I start from a personal experience and at the end of the story you will understand why.
My wife was hired in 2011 by an Italian software company.
In 2017, the branch of the company she works for is sold to an American company, in turn wholly owned by Goldman Sachs.
After 4 years, Goldman Sachs sells the branch of the company where my wife works (which is practically the piece sold by the original Italian company) at a higher price than it was bought. The new buyers are also Americans and in turn are controlled by an investment fund that at the time of purchase already has in mind to resell within 5 years the new entity born from the merger; this is evident from the new contract signed by my wife in which they give her stock options linked to the sale of the entire “package” within 5 years.
In 2022, my wife receives a very advantageous offer from another software company but she refuses because she is promised professional improvements in the research and development of the product.
Towards October of the same year things start to change. The manager of the project that my wife works on (the same one who had given her guarantees of investments in the development of the product) is fired.
He is not the only one to be fired, but for now they are sporadic and clash with the rigid protection of workers that we have in Europe that makes cutting heads more expensive than it is in America.
We are now in 2023 and following the example of large companies like Amazon, Google and X, the possibility of doing smartworking is reduced to a minimum with the excuse of having to work as a team …but the type of work of a programmer employed in a multinational company with offices scattered around the world involves contact with colleagues thousands of miles away and most of the time the colleagues you meet in the physical office do something else. Nor does the motivation of favoring the commercial activities that serve the offices hold up: in particular, my wife’s office is isolated 5–10 km from the first restaurant and since the covid-19 there is no longer a company canteen for employees.
It becomes progressively clear that the product and skills will be outsourced to China and India, where however the “brains” make the little for which they are paid. A suicide because losing who created and developed the product it means losing the product itself.
And we are in the present day when extensive layoffs have been announced.
Although not part of those who were fired, my wife has already found a new job that will start in February with another american software company, strategically autonomous. She will have increased salary and smartworking guaranteed by the absence of a physical office (except the central one in Milan).
Many older colleagues, with less skills will find more difficulty in reintegration and you can imagine the problems of a 55-year-old, single, with a mortgage, who worked for 25 years in the same company.
While everyone wondered why to make such a move that leads practically to the loss of a big part of the initial investment as well as the loss of work for many people, I think about it and explain to my wife my hypothesis, something like: “You know, I think this is the reason why they decided to put their hands on a “toy” that, although in need of new investments (the total transition to the cloud for example) enjoyed a good clientele (big luxury brands for example). With the risk of rates “higher for longer”, regardless of whether it was founded or not, they realized that this “game” of buying cheap and selling high does not work and they are running for cover. Which means cutting investments. And cutting costs, which means many lay offs”.
Let me explain my point of view.
There are 2 factors that have driven the economy of Europe and the USA from post GFC to today: near-zero interest rates, reinforced by QE and fiscal policy.
Zero interest rates favor 3 phenomena:
1 — Trading on unlisted companies which, like the listed ones, have seen their value steadly grow as we have seen well in the past decade.
2 — Zombie firms
3 — Public investments and welfare
The story I told you probably falls into the first case. The higher rates, prevented the plain and simple buy low and sell high. The phase of leveraged build-up was eliminated; in this phase, through the union of forces, business activities continue to support cash flow, grow, and repay the debt incurred following the acquisition, and then resell. And it is no coincidence that the second transfer of ownership was defined in 2021 when inflation was still seen as transitory without the need to raise rates to counter it. In a situation of low rates, there is no need to contain costs to repay the debt, and employees also benefit.
Similarly, low rates allow the proliferation of zombie companies: those whose operating profit does not cover interest costs and have poor growth prospects.
Zombie companies, therefore, are those that benefit from conditions of so-called ‘low financial pressure,’ linked to the low level of interest rates, thanks to which they manage to borrow money through high-yield bond issues, which the market readily absorbs, given the hunger for yield.
This phenomenon has gone hand in hand with ‘the incentives for some banks to repeatedly extend or alter loan terms so as to avoid writing off their loans (forbearance).’ (https://www.ecb.europa.eu/pub/financialstability/fsr/html/ecb.fsr202105~757f727fe4.en.html)
‘Corporate trading’ and zombie firms are two factors that have contributed over the years to support aggregate demand and lightening the burden that would have been unloaded on welfare.
