Out of the groove
22 May 2018
US corporate insolvencies are running at low rates. Just over 23,000 businesses have filed for bankruptcy proceedings over the past year, the lowest recorded since before the financial crisis – which proved a traumatic event for firms. Indeed, the number of business failures more than doubled to over 60,000 in 2010, as the deepest downturn since the Great Depression took its toll. When we look back over the past 40 years it is clear that insolvency rates are sensitive to the cycle (see Chart 2). However, the degree to which these rise during downturns varies widely. Indeed, during recessions in the early 2000s and 1990s insolvencies increased as the downturn struck, albeit by a much more modest 10%. In comparison, the recession in the early 1980s triggered a larger shakeout, with bankruptcy filings up by over 40% six quarters after the downturn started. In part this reflects the differing severity and duration of these downturns. Moreover, this also likely relates to the extent of financial imbalances in the corporate sector, which were particularly large heading into the latest downturn. Finally, the interest rate environment is also critical in determining whether firms are able to service their debt obligations. With interest rates peaking at not far off 20% in the early 1980s as part of the Volker disinflation drive, it is perhaps not a surprise that insolvencies surged. Indeed, even after the downturn abated these rates remains high, reflecting an average interest rate just shy of 10% over the decade.
Looking forward, while there are few signs of rates reaching these heady heights, the Fed is actively tightening policy. Moreover, debt in the private non-financial sector has risen as a share of GDP to new record highs, reversing the deleveraging seen in the wake of the last crisis. The combination of these factors means that debt servicing burdens are likely to increase over coming years, putting more pressure on firms. A robust growth backdrop should help support profitability for the time being, while corporate tax cuts provide another temporary boost to earnings. However, we will need to watch the insolvency data carefully for any signs that the tide is turning. Insolvency rates started to trend higher around a year before the financial crisis struck.
Stepping aside from cyclical shifts, we have seen clear signs of a structural decline in bankruptcies over the past 40 years. The Census Bureau measures firm ‘exit rates’ which track the proportion of firms failing in any given year. This averaged close to 14% in the 1980s, 12.3% in the 1990s, 11.6% in the 2000s and 9.7% thus far over the current decade (see Chart 3). At first reading this may sound positive. However, this structural decline in exit rates, which has been mirrored by a similar slowdown in firm birth rates, reflects deteriorating business dynamism in the US economy. Business dynamism is critical for helping shake out underperforming firms and reallocating their resources to more successful companies/sectors. This Schumpeterian creative destruction is critical for boosting productivity. Worryingly, the decline in US dynamism has been apparent both geographically and across sectors, suggesting macro policy responses are required. One area of focus should be on boosting competition through stronger anti-trust legislation, patent reform and changes to occupational licencing. These steps may help firms enter markets, encourage less productive firms to exit and make the US economy more dynamic again.