Future Economic Trends: Innovators, Disruption, Cycles, and the Threat of Stagnation
The old adage, “If a tree falls in the forest and no one was there to hear it, does it make a sound?” can also be applied to business. If an individual has invented a new product or has an idea for new service but does not have capital to bring it to the marketplace, is it really a breakthrough?
A key component in taking a product or idea to the marketplace is private equity—namely, the pooling of funds from major firms such as the Blackstone Group, Kohlberg Kravis Roberts, the Carlyle Group, or dozens of other private equity outfits and/or from very high net worth individuals who take part ownership in a new venture. These funds make it possible for a start-up to invest in capital equipment, software, R&D, and hiring key personnel. If the new product or service has a successful “incubation” period, then the company may go public with an IPO—an initial public offering—to raise additional funds from the general public and institutional investors.
In recent years, private equity has been very active in buying the songbooks of major artists such as Bob Dylan and Taylor Swift, allowing these artists to “cash out” this valuable asset. However, David Stockman, former director of the Office of Management and Budget during the Reagan administration, points out how private equity firms such as Bain Capital rode the financial bubble to great profits by loading up companies with debt, “cashing out” and leaving shareholders holding the bag.1 Private equity, therefore, was criticized for hollowing out companies at the expense of employee, shareholders, and local economies.
Nevertheless, private equity plays an enormous role in the U.S. economy, creating value for consumers, employing millions of U.S. workers, and increasing wealth for pension plans and other institutional investors.2 Smith and Earle cite a report issued by Ernst & Young revealing widespread economic impact of private equity-controlled firms, such as employing eight million workers who are on an average salary of $71,000 annually. These firms also generated more than $1 trillion in account activity in 2018.3
During the 2020 pandemic, despite the private equity investment ($708.4 billion), the number of deals (5,309) declined—not unexpectedly —from a year earlier. It was the first annual drop since 2009, as the first half of the year put a lot of deals on hold.4 However, as 2020 unfolded, private equity deals picked up steam as the year drew to a close. And as we shall see below, private equity has been funding the “disruptors,” start-ups that have been in the vanguard of the latest generation of innovators who have been creating solutions in virtually every sector of the economy.
Innovation will cause disruption in businesses where new processes are created to challenge long-established firms. For example, technology is one area that has caused a major disruption in how people get their news. Newspapers were completely derailed and disrupted from this outside force. If you plan to be a disruptor, then you are more likely to be prepared for when a disruption comes into your own business and impacts the way your customers perceive the product or service. Private equity allows entrepreneurs to figure out ways to upend the status quo and conduct processes and tasks in a new manner.
Innovator and disruptor Elon Musk has established a new way of thinking in education by disregarding grades or set class structures. In 2014, he opened a nonprofit school at SpaceX headquarters with these new ways of learning and allowed students to even opt out of subjects they do not enjoy. To be a disruptor in business and in society, one needs to look for inspiration even in the most unlikely of places. Often humans fear change when they should embrace it and be preparing for the next upheaval, whether in business models or the consumer market. Even Deloitte reported that “90% of managers and executives surveyed said that they expect technology to disrupt their industries” but less than half said they are prepared for it. This shows that many entrepreneurs know they need to prep for change, but they struggle to become prepared.5
Since 2013, cable channel CNBC has compiled an annual Disruptor 50 list which it announces every June. For the past eight years, 58 other companies went public via an IPO (Peloton, Casper, and DoorDash, to name a few of the recent start-ups that have gone public) or by direct listing. Large companies such as Facebook, Alphabet, Microsoft, Verizon, and American Express have acquired one or more of the 33 companies that were on the list. Not surprisingly, eight companies fell by the wayside.6
The start-ups on the 2020 list include disruptors in higher education, e-commerce, cosmetics, language instruction, warehousing, trucking logistics, and in virtually every sector of the financial world. Thirty-six of the companies have already passed on the billion-dollar market valuation, and have raised $74 billion in private equity, implying that all 50 companies have a total market valuation of $277 billion. In addition, 37 companies have hired new employees because of the increased demand for their products or services as the pandemic unfolded.7
The companies that have made it onto the Disruptor 50 list are a reflection of human ingenuity that continues despite business cycles, financial bubbles, burdensome regulations, and shifting tax policies, which have affected to some degree the firms’ revenues and profitability. Nevertheless, disruptors have proven to be resilient and successful for longer than the eight years CNBC has been compiling its list. Companies such as Amazon, Netflix, and dozens more are changing the business landscape and by doing so improving living standards for the vast majority of Americans. This will confirm Warren Buffett’s insight that the best days of America are still ahead.
