U.S. Monetary Policy and the Quality of Everything
An investigation into the economic incentives created by Federal Reserve policy and their impact on Quality.
I just finished reading Christopher Leonard’s The Lords of Easy Money in which he brings you through the history of U.S. monetary policy in the years following the 2008 financial crash. He explains what actions the Federal Reserve took to bring us out of the recession and what they have done since. During that time, he explains, the Fed kept interest rates pinned at near zero, offered forward guidance for the first time in history, and initiated a program of quantitative easing. He refers to this, generally, as a policy of “easy money.” For the purposes of this article, I will focus mostly on interest rates as the defining feature of the policy; interest rates are the most straightforward measure to comprehend and this is an article about Quality, not macroeconomics. I think it is worth reflecting on what the Federal Reserve has been up to and the impact it has had on Quality during this period, which extended into early 2022.
A prolonged period of near zero interest rates, with forward guidance, incentivizes organizations to utilize more and more debt to finance their operations. The most optimistic interpretation of this policy suggests that it allows businesses to expand their operations, increase investment into new technologies, and create more jobs. That all sounds good and has occurred in some cases. However, easy money has not solely incentivized investment in the growth of organizations. The best example of the kind of Quality-decreasing financial mechanisms that come from an extended period of easy money, as Leonard describes, is the Leveraged Buyout (LBO). According to Seeking Alpha, an LBO is a tool that “…creates leverage for the buyer. This means that a buyer may only need to come up with 15% of the capital to buy the company, and investors back the remaining amount through loans that require repayment over time from the cash flow of the company.” You might be asking yourself: How does this decrease Quality? Simply put, it takes money that would typically be reinvested in the company to help it grow and reallocates it to service debt obligations. The debt, instead of being used to help the company grow, is used to pay out the previous shareholders, and unless the organization is employee-owned, the majority of shareholders are typically made up of the executive team and outside investors.
To illustrate how it plays out in real life, let me use an example from what I have seen in industry. I was on a team within in a large organization that was dedicated to acquisition integration. My take-away from that time was simply that large organizations do not prioritize acquisition integration. The prevailing attitude was that a given acquisition wouldn’t be part of the organization for long, so it was not fiscally responsible to dedicate resources to improve Quality. These acquisitions, or at least the sheer quantity of them, are made possible by mechanisms like LBOs. Larger organizations will utilize an LBO to acquire a smaller organization with an innovative technology that is growing and hasn’t figured out how to economize at scale. The founders agree to the acquisition, convinced that the resources of the larger organization will help them accomplish their goals. In many cases, this is followed by an effort to drive costs down to increase profit, with no consideration given to Quality. Once the bottom line is improved, the once promising company is sold off again, no closer to achieving its goals. The executives who are responsible for this receive bonuses or promotions, as they were able to turn the acquisition of a dud into a net gain for the company, completely blind to the fact that it was the cost reduction measures they put in place that limited the technology’s market potential. This is to say nothing about the human casualties of the process; a large percentage of the original employees will inevitability lose their jobs. Likewise, it ignores the spiritual causalities of the process; many years of creative energy from those employees will be wasted entirely, causing mass disenfranchisement.
In one case, I personally observed a supplier, that was a prospective acquisition, make several managerial decisions strictly to make themselves more attractive for purchase, on the promise of a partnership with a larger organization. When the acquisition fell through, despite promises from the larger company, they were forced to lay off 80% of their employees and significantly delay the development of their technology. This is a specific, but not unique case, where the specter of easy money stripped an organization of Quality all by itself.
I personally experienced another example of how the specter of easy money can strip an organization of Quality earlier in my career. I was working for a smaller company that had recently gone public, which was not going well. With stock prices plummeting, the board decided to replace the founder/CEO, who was a doctor/scientist/inventor, with a CEO that had more of a background in business. They became consumed with the idea of being acquired and launched an initiative to reduce the cost of goods sold (COGS) to make themselves more attractive to larger buyers. This of course is conjecture, since I was not in the boardroom where these conversations were had, but in my experience as an auditor, where there is smoke there is fire. This had the very predicable effect of decreasing Quality.
At the peak of this initiative, an acquisition of a high-performing, low-cost supplier was made for the sole purpose of reducing COGS. This was simply an accounting trick to move costs around. The COGS were reduced, but the overall costs to the business increased, while the overall Quality fell. The management team from the acquired supplier was paid out and moved on. Well, not fully; they had sold only part of the business to the organization I was working for. They built a wall in between the part of the shop that was acquired and their remaining business and continued to service industry competitors right next door. They even shared a lunchroom. All of the technical talent went with the management team and the organization struggled with efficiently operating the newly acquired facility. Many of the operators left for other opportunities, and many simply walked next door to their previous employer, causing the organization to need to outsource again.
