LONDON (Reuters Breakingviews) - The economy is like a rubber ball. The harder it hits the ground, the faster it bounces back. That’s what normally happens. After the Lehman Brothers bankruptcy, Western economies experienced their deepest contraction since the 1930s. Yet their subsequent recovery was decidedly lacklustre. Soon after, the markets witnessed a startling rise in the number of zombie firms – marginal businesses that appear to feed and multiply on an unchanging diet of cheap capital.
It’s no secret why economies normally rebound after sharp contractions. During a downturn, many companies restructure and loss-making businesses hit the wall. As a result, capital and workers are reallocated to more productive uses. Outdated machines and old-fashioned practices are replaced by the latest technologies and new forms of organisation. More efficient businesses can invest more and produce jobs. Business failures are essential to the recovery. As the saying goes, “capitalism without bankruptcy is like Christianity without hell”. This is how famed Austrian economist Joseph Schumpeter’s creative destruction, the driving force of capitalism, is supposed to operate.
The rate of interest plays a vital role in this process. The “true function of interest”, wrote Schumpeter, is as a “brake or governor” on economic activity. By setting a hurdle rate for businesses, interest rations the use of capital. Interest sets the tempo for economic activity, says James Grant of Grant’s Interest-Rate Observer. It is like the shot clock in basketball, he argues. When the clock is ticking, there’s no dawdling. During a credit crunch, interest rates spike and creative destruction goes into overdrive. “The riches of nations can be measured by the violence of the crises they experience”, observed Clément Juglar, a 19th century economist who studied business cycles.
During the global financial crisis, interest rates on corporate debt spiked. In November 2008, the yield on U.S. junk bonds topped 20 percent. Then the Federal Reserve went into action: expanding its balance sheet, cutting the Fed funds rate to zero, underwriting toxic loans and lending money to investors to buy up distressed debt. Those panic rates soon disappeared. Once the economy recovered, credit watchers noticed something surprising. Over the course of the recession, the cumulative default rate on junk bonds amounted to just 17 percent, around half the level of the two previous downturns. “The Fed’s extraordinary intervention”, opined high-yield analyst Martin Fridson, “enabled companies [to survive] that should have failed”.
The low level of corporate failures might appear a boon. But in the past decade, U.S. productivity growth collapsed to below half its postwar average. New business formation, although recovering, has created fewer new jobs than in past upswings, according to the Bureau of Labor Statistics. The U.S. economy operated for years with excess capacity, yet fewer firms than in similar periods in the past went bust. Even though corporate interest costs had never been lower, a rising number of American companies had trouble servicing their debts. These are the corporate zombies.
Among rich nations, the OECD in 2016 estimated that 10 percent of firms qualified as zombies. For many reasons, these creatures are bad for economic growth: they invest less and create fewer jobs; they crowd out more efficient businesses and act as a barrier to entry for new firms; when industries are dominated by zombies, profitability declines and new investment is discouraged; weighed down with these firms’ bad debts, banks are hindered from making fresh loans. “When too many resources are stuck in low productivity areas and in zombie businesses”, writes economist Phil Mullan, “then the potential for the wider positive impact of particular innovative business investments will be frustrated”. And without productivity growth, there can be no sustained growth in worker incomes.
In the post-Lehman period, a close relationship exists between the rise in the number and survival rate of zombies and the decline in interest rates, according to the Bank for International Settlements. This phenomenon was first observed in 1990s Japan after the collapse of its “bubble economy” at around the time when the Bank of Japan inaugurated its zero-interest rate policy. Zombies survive for longer nowadays, says the BIS, because they face less pressure to reduce debt.
This problem has not been confined to the United States. Europe has suffered an even worse infestation. Italy has had some of the worst cases. Clothing retailer Stefanel is a prime example. Beaten up by strong competitors, such as Spanish fashion house Zara, Stefanel has produced a string of losses and faced several debt restructurings over the last decade. Still the Veneto-based firm clings onto life – its shares down 70 percent since 2014 - thanks to loan forbearance from its banks and to the ECB’s negative interest rates. Zombies are largely responsible for the mountain of nonperforming loans on the balance sheets of Italian banks, among them Stefanel creditor Monte dei Paschi di Siena.
It is conventional wisdom in policymaking circles that a repeat of the Great Depression must be avoided at all costs. That was the rationale for the great monetary experiments of the past decade. Yet contrary to popular lore, the Great Depression was not an unmitigated disaster. Nearly a quarter of a million businesses failed but the survivors, in industries such as auto-manufacturing and aerospace, were given a clear field to invest in new more productive technologies. Economist Alexander Field describes the 1930s as the “most technologically progressive decade of the century”. In the following decade, U.S. economic output returned to its pre-1929 trend. For the postwar generation of Americans, it was as if the depression had never happened.
We may not be so lucky this time. A recent paper by former Treasury Secretary Larry Summers and former IMF Chief Economist Olivier Blanchard points out that U.S. economic output (per working-age adult) was on course to recover by less than in the years after the 1929 crash. This year, economic growth has picked up and wages are also rising. But should this “Trump Bump” collapse, then the verdict of history may well be that central bankers after Lehman saved the world from another Great Depression - only to deliver the Great Stagnation.
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