The structural change that genuinely changes everything

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Over the past five years we have researched how the changes in the corporate sector globally – and in Europe in particular – are changing the potential growth of economies, the behaviour of inflation and by extension voters’ preferences and preoccupations.

Here you find a summary of our findings and concerns.

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In 2018, we published a report documenting how we had observed an increasing widening gap between the performance of large and ultra-large companies and the small/medium ones. Back then, we highlighted that this process, in our view, was fuelled by three big trends: persistently low interest rates; deep globalisation; and the data-IT technological leap.

Each factor draws strength from the other two, and the three together make an increasing polarisation of balance sheets unstoppable, in our view, in the current macroeconomic and fiscal policy framework.

Globalisation and the data-led technological leap make global reach easier than ever before, and persistently low interest rates make leverage easier, which ultimately means faster business strategic decisions and thus represents an immensely powerful competitive advantage.

In 2018, we subsequently published a correlated report on inflation and why it was not as low as it appeared from the widely available consumer price inflation indices. Among the reasons we flagged then, we noted that the deepening of big data and artificial intelligence, make the pricing of items more complex in a way that it makes it more likely that national statistical offices are underestimating the actual pricing of goods and services.

In this presentation, we build on those two intuitions, and we expand them with the hindsight of a further year of research and the confidence that the process of the polarisation of balance sheets in the business sector (or what we also called “growing inequality of corporate balance sheets”) is the critical phenomenon that is behind the business cycle downturn that started last year and, in our view, will be the factor behind the next global recession.

We remain convinced that a global recession is highly unlikely soon, but we are very concerned that, when it hits, it will be worse than 2008 and the policy responses may be very different to what the markets have grown addicted to: monetary stimulus and mild fiscal support.

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The polarisation of business sector balance sheets has three critically important elements:

• the large companies in a country are getting bigger at a faster rate than the rest (size here should be interpreted as financial size, not in terms of employment);
• there are more and more of these “titans” as time goes by;
• and their size is now comparable in gross profit terms to the nominal GDP of a medium-sized country.

That is: the distribution of companies based on their financial strength metrics (profits, revenues or market capitalisation) has a long right-hand side, which is getting longer compared with the left-hand side of the distribution, where micro/small and medium-sized companies cluster. Even among the large and the very large, we can see a tendency for the largest or biggest to get bigger still faster than the rest.

The first legitimate question on this process is why should this be any different from the historical dynamic of the business sector, where large companies always existed.

The answer is twofold:

1. Historically, only a few sectors could aspire to become enormously large relative to the bulk of the corporate sector: banking and utilities. These sectors benefit from particular network features and, thus, to curb their natural monopoly or oligopolistic strength, special regulation is in place pretty much everywhere globally.
2. The second very important thing to remember is that, historically, these companies have been significantly limited by the geography of the country in which they reside: the European single market and lower barriers to trade have permitted banks and energy companies, for example, to expand their operations to other countries, but generally the home market remains the critically important one and they remain subject to extra regulation in most of the countries they operate in anyway.

This is not what we are facing today: where the ease of reaching global demand and recognition allows companies in pretty much any sector to behave or aspire to behave like an oligopoly.

Most sectors can see one or more companies aspiring to build a global oligopoly-like status, but we only regulate the traditional “network” sectors.

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In our view, the polarisation of business sector balance sheets has profound implications for economic growth and, in this phase, the impact is largely negative.

First, the more this trend carries on, the more there is a crowding out of the market share of micro to medium-sized companies, which are responsible, on average, for half of the employment in any country. The more the smaller end of the balance sheet distribution spectrum is squeezed, the lower, on the margin, will be the benefit of robust real GDP growth on employment. Beware that we are talking about a less powerful connection between real GDP and employment, not that employment cannot get better.

Crowding out of SMEs also implies less support for investment in the aggregate for that segment, which largely invests out of retained earnings and expected future demand.

Secondly, polarisation implies an imbalance in the competitive equilibrium present in an economy. Beware that competition is a changing phenomenon, not a static one; however, broadly speaking, the deeper the polarisation, the less competitive the playing field in the business sector becomes; and, the more widespread this phenomenon is, the less likely it is that it will self-correct.

• Financial power is an important factor defining access and protection from and by the judicial system.
• Balance sheet size means visibility at the policy-making level: the bigger, the more visible; while, at the smaller end of the balance sheet distribution, government policies become increasingly less well-tailored because companies become too small, less visible and, thus, less well-understood in a timely manner.
• Financial size affects the speed at which a company can respond to a change in the business environment; in particular, how quickly it can adapt to the changes brought about by big data and artificial intelligence.
• Ultimately, financial power dictates a company’s ability to survive and how long other companies can survive as well. In fact, the more the SMEs are squeezed, the harder it becomes for new companies to break through.

Any country, to sustain a healthy degree of employment, social prosperity and, thus, a robust real potential growth rate, needs:

1. a high birth rate of new companies;
2. a decent survival rate of new companies;
3. and a reasonably dynamic process that allows the occasional small company to grow in size and eventually become dominant.

Only 1) does not guarantee stable potential growth – it can simply be an indication of changing labour market dynamics, but not one of a healthy business environment.

Only 1) and 2) are not a sufficient shield against the changes that are brought about by polarisation at the global level. You can have a country of plentiful and skilled entrepreneurs but, if they do not reach a sufficiently large scale, they risk becoming easy prey for external players, which will not safeguard potential GDP growth, in turn.

Ultimately, what we are saying is that the polarisation of balance sheets eventually brings down the real potential growth of an economy.

This process is not immediate because, in our view, there needs to be a certain critical threshold of “imbalance” to “backfire”, so to speak. Think, for example, about a small open economy at the beginning of a large wave of foreign direct investment. In that phase, usually there is a phase of polarisation because the incoming companies tend to be much stronger in terms of financial strength than the domestic companies. However, this process also brings knowhow and better integration with global supply chains and a widening of the aggregate production ability of the country, so it is largely beneficial.

However, this is only one side of the story. The negative side is what is becoming clearer, especially in the past 10 years and particularly in Western Europe. The fact that it hurts Europe more today does not mean that other countries are immune. It only means that it will take longer to reach them.

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