When anyone talks about macroeconomics and the boom/bust cycle, they more often than not focus on the big picture: GDP growth rates, inflation expectations, and central bank policies. In most of my articles, I am as guilty as anyone else of this. So today, I want to switch it up and discuss the boom-and-bust cycle from the perspective of a small business. How is that a period of low interest rates and excess credit can cause such widespread destruction among enormous banks as well as small businesses? After all, it's not like Mom and Pop were playing with risky derivatives.
Suppose I was starting a new business during a credit bubble. Let's say that it's something somewhat bubble-related, perhaps a high-end kitchen accessories store. Since I'm a very prudent person, I'm not just starting my business on a whim. In fact, I've done some serious calculations to discover that my monthly profit margin would be about 20%. It's not huge, but enough to start my small, high-end kitchen accessories store.
How do the Fed's policies affect my decision to open? First of all, consider that interest rates factor into my overall monthly profit margin. With rates extremely low thanks to the central bank, my business can finance its startup expenses at a much lower cost. If interest rates were much higher, my margin would be necessarily lower. As a result, the interest rate could determine whether my business is worth starting or not. If my margin after debt was only 15% rather than 20%, the business might look too risky, with only a small cushion should something go wrong.
Another way of putting it is that I'm starting a business which, under other interest-rate circumstances, might not make sense. See the problem here? Rather than the strength of my business determining its viability, rates have become a primary issue.
Now you might be thinking to yourself, how many businesses does this really affect? How many people are starting such marginal business where the outcome depends on interest rates? That's a great question. The majority of new businesses wouldn't cut it so close. However, it does happen. Think about investors flipping houses on adjustable-rate mortgages. When rates started to rise, many almost instantly went bankrupt. This is one of the clearest examples of low interest rates leading people to malinvest in projects which don't make sense. If interest rates were higher, they likely would never get themselves into the same business.
Beyond the interest payments on your debt, a second part of the profit margin is affected by low rates and plentiful credit. My margin calculation assumes that the current demand for kitchen accessories is realistic and stable. However, in a credit bubble, the demand in the economy may not be a reflection of long-term demand. Since credit is cheap, I'm starting my own business. But there's a few stores next door opening up too. And other people in the economy are taking advantage of the cheap credit as well. Whether it's through spending more through credit cards or getting a second mortgage on the house, everyone is flush with money.
And with so much money flowing around, demand is being fueled by the cheap credit. Without the cheap money, my kitchen accessories might not be huge sellers. I might not be able to charge as much for my products, and my business idea might not break even at all.
However, at some point in any credit-induced bubble, the money stops flowing into the system and the problems begin to arise. In one case, the central bank may contract the money supply and raise rates to battle inflation. In another, the credit expansion could just reach its limit. When almost everyone has maxed out their credit cards and taken second mortgages on their homes, where else is there left to go but down? Necessarily, spending will take a dip to match the realities of their debts.
When the inevitable contraction of credit happens, the demand for my products will plummet. For example, my monthly margin might fall as low 5%. At that point, my business no longer makes much sense. Things often get even worse from here. Other marginal businesses begin closing down and laying off workers. And guess what this does to my margins? I'm getting battered even more. At that point, I'm likely operating at a loss.
My kitchen accessories store was built with the assumptions of a high-demand bubble environment. In the credit-contracting economy, it no longer makes economic sense as a going concern. The business essentially just loses money. It is a malinvestment and a waste of capital.
In a recession, these wastes of capital are cleansed from the system. The economy slowly repairs itself through new businesses. The new businesses are built assuming the margins of hard times and credit constraints, i.e., assumptions of real demand versus the illusion of prosperity created by cheap credit. Businesses built with these assumptions become the bedrocks of the economy. They make sense as an investment of capital regardless of the Federal Reserve's actions.
During the current recession, plenty of businesses have been very successful. They make their business plans based on the new normal around them. For example, Apple isn't a successful company because of the Fed's interest rates or artificial demand. It has a product and cost structure which appeals to consumers despite the economic turmoil. The company's growth is based on real, long-term demand for its products. If the economy started booming tomorrow, surely Apple would sell even more iPads and iPhones, but its business plan does not require boom-time demand to make economic sense.
So is my kitchen accessories store doomed? Not necessarily. When things hit the fan, central banks try to keep the party going as long as possible - hence, the Federal Reserve's near-zero interest-rate policy. Not only does plenty of cheap credit allow businesses to refinance, but it also fuels more artificial demand.
This helps business across the board, but the biggest beneficiaries are the most marginal ones. In a way, it's a backdoor bailout for the worst investments of the bubble period. Think again about the guy flipping houses with adjustable-rate mortgages. He gets the biggest benefit from lower rates. The average homeowner might have a slightly higher home value as a result of additional demand, but his gain is not huge. Sure, housing prices are bad now, but trust me, if 30-year rates jumped to 8% or 9%, the already low demand for the homes would fall through the floor.
Because of loose monetary policy, people make bad long-term business decisions. It's not necessarily their fault. All too often, we try to attach some sort of moral connotation to their decisions, i.e., they were greedy. However, what happened across the country is that everyone from small business to house flippers to bankers saw a lot of money floating around them. They saw an opportunity and jumped on it. In some ways, they were smarter than many of us who did nothing. That said, their mistake was confusing decades of monetary stimulus for real growth in the wealth of society.
The main takeaway as an investor or even as a business owner is to assess the economic environment around you prior to making a long-term investment decision. Is the economic growth in your community real, or temporary and fake? Has your community really gotten wealthier as a result of growing capital, or is it stimulus fooling us again? It's not an easy question to answer. So many people were sucked into bad investments during the boom for the very reason that it can be hard to tell the difference. Those investments typically don't come with a warning sign, and there are few barometers to help make one's decision.
However, there is one barometer which is a sure sign - interest rates. And unfortunately for us, they've been extremely low for quite some time. Does that mean the demand in the economy is all illusionary? No, but some part of it is. The million-dollar question - if not the billion-dollar question - is how much of the demand is real and how much is fake.
Source: Casey Research
