There Ain’t No Such Thing as a Free Lunch – Part 2
‘Situations emerge in the process of creative destruction in which many firms may have to perish that nevertheless would be able to live on vigorously and usefully if they could weather a particular storm’
One year ago, I posted an article discussing the negative side-effects of so-called quantitative easing measures, focusing on the asset inflation problem that leads to a financial squeeze of lower and middle classes in most developed economies (see There Ain’t No Such Thing as a Free Lunch)
Today, I would like to talk about another consequence of MMT that is related to the corporate sector.
Since Covid-19 pandemic hit financial markets, billion to trillion dollars stimulus packages and new unconventional monetary decisions have been announced in the US, in Europe and in Japan. The main motivation of authorities has been to counter the economic shock provoked by several weeks of human lock down. And one of the key measures has been a huge bail-out program for companies that would run out of cash because of this crisis.
People might say that such decisions are a natural application of the Keynesian theory. However, bailouts have become more and more frequent since the end of the 1990’s, and the amounts spent seem to grow at an exponential rate, raising questions about their real effectiveness.
Before moving forward, let me remind what we have already experienced so far: the spectacular LTCM bail-out in 1998, a big interest rate cut by the Fed after 9/11 that also came during the burst of the dot-com bubble, the massive bail-out of financial and mortgage institutions in 2008, and finally the rescue of indebted Southern Europe countries in 2012.
In 2020, the situation seems to have worsened again with various types of non-financial firms now requesting help from authorities. Boeing is probably the most emblematic of them. A company that announced a $20 billion share buyback program in 2019, granting a $60 million bonus to its CEO recently, and that is now facing a $6 billion cash burn problem.
Of course, aircraft constructors and airlines companies should not be accountable for the coronavirus pandemic. But one could argue that a well-run company should have taken advantage of good economic conditions to reinvest in its business and grow its cash reserves in order to prepare for a potential downturn. The truth is that many of those companies chose instead to increase dividends and share buybacks, some of them issuing new debt in order to finance those programs.
Cost of Capital and Economic Value Added
The problem is that we have lived in easy money conditions for almost two decades. And equity valuation has become the new norm for many people, from shareholders to executives. Some VCs have warned about startup founders chasing fundraising and high valuation instead of focusing on the quality of their project. Listed tech companies have suffered from the same bias, looking for high market multiples in order to offset weak balance sheets (e.g. Tesla).
But even larger firms from more traditional fields have suffered from that, giving priority to non-profitable activities and/or buying their own shares in order to boost the stock performance. In a financial environment characterized by low economic growth and negative yields, investors have always welcomed such decisions.
From startups to S&P 500 giants, MMT has led economic agents to seriously underestimate the cost of capital of investment projects. Thus, it has become more difficult to appreciate the real quality of cash flows, leading to a wrong perception of the economic value-added concept.
Bailouts and money printing measures derive from a post-Keynesian vision of economic policy. From this perspective, money is assumed to be only a flow and debt creation is a necessary condition for growth. However, after several decades of high public deficits in many countries, and years of quantitative easing, the impact of those measures on GDP is doubtful.
Actually, the rise of monetary easing solutions in Western countries could be treated as the political by-product of a structural organic demand problem affecting their economies. In a coming article, I will detail the reasons for this long-term decline of domestic demand in the US, Europe and Japan.
In my opinion, bailouts and quantitative easing are likely to fail to address this problem. They could lead at best to a short-term economic and social relief, but definitely not to long-term self-sustaining growth.
Besides, they might even worsen structural issues because of negative externalities such as moral hazard and the accumulation of non-performing assets among the private sector, with more bad investment decisions to come and mismanagement. Said differently, the absence of creative destruction might undermine Western economies for years.
As far as today, many developed countries have embraced MMT and the infinite bailouts idea. Nevertheless, it is worth noting that China has recently started to fight against excessive leverage and zombie companies. Since the non-performing loans crisis of the 1990’s, Chinese authorities had solved almost every debt problem sweeping under the carpet. But things dramatically changed with the rise of Xi Jinping and his will to open a new economic era based on a more sustainable model. Will China succeed on establishing a more balanced macroeconomic system?
As already mentioned before, the ongoing health and economic crisis might be revealing a slow but powerful shift in the world (see Reverse Black Swan?). Therefore, from a long-term investment perspective, everyone should carefully look at the fundamentals of each region.
This article was originally published on LinkedIn April 8, 2020.