Note: ZIRP is an acronym for zero interest rate policy. ZIRP became popular with the financial media after Fed Chair Bernanke cut policy rates to zero from 5.25%.
Albert Einstein said that “Imagination is more important than knowledge.” He didn’t make this statement to deemphasize the importance of facts but to accentuate how the combination of knowledge and imagination stimulates progress and the evolution of thought.
Today I ask that you activate your imagination and travel with me to a fictional place, the planet ZIRP, to expand your perspective on the current market volatility that’s dominating financial headlines. Let’s fire up the rockets and blast off to a place where companies and economies go to regain their financial health- Planet ZIRP.
Setting the stage
There is nothing like a financial crisis and recession to separate smart, innovative companies that practice sound financial management from those who do not. Warren Buffet said it beautifully in early 2009, “only when the tide goes out do you discover who’s been swimming naked.”
In the theoretical world of pure and true capitalism companies compete and evolve without a safety net, driven to excel by Darwinian forces of natural selection, what the economist Joseph Schumpeter called Creative Destruction. Driven by a fear of failure and extinction competitors struggle, fight for turf and innovate to stay a step ahead of the axe.
The Financial Crisis and Great Recession created existential threats to many industries, especially banking. The peril was exacerbated by globalization. The interconnectedness of national economies served as a conduit, spreading financial instability and then economic contraction around the world.
Darwin and Schumpeter be damned! Central banks intervened in market capitalism trading competition and innovation for a chance at survival. They dropped interest rates to zero and printed money to prop up failing companies, provided near free credit and stem rising unemployment in hopes of avoiding a global financial seizure.
Thus, begins our trip to Planet ZIRP.
Imagine….
On Planet ZIRP extremely low interest rates and exploding money supply produce zero gravity. Planet ZIRP’s medicinal, recuperative powers originate from the absence of gravity and lots of nearly free money. It is an ideal environment for those companies who have become sluggish, inefficient and downright unhealthy to regain their competitive edge. Weak and infirmed companies go to ZIRP to recover from poor financial diets and bad habits acquired during times of great abundance.
During the good times companies can grow lazy, failing to innovate, often feasting on the low hanging fruit of short term and unreliable derivative financing. Rather than fighting for new market share and increasing revenue, they borrow from future earnings, believing the abundance will continue indefinitely. Leaders procrastinate, basking in the limelight, enjoying the trappings of success, inviting the conditions of their own demise.
Putting off the hard work that keeps them fit and battle-ready companies become soft and vulnerable. They lose the competitive hunger and ability to hunt for growth. The gravity of market driven financial demands weighs them down and the axe gains ground. A trip to Planet ZIRP and its zero gravity is all that stands between the vulnerable company and extinction.
One man’s interest expense is another man’s interest income.
A trip to Planet ZIRP provides an opportunity for many companies to regain their mojo by reducing borrowing costs but it puts others in immediate jeopardy. Insurance companies, pension funds, retirees and other fixed income investors who rely on interest income for their survival assume the role of sacrificial lamb. These companies are deprived of their primary source of sustenance to subsidize the recovery of the faltering companies. Economists call this strategy financial repression.
Don’t stay too long…
All companies and economies that overstay on Planet ZIRP eventually suffer negative consequences. Exercising competitive muscle at zero gravity is only a temporary solution with rapidly diminishing returns.
The directors of ZIRP must ensure that visiting companies use the opportunity to reshape survival strategies, reform financial diets and prepare for the difficult struggles associated with a return to “normal gravity.” Many companies will use the reprieve wisely, others will fail to break old habits. Some will merely camouflage weakness, suck in their tummies, puff out their chests and declare victory.
Departing Planet ZIRP involves considerable risk.
The escape from Planet ZIRP, particularly after a prolonged stay can create unforeseen consequences. For the best possible outcomes, the return to normal gravity should be pursued cautiously and gradually providing visitors an opportunity to adjust to the stresses of normal gravity.
Under some circumstances it becomes necessary to accelerate the return and re-acclimation process. The uplifting conditions on Planet ZIRP may cause a visiting company’s perceived value to inflate and occasionally bubble and pop! Unfortunately for investors it is difficult to know which companies have regained competitive fitness and which are headed for trouble. Those revived in the cushy environs of Planet ZIRP don’t always survive a return to the market driven jungle.
Visitors have never stayed at Planet ZIRP for seven years before. It’s difficult to know how many will burn up upon reentry.
Companies that comprise the global economy are in the early stages of liftoff from planet ZIRP. Thrusters that have been applied sparingly since 2015 are now accelerating a bit. Some central bankers believe further acceleration is needed to avoid undesirable consequences while others are more sanguine.
Back to reality…
Markets hate uncertainty. Inflation is scant today but might be increasing. America has a new Fed Chair in Jerome Powell. Will he be supportive like Bernanke and Yellen when risk markets get rocky or let valuations find unfettered price equilibrium? A laisse-faire Fed Chair would certainly be a cause for concern for those accustomed to more generous accommodation.
The recent gyrations in stocks and other risk assets emanates from uncertainty. Rising interest rates will expose the companies unable to rehab at near zero cost of funds. As borrowing costs increase, the threshold of profitable return on investment rises as well. We’ll soon know who is swimming naked.
Thanks for powering up your imagination and joining me on Planet ZIRP.