Business Cycles as Far as the Eye Can See?
As we have seen in Chapter 2, the U.S. economy has had booms and busts since its founding. In the 19th century, banking panics occurred periodically because the banks created more banknotes than the gold and silver they had in reserve thus creating an unsustainable boom in their communities. When depositors became concerned about the solvency of their local banks, they attempted to redeem the banknotes for “specie” and if they were lucky enough to be the first in line, they got “real money” in exchange for their paper banknotes. Latecomers to the banks would get a percentage for their banknotes or nothing at all.
When it was founded in 1913, the mission of the Federal Reserve was to “smooth out” the business cycle, maintain the purchasing power of the dollar, and end bank runs by becoming the “lender of last resort.” The evidence is clear: the business cycle has not been dampened, the dollar’s purchasing power has declined by 95 percent since 1913, but the Fed has injected “liquidity” into the financial sector to prop up banks and other institutions. In other words, the Fed has the “backs” of the bankers.
Despite the Fed’s failure to create a sustainable economy, its mission has shifted over the years and now is focused on targeting the consumer price inflation rate to 2 percent annually and promoting “full employment.” In other words, the Federal Reserve’s primary tool—targeting short-term interest rates, the so-called Fed funds rate—to achieve its goals has caused another set of distortions and dislocations in recent years, massive financial bubbles in the stock market and real estate.
After the Great Recession (2007–2009), the so-called everything bubble began lifting stock prices and other assets to frothy levels. The pandemic of 2020 caused the shortest and swiftest drop in the stock market from February to March, and the subsequent boom in the stock market and real estate prices reflected the enormous amount of liquidity the Federal Reserve created (Figure 10.1) to prop up the economy as both short-term and long-term interest rates declined markedly (Figure 10.2 and Figure 10.3).
As governors and mayors locked down their economies and the unemployment rate soared (Figure 10.4), federal spending increased dramatically (Figure 10.5), and the federal budget deficit skyrocketed (Figure 10.6). Policy makers used all the tools at their disposal to make up for lost income of individuals and businesses and to keep rates low to “stimulate” spending and investment. Although the economy has rebounded from its pandemic lows, there is growing evidence that consumer price inflation will accelerate, which is not surprising given the 25 percent increase in the money supply in 2020 (Figure 10.7). Money supply growth always precedes price inflation.
Figure 10.1 Total assets (less eliminations from consolidation)
Source: Board of Governors of the Federal Reserve System (U.S.), Assets: Total assets: Total assets (less eliminations from consolidation): Wednesday level [WALCL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WALCL, March 01, 2021.
Figure 10.2 Effective federal funds rate
Source: Board of Governors of the Federal Reserve System (U.S.), Effective Federal funds rate [DFF], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DFF, March 01, 2021.
Figure 10.3 Ten-year treasury constant maturity rate
Source: Board of Governors of the Federal Reserve System (U.S.), 10-year treasury constant maturity rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DGS10, March 01, 2021.
Figure 10.4 Unemployment rate
Source: U.S. Bureau of Labor Statistics, Unemployment rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UNRATE, March 01, 2021.
Figure 10.5 Federal net outlays
Source: U.S. Office of Management and Budget, Federal net outlays [FYONET], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FYONET, March 01, 2021.
Figure 10.6 Federal surplus or deficit
Source: U.S. Office of Management and Budget, Federal Surplus or Deficit [-] [FYFSD], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FYFSD, March 01, 2021.
Figure 10.7 M2 Money stock rate of change
Board of Governors of the Federal Reserve System (US), M2 Money Stock [M2SL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M2SL, March 30, 2021.
