall business would have been given two decades earlier. In the middle 1990s, over 140 new shopping malls a year were being opened; the closure of Sears would have brought a stop to this, at a time when there were still many alternative uses for the space being vacated by the dead Sears.

Since 1998, the shopping mall business, heavily overbuilt in the late 1990s, has gone into decline, with 2007 being the first year since the 1950s that no new malls were opened, and the percentage of “dead” malls increasing rapidly from that date. Poorly performing Sears stores have contributed to the malls’ malaise, reducing traffic through malls where Sears is an “anchor” tenant and reducing their attractiveness. The demise of Sears now, if it includes closure of all the stores, will cause the number of “dead” malls to skyrocket, at a time when the retail sector is struggling and there are few new potential takers for most large Sears retail spaces. Thus, the delay in Sears’ Schumpeteran destruction from 1998 to today has inflicted huge collateral damage across the shopping mall industry as a whole.

Retail store chains, with their high fixed costs and low margins, are typical of the types of business whose lives have been artificially prolonged by 24 years of artificially low interest rates — Toys R Us, finally shuttered earlier this year, is another such example. All over the Fortune 500 are companies that have not invested properly for a decade or more, because they have been unable to find projects that meet their “hurdle” rates of return. Instead, they have wasted huge amounts of shareholders’ money on gigantic stock buybacks and useless acquisitions, which have left them leveraged up to the eyeballs, vulnerable to even a breath of the Schumpeteran gales. With even the modest but persistent rise in interest rates of the past two years, Nemesis for those companies is now in the process of arriving. Most of them will not be missed in the long run, however loud the short-term howls from their management and shareholders.

The reverse of Schumpeteran destruction is Schumpeteran creation, and here it will be no surprise to learn that the past two decades have seen a dearth of new business formation. From Census Bureau data, the entry rate of new establishments (the new to total ratio) was 17.1% in 1977, the first year covered by the data. The statistic is somewhat cyclical, and 1977 was the peak of that cycle; by 1981, at the bottom of the recession, the entry rate had dropped to 13.2%, with the number of new establishments formed having dropped from 698,000 to 578,000.

There was a mild recovery in the 1990s and a steeper drop in the early 1990s; by 1994, near a low point in that cycle, the establishment formation rate was only 12.1%, with 688,000 establishments formed (bear in mind that the U.S. population and the total number of establishments is growing all the time.) Low interest rates and the decline in Schumpeteran destruction then clearly had an effect; the peak formation rate of the 1990s cycle, reached as early as 1997, was only 12.9%, compared with 15.1% a decade earlier. In 2006, at the peak of the following cycle, the entry rate was only 12.3%; then the rate falls to a new low of 9.1% in 2009. This time, it did not recover with the economy; the formation rate in 2016, the latest data we have, was only 10.3%, with 705,000 establishments formed, less than 3% more than 39 years earlier from a U.S. population 47% larger.

The same trend can be seen in the establishments exit rate (Schumpeteran destruction) except that exits exceed formations in 2009-10; overall the exits rate in 2016 was 8.6% compared to 12.9% in 1977, or 590,000 establishments exiting, an increase of 12% on the figure 39 years earlier. Overall, the rate of Schumpeteran creation and destruction in the U.S. economy, at this most granular level, has dropped by about a third.

It is likely that President Trump’s policies and the rise in interest rates have improved new establishment formation somewhat since 2016. Still, given the dearth since 1995, there are a lot of new establishments to form and a lot of old ones to fail before the U.S. economy is in a healthy state again. Higher real interest rates and Schumpeteran destruction are essential for this creation to resume a healthy trend.  Even President Trump must be made to realize that the wellsprings of America’s supreme creative ability do not derive from low interest rates and tower blocks with gold-plated bathrooms.

This is not to say the United States is in for a deep depression. Clearly the stock market will crash, and bond markets, the junk bond market in particular, will suffer unprecedented levels of losses. That will in turn affect everybody’s retirement savings, probably causing American consumers to save at a greater rate – no bad thing, at all. However, with new business formation finally recovered, maybe even to 1970s levels, taxes down and productivity growing again, there should be plenty of opportunities for those affected by the bankruptcies. Disruption there will be, but provided something like the current economic policies are kept in effect (ideally with cuts to public spending) the economy should continue pretty satisfactory for Main Street, even if Wall Street is forced to tighten its belt or possibly – perish the thought — find new employment.

“Blow, winds, and crack your cheeks! rage! blow!
You cataracts and hurricanoes, spout
Till you have drench’d our steeples, drown’d the cocks!”
wrote Shakespeare in King Lear. A good Schumpeteran hurricano is just what the U.S. economy – and indeed, the global economy – needs. I cannot wait for the surge in innovation and new businesses this will bring!

(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.)