Could Covid-19 kill the plague of zombie firms?

One of the main principles of market-based economies is the concept of “creative destruction”. This refers to a process where old firms close down and are replaced by competitors with new, innovative ways of doing business. A process that has become increasingly threatened by the rise of the so-called “zombie firms”.

A zombie firm is defined as a generally older business that is persistently struggling to pay interest payments. Over the last two decades, the number of not just unprofitable but debt-ridden businesses has grown.

A 2018 paper by the Bank of International Settlements found that the percentage of zombie firms in the 14 major Western economies was 6 times larger than in the late 1980s. In addition to this, the paper concludes that the chance of a zombie firm remaining in the same state the next year has risen by 15-20% during the same period.

The effects of these businesses on the economy as a whole are significant. A paper published in 2017 by the OECD suggests that the increasing prevalence of zombie firms contributes to the stagnating productivity growth that many modern economies face.

The logic follows that younger firms, those more likely to be productive, are crowded out by older firms propped up by increasing levels of debt. There is little incentive for these firms to become more productive, and the road to bankruptcy is long and painful.

An example of a prominent zombie firm in recent times is the US retailer Sears. Having been dominant during the 1980s, the companies’ decline began with the advent of Walmart but became more marked following the 2008 financial crash.

In 2018, 7 years after ceasing to be profitable, Sears finally filed for bankruptcy. The aftermath saw the company file a lawsuit against its owner Mark Lampert, accusing him selling off the companies’ assets with no plan to restructure the company to become profitable again. This example also highlights that whilst “zombie firms” can sometimes lead to workers keeping jobs, this more often isn’t the case. During this time, tens of thousands of workers lost their jobs every year and 30% of stores were closed.

Lampert was accused of spending the years until Sears’ bankruptcy buying back its own shares so as to artificially raise the share price whilst the debt the company owed rose from $1.6bn to $3.5bn, from 2012 to 2016.

Whatever the truth of this case, the situation surrounding Sears highlights how the rise of “zombie firms” guarantees neither the efficiency of market forces nor any protection for workers at these firms. This slow decline sees neither workers saved from redundancy nor new businesses able to flourish as old firms decline.

Another prominent example of a zombie firm, this time in the United Kingdom, was Carillion, a prominent government contractor for public infrastructure. Carillion’s collapse created a shock across numerous sectors of the economy alongside a pension liability of £2.6bn as well as debt to other firms and creditors of around £2bn.

Thousands of their workers were made redundant whilst executives took sizable bonuses and its collapse led to House of Commons select committee reports that described the government’s reliance on private sector contractors as encouraging “reckless acquisitions and efforts to achieve unsustainable growth.

The most simple cause to explain the rise of more zombie firms is interest rates, which have been constantly on the decrease since 2008, with even negative interest rates being discussed.

The discussion of this topic at all is a fairly recent development, with the term “zombie firms” only being coined by economist Anil Kayshap in 2006. Kayshap, now a part of the Bank of England’s Financial Policy Committee, used the term to describe aspects of Japan’s “lost decade” during the 1990s. This period of low real-term economic growth and deflation was a far cry from the countries’ economic performance in the previous decades, which had seen it grow faster than the United States during the 1980s and even faster during decades prior.

The state of the economy at that time, with low growth often not rising above the rate of inflation despite falling interest rates, does in some respects mirror the contemporary situation in many Western nations.

Kayshap and Takeo Hoshi argued that a major reason for Japan’s economic collapse was a “conscious policy of Japanese banks to keep extending credit to firms even when the prospects for being repaid were limited.” One policy failure mentioned by Kayshap and Hoshi was that of overly generous bailout packages, giving money to “banks that should have gone out of business”. This is echoed by research suggesting that the European Central Bank’s OMT policy led to an increase in banks lending to “zombie firms”.

Another major issue discussed by the OECD is how the process of insolvency works in different countries. The paper found that insolvency processes that mitigate the cost to failed business owners, make it easy to restructure insolvent businesses and have mechanisms to prevent insolvencies occurring generally see fewer zombie firms. They also see a better reallocation of capital towards more productive firms.

The recent economic consequences due to COVID 19, such as the oil price crash, do provide opportunities as well as challenges. Unleashing the creative destruction of zombie firms while utilising retraining programs, as some economists have suggested could help tackle important goals such as climate change or revitalising forgotten areas of the countries like the UK or US.

The firms most impacted by COVID and the oil price crashes of the last 2 years have often been in sectors with large emissions, such as the automotive, energy or airline sectors.

Jobs and infrastructure programs to lay the groundwork for future growth would be a positive step for the survival of our planet and the health of the economy especially if pursued through creative destruction of zombie firms that have a destructive impact on the environment.

Zombie firms have become an increasingly significant problem within Western economies over the last 3 decades. Beginning with Japan’s “lost decade” during the 1990s, the growth of firms whose existence is dependent on the continued lending of banks has contributed to declining productivity and stagnant economic growth.

To tackle this problem will require both a painful acceptance of deep contradictions within our economic system. The economic spectre of the Coronavirus does offer the opportunity for new discussions to open up as the virus will likely to expose many hidden weaknesses in Western economies.

Difficult decisions cannot be avoided, and letting zombie firms die would not be a painless process. Not grasping the unique opportunity to do so, provided by the COVID pandemic, might however prove to be more harmful in the long term.

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