There are several scenarios besides higher consumer and producer prices in years ahead. The last episodes of higher inflation (1970s) were also known as the “lost decade” because the unemployment rate remained relatively high, the economy was buffeted by recessions, and real economic growth was erratic (Figure 10.8).
The stagflation scenario is based on the assumption that low short-term interest rates, which the Fed announced it would maintain until its inflation and unemployment targets are met, would not produce a robust recovery but higher prices and a subpar economy.8 In other words, if the Fed tries to “normalize” interest rates, an economic downturn would follow, which would cause it to reverse course and pump liquidity into the economy. Hence, stop-and-go monetary policy would give us the worst of worlds—higher inflation and recession: stagflation.
Another (ominous) scenario that was beginning to be discussed in early 2021 was the possibility of hyperinflation in the United States. Hyperinflation is typically defined as a period when prices are rising 50 percent or more per month. Something as inconceivable as runaway inflation in the United States would occur, and the Federal Reserve may have already planted the seeds of such a scenario in 2020.
Figure 10.8 Real gross domestic product rate of change
Source: U.S. Bureau of Economic Analysis, Real Gross Domestic Product [A191RL1Q225SBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/A191RL1Q225SBEA, March 01, 2021.
Although the rate of consumer price inflation has been tepid for more than 20 years, the historic increase and the money supply in 2020 could be a harbinger of how the Federal Reserve would react to a major stock market meltdown and/or economic implosion. The Fed’s unprecedented money printing in 2020 reveals how it may react if stock market fell off the cliff … again, and the unemployment rate skyrocketed … again.
One of the key factors in a hyperinflation scenario is when the so-called velocity of money increases exponentially as people want to exchange their cash and checkbook money rapidly before it becomes worth less and less as the central bank floods the economy with new money to prop up economic activity.9 In other words, a hyperinflation scenario would unfold if the Federal Reserve throws caution to the wind and floods the economy with an extraordinary amount of new money and people spend it like a “hot potato” to avoid losing the purchasing power of their dollar holdings.
Can hyperinflation happen in America? It already has. Inflation occurred during the Revolutionary War when the Continental Congress authorized the printing of money to pay for the supplies needed to fight the British and pay the soldiers.10 During the Civil War, the South printed money to pay for its secession effort and caused hyperinflation.11
So the real question is: can hyperinflation happen again? If foreign holders of dollars decide to swap them for other currencies, gold, crypto currency, and other assets, the value of the dollar would decline precipitously on foreign exchange markets. Thus, one of the leading indicators of a hyperinflation scenario would be the action of dollar holders around the world. If a “run” on the dollar unfolds, the Fed could buy up dollars with gold and other “hard assets” on its balance sheet or borrow foreign currencies from the U.S. Treasury to stem the collapse of the greenback’s value. But with trillions of dollars and U.S. government securities held overseas, a run on the dollar like a massive tsunami coming ashore would be devastating to the American people holding dollars.
In short, the U.S. economy could be on the precipice of a hyperinflation scenario. There is one sure way to prevent such a phenomenon and that would be for the Federal Reserve to stop printing money and allow the marketplace to set interest rates and prices. Unfortunately, the groupthink at the Fed still clings to the notion that the Fed can manage the U.S. economy with impunity for the betterment of society. Both history and theory suggests otherwise. Sustainable prosperity depends upon price discovery and sound money, which can only be accomplished by replacing the Fed’s targeting of interest rates and an “unlimited” checking account with a free market money and banking sector. Until that day arrives, we can expect more booms and busts, bubbles, and the possibility of hyperinflation.
Boom to Bust to Stagflation? Is the United States on the Verge of Becoming Japan?
One of the continuing fears of policy makers since the Great Depression is that deflation would occur again causing an implosion in economic activity as sales, investment, prices, and wages collapse producing widespread misery. According to policy makers and most economists, the pain of a deflationary depression thus must be avoided at all costs. But as economists who apply the Austrian theory of the business cycle point out, a deflationary depression is inevitable if the central bank inflates money and credit, which sets into motion an unsustainable boom.12 The so-called Austrian advice to avoid a depression therefore is for the central bank to refrain from manipulating interest rates below what the free market would fix and cease from creating new money, which inflates asset prices and both consumer and producer prices that will deflate when the bust unfolds.
