Creative destruction is a concept in economics that describes a process in which new innovations replace and make obsolete older businesses and technologies. An economic slowdown or recession literally destroys many businesses in an economy because they can no longer operate in a more challenging demand environment, or with higher interest rates.

This act of destruction is positive in the long run for other more productive businesses, who will then have access to capital, labour, and investment which otherwise was being used by those now defunct companies.

In the short-term the destruction part of ‘creative destruction’ is all we see during a slowdown or recession. The drop off in demand in the economy hits weaker and more highly levered companies the most. Businesses with old products, or legacy technologies, some with high levels of debt, were able to survive during the previous economic upcycle. Rising demand across the economy often means that even poorly run companies with high levels of debt, out of date technology, etc. can keep generating enough revenue to survive.

But if the economic environment changes such that the revenue of these companies declines sharply, due to a demand slowdown, or interest payments on debt rise substantially because of elevated inflation and higher central bank interest rates, these same companies can very quickly find themselves insolvent and unable to continue doing business.

This shows up in economic data in the short-term as weaker output and GDP for the economy. The slowing of demand, or rise in interest rates, which triggers business insolvencies means higher unemployment as those companies shut down and have to layoff their staff. Those recently made unemployed have less spending power and so retail spending across the economy is negatively affected too.

The positive or ‘creative’ side of this destructive process takes longer but has a considerable positive long-term impact on the economy. Smaller and more nimble companies, those more likely to be the innovators of the future, typically with much lower levels of debt, much greater users of and owners of innovative technologies, these companies can, after the decline and fall of the ‘zombie companies’, have access to cheaper and more abundant capital, labour, and investment.

An example is helpful here. Imagine a large, highly indebted, poorly managed business manufacturing fax machines. It goes out of business during a recession. The factory premises they owned is an asset which other companies had no access to while it was still in operation. After the business goes under, that asset is now available to more productive businesses who can use the real estate in a more efficient way, creating more wealth and employment for the economy in the long-term.

Scaling up this example across an entire economy has a significant impact on the availability and cost of factors of production for the more productive businesses who survive a recession, or period of rising interest rates. Imagine trying to grow a business selling a new innovative technology, and then very suddenly the costs of labour decline, availability of investment capital rises, and the cost of renting or buying real estate, offices, etc. all come down. This would have a very positive effect on your business. Scaled up to the economy, the medium-term impact is very positive, with older less efficient users of the factors of production replaced by the more efficient.

Over the past 18 months we have seen interest rates around the world rise quickly in response to higher inflation. This has already or will soon (depending on debt term structure) start to push up the interest costs on companies with high levels of debt. Many of those companies are older, less efficient, poorly run companies who have managed to survive thanks to interest rates remaining rock bottom since 2008.

Higher interest rates are having an effect already. Corporate bankruptcies in the US are hitting their highest levels since 2010. The UK is already at a post-2008 high for business failures. Rising levels of business failure are now evident in the Eurozone too.

These data are being interpreted negatively in the news as it means we could see slower economic growth and potentially a recession. While we remain on the fence about the possibility of a recession in the short-term, we note with optimism that higher business failures in the short-term of inefficient, highly indebted companies, and their replacement by more agile, innovate businesses, lays the groundwork for the next innovation cycle and eventual stock bull-market rally.

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