While low interest rates are generally welcomed as they help businesses stay afloat and employees retain their jobs, they also lead to less competition and the survival of inefficient firms, known as ‘zombie’ firms.
These firms drag down the financial performance of more productive companies in the same industry. This phenomenon is referred to as ‘creative destruction,’ where only the most competitive and efficient businesses thrive, leading to overall productivity growth. However, this can result in job losses for those who are less prepared.
High interest rates can disrupt this dynamic, often impacting workers the most.
It should be added that in countries like Italy, the same ‘market distortion’ allowed by zero rates is operated by tax evasion. Working in the sector, I know well that the tax evasion of small and micro-enterprises is enormous and it is precisely that which allows many of them to survive. Paying all taxes would mean closing the activity.
Years of easy money have allowed brushing the dust under the carpet.
To calm the populist anger caused by inequality and asset inflation due to low or negative interest rates, politics has offered various benefits, such as tax breaks and generous pensions.
Many countries have been able to sustain social needs and expand welfare systems despite demographic decline, thanks to their relatively low initial debt levels.
Even before the pandemic, both public and private debt was already high and growing, with a high global propensity for deficits.
Western countries and China themselves face a dilemma: the ability to sustain growth through support and investments in key sectors while maintaining an adequate level of welfare and at the same time keeping the debt-to-GDP ratio below alert levels.
As long as money was cheap and easy, governments could spend without worrying about debt, but high interest rates make it harder for businesses to make profits and for governments to act.
Firstly, in a situation of high private and public debt and state deficits, high interest rates for an extended period can trigger a so-called Minsky moment:
Over periods of prolonged prosperity, the economy transitions from financial relations that make for a stable financial system to financial relations that make for an unstable system. In particular, over a protracted period of good times (the virtuous effect of growth rates higher than the average cost of debt), capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is a large weight to units engaged in speculative and Ponzi finance.
The current situation sees a combination of factors that make the risk of a financial and therefore economic crisis much more likely than in the last 2 years. Here’s why:
1- Two data points that highlight the extent of corporate trouble: companies have about $425 billion of dollar-denominated junk debt due to mature before the end of 2025, and market yields for speculative-grade bonds are now at least 3 percentage points higher than the average coupon the borrowers are paying on their existing debt. The higher borrowing costs that many companies face could cut into profits and increase the risk of default. Effects that could also worsen if, for example, large zombie companies in declared crisis were to provoke political intervention, with nationalizations, de jure or de facto. In that case, the result would likely be a worsening of the situation, with private debt becoming public, as happened during the European banking crisis.
2- We’ve committed to a shift in energy sources that’s irreversible. Sometimes, people mistake any deceleration in this shift as a sign that it might be abandoned, but we’re already too far along to stop now. This energy transition is driven more by economic factors than ecological ones; it’s about diversifying our energy sources and reducing dependence on unreliable nations. It promises to improve public health, lower healthcare expenses, and eventually lead to lower inflation. However, this change won’t be easy — many companies will struggle to adapt, and governments will likely have to spend more than they planned to support the transition. The recent increase in interest rates has particularly affected renewable energy companies by decreasing the future value of their profits and increasing the cost of raw materials needed for infrastructure. Companies with high fixed costs or those that require significant capital are especially vulnerable to becoming unproductive, or ‘zombie,’ companies. Government intervention to support these companies seems unavoidable.
3- In 2023, 66.8 million citizens received Social Security benefits, amounting to $1.23 trillion the previous year; studies predict that the Trust Fund will be depleted by 2034. At that time, without adjustments, the coverage of benefits will drop to about 77% of current amounts, due solely to the withdrawal of social contributions, i.e., the pure distribution component of the system. Some simulations, conducted over a standard 75-year time frame, indicate that an increase in contributions of 3.61% of payrolls would be needed to keep the system in actuarial balance at current levels. Social Security contributions today amount to 5.2% of the U.S. GDP. Once the Social Security Trust Fund is depleted, the benefits will be paid out from the ongoing payroll tax contributions collected from employers and employees. This means that the amount of benefits that can be paid will depend on the current inflow of taxes at that time. If the inflow is insufficient to cover the promised benefits, the benefits may have to be reduced unless other funding solutions are implemented. This situation applies to the United States but also to Europe. The latest U.S. employment data emphasize the increase in employment related to the welfare state and the public sector in general, so much so that it constitutes the largest slice of jobs created in the market.