In a free market, slowly falling prices, that is, deflation, is the “natural” tendency for virtually all prices as the output of goods and services increases as the supply of money is relatively stable. Even as the U.S. economy has experienced virtually higher consumer prices across the board since the 1930s, the prices of some goods and services have declined to reflect the enormous productivity in areas like high-tech (high definition television, computers, and so forth) and Lasik eye surgery—to name some obvious examples of how deflation benefits consumers and thus is a boon to society.13
As the pandemic was unfolding in 2020, the financial press began to cite the threat of stagflation—subpar economic growth and rising inflation.14 That could be one scenario in the cards similar to the Japanese economy experience since its huge bubble burst in 1989. When the Japanese bubble burst, policy makers implemented another round of easy money policies and robust government spending to boost the economy. The result has been three decades of lackluster economic performance and the creation of “zombie” corporations.15 These corporations are hanging on by a thread only because the central bank is subsidizing them in the form of ultra-low interest rates. In a free market, these corporations would have been liquidated or merged with a financially strong company so their assets could be put to better use.
Could the United States enter an extended period of stagflation with very low short-term interest rates to prop up shaky corporations? This is one of the real possibilities in a postpandemic America. According to economist David Rosenberg, “Stagflation is inevitable,” because costs are rising for producers, who in turn will raise prices for customers.16 In other words, it would be a period of so-called cost-push inflation. In the final analysis, inflation, as Milton Friedman reminded us decades ago, is always a monetary phenomenon; then any price hikes—wages, raw materials, consumer prices, real estate, and so on—are the consequences of the Federal Reserve’s creating new money.
Federal government’s “stimulus” spending in 2020 and 2021, the Federal Reserve’s commitment to keep interest rates low for several years, and the huge money supply increase in 2020 are all the ingredients for stagflation. For both large- and small-sized businesses, their task will be to use the tools outlined in earlier chapters to navigate the ebbs and flows of the economy during what could be a very tumultuous number of years in the 2020s.
Lastly, the so-called graying of the world’s population is well underway and the challenges for policy makers cannot be overstated. In addition, the opportunities for businesses are multifaceted. How will countries, especially the United States, deal with the pressures on social security and Medicare benefits promised to America’s senior citizens to avoid a reduction in benefits and higher taxes on workers to shore up the system, when the Medicare Trust Fund runs out in 2024 and the Social Security Fund runs out in 2031? And the pandemic’s impact on retirees and soon-to-be retirees’ plans may have been permanently transformed. Because of the depressed short-term interest rates, many senior citizens have decided to keep working because the return from their savings accounts is virtually negligible and thus their retirement income would be much less than expected.
An aging workforce may be a boon to businesses because older workers take fewer sick days, are more productive, and have more experience than their younger counterparts.17 Ironically, then, the looming trust fund crises may spark a productivity revival in American businesses. In addition, a major challenge facing America, given the enormous amount of deaths from COVID-19 in nursing homes during the pandemic, is how to provide safe facilities for retirees. One possible entrepreneurial opportunity would be to create small clusters of housing—serving 10 to 20 retirees—instead of nursing homes with dozens of residents.
As we have seen in virtually every sector of the U.S. economy, innovation and ingenuity are ubiquitous to America. If entrepreneurs have the freedom to innovate and are not stymied by unnecessary regulations, we should expect “disruptors” to tackle America’s retirement crisis with gusto. Time will tell if America’s policy makers will reverse course and not have the economy go down the road Japan has traveled for three decades. Implementing market-oriented policies in the 21st century would avoid the counterproductive stop-and-go policies that undermine sustainable prosperity. American businesses will survive and thrive by continuing to create value for consumers and focusing their attention on changing consumer tastes and preferences. Unfortunately, they may have to deal with future bubbles bursting, as long as policy makers believe they can—and have to—manage the $21 trillion U.S. economy.