Obscure Economic Indicator: The Global Failures Index

The bad news: It’s going way up in 2006.

Signs don't bode well for 2006
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Signs don’t bode well for 2006

Rosy economic news is everywhere these days. Last week, the Commerce Department reported that the gross domestic product rose at a 4.3 percent annual rate in the third quarter. There was a nice jobs report on Friday. The folks at CNBC are busting out the “Dow 11,000” hats again (though the “Dow 36,000” Windbreakers remain in deep storage). And the next few weeks will bring sunny forecasts for 2006—not whether the economy and stock market will rise, but by how much.

But one often-overlooked source suggests dark times ahead for the U.S. economy. The source is Euler Hermes, a France-based company that may sound like a fashion house but is far, far less glamorous. It provides credit insurance to businesses. As such, Euler Hermes is the Michelin Guideof business failure. Its researchers constantly scan the globe for the latest in bankruptcy and liquidation to compile the Global Failures Index. And lately Euler Hermes doesn’t like what it’s seeing in the United States. The firm predicts that in 2006, U.S. business failures will rise for the first time in the 21st century.

The last four years have been traumatic times for the U.S. economy—a stock market crash, the attacks of Sept. 11, a brief recession, a war, and a spike in commodity and energy prices. But American businesses have weathered them all quite well, thanks in large part to low interest rates. Contrary to what one might expect, and despite scores of high-profile bankruptcies, the number of business failures—businesses filing for either Chapter 7 or Chapter 11—has fallen in each of the last four years. U.S. business failures fell from 39,885 in 2001 to 34,167 in 2004, according to Euler Hermes. And through the first half of 2005, when 16,799 businesses failed, corporate fiascoes were running at their lowest annual rate for 25 years.

Bankruptcies in ailing industries like airlines and the technology sectors may have garnered big headlines. But Dan North, chief economist at Euler Hermes, notes that business failure numbers are correlated with two factors: low interest rates and GDP growth. And for much of the last two decades, with interest rates generally falling and recessions rare, the macroeconomic climate has been favorably disposed toward business survival.

But now, North believes that both trends are working against American businesses large and small. First, interest rates have been rising. The Federal Reserve has increased the federal funds rate from 1 percent in 2004 to 4 percent today and shows no sign of stopping. Long-term rates on instruments like mortgages and government bonds have been rising, albeit at a slower rate. Just as lower interest rates can extend the life of a struggling business—refinancing helps companies, not just strapped homeowners—a climate of rising rates can cut them short. If you’re financing a startup on credit cards, the margin for error declines when the interest rate goes from 16 percent to 20 percent.

Second, North believes the pace of GDP growth will slow, which will lead to business failures. When the economy has been growing at a steady clip, businesses tend to invest and build up their infrastructures to accommodate continued robust growth. When growth fails to materialize as expected, they can easily get caught short, with too much capacity, too many employees, and too much debt. “In a way, the fact that GDP growth was 4.3 percent in the third quarter works against us,” said North. The more sharply the brakes are applied, the more people go crashing into the dashboard.

From the perspective of business failures, the United States will be worse off than the rest of the world next year. While Euler Hermes expects business failures to rise 3 percent in the U.S. in 2006, the Global Failure Index is expected to rise just 1 percent. (Word to the wise: Avoid investing in that Slovakian chain of photo shops your brother-in-law is touting. Euler Hermes expects business failures to rise 24 percent next year in Slovakia.)

Of course, the rise in failures isn’t necessarily a bad sign for the economy at large. The U.S. economy runs on a variety of fuels, the most powerful of which is our collective capacity for risk-taking. As North notes, “Good times make people feel like they’re very strong and able to start businesses and take risks.” Remember 1999, when everybody was somehow involved in a dot-com startup? U.S. businesses have a high mortality rate precisely because of the widespread tendency to entrepreneurship. So many businesses fail because so many are created. Ohio State University Professor H.G. Parsa found that about 60 percent of restaurants failed in three years, for example. If Euler Hermes is correct, the increase in the rate of business failures will surely prove difficult for owners, employees, and creditors. But we should probably be more worried if the economy grew at 3 percent, interest rates rose—and business failures continued to drop. It would mean Americans had stopped trying to get rich.