There is a need to overcome this historic transition which will likely see an increase in productivity and a reduction in costs, thanks to the new energy paradigm and AI; on the other hand, there will be a rethinking of welfare, education, and healthcare. To do this, money is needed, and it can only come from the finances of the involved governments.
There is therefore a need to keep the debt-to-GDP ratio under control.
Given the necessity of running deficits, it is even impossible to generate primary surpluses.
So, what is the possible solution?
In October 2020, IMF Fiscal Affairs Director Vitor Gaspar told Reuters in an interview: ‘What we see is a one-off jump up of debt in 2020, then stabilization after 2021, and even a slight downward trend in 2025.
While public debt will stay elevated at about 100% of GDP, the resumption of economic growth and extremely low interest rates will help ease primary budget deficits.
The difference between interest rates and growth is not only negative but more negative — in our projections - than it was before COVID-19. So low interest rates play an important role in debt dynamics.’ https://www.reuters.com/article/us-imf-worldbank-fiscal/imf-sees-debt-soaring-but-stabilizing-at-100-of-gdp-if-pandemic-eases-growth-resumes-idINKBN26Z1PN/
The only way to manage the transition is to keep interest rates low.
This is possible by limiting inflation spikes as much as possible, and the only way is to ease tensions between the great powers, namely China and the USA, maintaining open trade as well as controlling trade routes.
As stated this week by Philip Lane of the ECB: ‘It is very important that the world has safe navigation routes and that measures are taken to make them safe again. If this turns out to be a persistent problem and global trade has to be diverted, we would have new, unwanted bottlenecks. But even in this scenario, there are different possibilities. Mechanically, the increase in transport tariffs would increase industry costs. But we could also have a deflationary effect, which would be unwelcome: many companies around the world could simply cancel orders and postpone investments. The result would be a more marked slowdown in the economy.’
https://www.corriere.it/economia/finanza/24_gennaio_13/philip-lane-bce-una-revisione-tassi-troppo-rapida-puo-essere-autolesionista-565ecb8e-b203–11ee-9299–5cd622bffa26.shtml
Just as there are forces pushing towards decoupling, exacerbating international tensions, there are others that act in the opposite direction. Regardless of the problem of having to deal with inflationary pressures
for an indefinite period of time with possibly a level of rates incompatible with global debt, the consequences of a trade conflict (up to a proxy war like the one in Ukraine, between NATO and China) would be lethal for both the West and China. I report an article by Joachim Klement that takes up an IMF study and an article by Bloomberg.
https://klementoninvesting.substack.com/p/geopolitical-decoupling-and-commodity
A team from the IMF has now built a model that looks at the global trade links of the 48 most important global commodities from crude oil via metals to palm oil and cocoa. They use this model to estimate how much prices in the Western bloc and the Russia/China bloc would change if trading between the two blocks stopped altogether.
Obviously, this is an extreme case, because even in an all-out trade war, trade in these commodities between the blocs would not stop altogether. Just look at Russia still being able to sell its oil and gas despite Western sanctions against it. But what this simulation does show is the sensitivity of commodity prices to a trade interruption and a trade war that affects them.
Effectively, what would happen is that the Western bloc would end up with a surplus of some commodities like iron ore or copper where there is more production than is needed in the region. Hence, steel prices
would drop a lot in the West and rise dramatically in China, which undoubtedly would put an end to a lot of the growth in infrastructure and real estate in that country.
But prices for magnesium and graphite, used extensively in the production of batteries and other renewable energy equipment as well as platinum, group metals, and rare earth metals would skyrocket in the West since we would be cut off from supply from China. https://www.bloomberg.com/news/features/2024-01-09/if-china-invades-taiwan-it-would-cost-world-economy-10-trillion
Invasion: China attacks Taiwan and the US intervenes. Taiwan’s GDP collapses by 40%, the US’s by 6.7% and the world’s by 10.2%. Japan, South Korea and Southeast Asia are the most affected. China suffers a contraction of 16.7% due to the war and sanctions. Blockade: China isolates Taiwan from the rest of the world. Taiwan’s GDP is reduced by 12.2%, the US’s by 3.3% and the world’s by 5%. China records a decrease of 8.9%.
I am glad you are posting your notes!