Central banks across the world have been trying to reignite inflation by injecting a massive amount of liquidity and buying financial instruments, most recently corporate bonds. In theory, a higher supply of money should devalue the currency, thus boosting both exports and domestic demand. In particular, demand translates into more investment, which is a necessary cornerstone for long-term growth. Needless to say, this classic monetary tool has been more than widely used over the last few months. But the target remains out of reach in many countries. Despite more than $1tn of debt now yielding negative interest rates, inflation barely climbed to 0.6% in the UK. The US Fed is considering raising interest rates again although inflation in the US is 2.2% and thus barely exceeds the official 2% target.
I have already highlighted in this blog the importance of confidence in driving the decision of individuals. When people are confident about the future (i.e. they can predict with relative certainty the future state of the economy and the implication for their personal wealth) they do not hesitate to invest part of their income in ‘non-vital goods and services’ such as domestic appliances, automotive etc. The same logic applies to companies – this is what we call investment. Today’s environment largely lacks visibility. Geopolitical concerns (elections in the US, France and Germany, Brexit in the UK, tensions in the Middle East) make economic decisions even harder to predict. As a consequence, despite the affordability of debt, households and companies prefer to save today in case the situation gets tougher tomorrow. The resulting drop in demand has been widely pointed out as a cause for low inflation or potentially deflation in some areas (e.g. food in the UK).
Not only are hyper-low interest rates inefficient, they are counterproductive, and central banks should raise interest rates as early as feasible. Let me explain. The excessive amount of non-invested liquidity has led individuals and companies to invest in financial assets such as bonds or funds. Venture capital funds have been particularly in demand given their risk-reward profile; they tend to be more risky than ‘plain LBO’ funds and according to theory should yield better expected returns. Unsurprisingly E&Y in its latest global venture capital trends report states that venture capital deal activity increased by 54% in 2015 to reach $148bn.
Flooded with liquidity venture capitalists are begging for start-up ideas to invest their money – given that the worst scenario for an asset manager is to show his investors that their commitments are sleeping at the bank. The number of start-ups has been logically soaring in all developed economies as a result, sometimes giving birth to incubators, the most famous certainly being Rocket Internet, and a few have been raising tens or even hundreds of millions of dollars to boost their development.
In the 2.0 economy, where marginal costs are almost non-existent and barriers to entry are low, ‘customer acquisition’ and ‘network effect’ are the new mantras. Rather than investing in expensive marketing campaigns, start-ups have decided to invest in prices, most often selling their services at a loss to ensure maximal penetration. Uber is a good example. Rides in London are on average 30% cheaper than a black cab. The company is present in more than 500 cities and has been valued at $68bn in its latest fundraising round completed last year. And yet, Uber reported $1.2bn in losses in H1 2016 – this raises a broader debate about the criteria for start-up valuation, which we will address in a later post.
Private investors have shown patience so far, hoping that the ‘hockey stick’ will materialise. And if it does not, investors often believe that it is simply due to a lack of scale and that further investment is required to ensure the user base is large enough to prove profitable. The stock market, conversely, has been indifferent to this thesis and very few start-ups have succeeded to make a strong enough profit to reach the IPO stage – a feature that differs from the 2000 ‘dot-com’ bubble.
My point is that for months now many aspects of our daily life have been ‘subsidised’ by increasingly risk-seeking venture capitalists and that behaviour has largely been driven by the abnormally high amounts of liquidity made available by Central Banks. Paradoxically, these start-ups have most often been bringing down prices and ultimately favouring deflation, pushing Central Banks further away from their initial objective. I am not saying that price cuts are always bad. But in this case price cuts have only come at the cost of corporate losses – simply put: value destruction.
The argument about the ‘hunt for worldwide scale’ is dubious. Although this hunt is legitimate in a limited number of cases (social networks represent the most typical examples), entering new markets brings limited benefits to most start-ups. When Uber decides to enter Santiago, it cannot rely on network effect: the taxi drivers operating in Santiago are different from the ones in Singapore and the customer base is also very distinct. Given the very lean cost base, the only synergy it can expect is the brand power – which may not justify hundreds of millions of dollars of losses. And, even if you do so, you cannot prevent an aggressive competitor to emerge with even lower prices – only the depth of the investors’ pockets will make the difference.
My recommandation to Central Bank governors is thus simple: raise interest rates and clean up the mess. We will not find growth by artificially subsidising value-destructing activities. The fear of the next crisis and the willingness to avoid recession at all costs are leaving everyone in doubt. Take the hit, start from a fresh and economically sane breeding-ground and build again from there.