The hyperfocus on making the balance sheet look attractive to a potential buyer decimated Quality. When the executive team is convinced that there is an opportunity for a buyout, Quality is the first thing to go, and when money is easy, there is always an opportunity for a buyout. The policy that created a prolonged period of easy money by the Federal Reserve has incentivized short-term thinking and devalued the future. It creates a fiscal tunnel vision within our business leaders that causes them to be blind, or apathetic, to the long-term implications of their actions.
As I said in the beginning, this is simply a reflection on the U.S. monetary policy since 2008 and its impact on Quality. I don’t know enough about macroeconomics to propose a solution, but I do know enough about Quality to identify a problem. If the goal is to improve Quality, we are going in the wrong direction.
Looking forward, in the face of historic inflation, it appears as though the Federal Reserve is determined to correct course by aggressively driving up interest rates. What does that mean for Quality?
For organizations that were acquired through financial mechanisms like LBOs, or any organization that has taken on substantial debt to fund operations, it isn’t good. During a period of easy money, servicing the debt obligation is manageable, but the organization still needs to increase profit to stay even. When interest rates start to rise, servicing the debt obligation becomes less manageable and it becomes even more urgent to increase profit. As interest rates get higher, these types of organizations are desperate to increase profit to survive. To avoid bankruptcy, organizations start to cut costs and if there was any consideration given to Quality before, there certainly isn’t now.
Regarding inflation, let’s look at a theoretical example that helps me put it into perspective. Inflation occurs when there is a discrepancy between supply and demand. If there are one million computer chips used to manufacture cars available for sale on the world market, but the car manufacturers around the world are planning to build two million cars that need computer chips, the price of a computer chip is likely to inflate by 100%, ceteris paribus. This makes the price of a new car inflate by a proportionate percentage as well, since car manufacturers typically operate with relatively small profit margins, they cannot afford not to raise prices.
Regarding interest rates, let’s also look at a theoretical example for perspective. Interest rates represent the price of money. As explained above, when interest rates are low, access to money is easy. Banks are more willing to accept the risk that comes with providing loans to the market because the amount they can make by saving the money has decreased. When interest rates are high, access to money is difficult. Banks are less willing to provide loans to the market, thus decreasing the flow of money. When less money is available, the demand for products goes down. Now let’s say that car manufacturers only have enough money available to build 1.5 million cars that need computer chips. There are still one million computer chips used to manufacture cars available for sale on the world market, so the price of computer chip has now inflated by only 50%. Success! Inflation solved.
Alternatively, here is another example of how things could go. Say the material experiencing a supply-demand discrepancy is the metal used to make the body of the car. The car manufacturers might decide that the consumer will not tolerate a price increase. The price of plastic is inflating as well, but it is cheaper than metal. Instead of paying an inflated price for metal, they may make a design change and use plastic to make the body of the car. Price to the consumer has not inflated, but Quality has decreased.
In these examples, notice that consumer need isn’t discussed. That is because it is never considered when the Federal Reserve is making U.S. monetary policy, but for most products, consumer demand is driven by consumer need. When the Fed decides to increase interest rates, that means the interest rates for things like credit cards and personal loans increase too. When the flow of money slows down, it slows down for consumers as well, but their needs don’t change. Normal people, like you and me, still need the ability to get to work, but they have less access to money to buy a new car. Instead of buying a new car, they are forced to buy a used one. Instead of getting a 2% loan for the car, they are offered a 9% loan because the asset backing the loan is riskier. Or in the second example, where the price of the new car has not increased, they may still be able to buy a new car, but they are offered a 4% loan for a car of lower Quality, since the interest rates have risen.
The price of goods is no longer spiking, but individuals who are living on the margin, using credit cards and personal loans to service basic needs, have experienced a decrease in Quality. The Fed does not consider consumer needs as they relate to consumer demand, and it certainly does not consider Quality. It keeps the analysis at a macroeconomic level, ignoring the microeconomic incentives it is creating and hoping everything just sorts itself out.
If you are a business leader interested in the quality of your organization, or a political leader interested in the quality of life of your constituents, I would recommend performing an investigation into the economic incentives you are responding to and how they impact Quality. It appears to me that U.S monetary policy, and the incentives it creates, has decreased Quality over the past decade and it does not seem to be on track to get any better over the next. As I mentioned, I do not have a solution, but with Quality improvement, the first step is an honest investigation.