OPINION: Over the past decade many countries have experienced persistently low inflation and short-term interest rates, while long-term interest rates have been trending down.
This pattern is unique in economic history. It poses questions around how effective monetary policy is in steering the economy in this environment and whether the way monetary policy affects the economy remains the same. It can create challenges if the low-inflation/low-interest rate environment reduces the ability to forecast the economy.
Besides the impact on monetary policy making, low-interest rates have also been contributing to a phenomenon called “zombification” by reducing the burden of financial pressure for firms. Zombie firms are firms that are unable to cover debt servicing costs out of the profits they generate.
This phenomenon has been observed around the world, in Japan and various European countries. Overall, the number of zombie firms in the developed world has increased since the 1980s. During the Covid-19 crisis, airlines can be considered zombie firms.
A famous example comes from the Italian cement industry after the Global Financial Crisis. A chief executive said in 2017 that in the cement industry, “we have zombies kept alive by banks … Banks do everything they can to keep these zombies alive to avoid realising losses on their balance sheets.”
One key factor in creating zombie firms is under-capitalised banks, who prefer to lend to insolvent borrowers in order to hide losses and increase their chance of government support. At the same time, these banks would increase the cost of borrowing for healthy firms, an effect economists call “zombie lending phenomenon”.
By keeping inefficient firms alive, the Schumpeterian idea of creative destruction or, put differently, the idea of cleansing effects of recessions is interrupted.
Another key factor in the creation of zombie firms is accommodative government policy. Research has shown that expansionary policies, such as ultra-low interest rates and quantitative easing, reduce debt financing costs and therefore keep inefficient firms alive that would otherwise have exited the market.
Because these firms do not exit the market, they create market congestion and lead to excess capacity, that is, excess supply in the economy. And ultimately, lower inflation.
Importantly, zombie firms reduce productivity in the economy and crowd out investment and employment in more productive firms.
It has been shown that industries with more zombie firms have lower productivity, more sales growth, lower mark-ups, lower inflation growth, and higher costs compared to industries with lower shares of zombie firms.
Moreover, in recessions, zombie firms slow the reallocation of resources towards more productive firms, which slows down the following recovery.
By keeping inefficient firms alive, the Schumpeterian idea of creative destruction or, put differently, the idea of cleansing effects of recessions is interrupted.
These ideas mean that the process of innovation is fuelled by the destruction of firms that are outdated and, thereby, increases productivity in the economy. In a way, the recession identifies inefficient firms and shuts them down, freeing resources more profitably employed in efficient firms.
The economic situation in New Zealand, with low interest rates, low inflation rates, and a very accommodative government policy – that is, quantitative easing and wage-subsidy schemes – could lead to a zombification of the economy. Firms in sectors such as manufacturing, education and training, transport, retail trade, or accommodation are candidates for zombification.
What can policy makers do to prevent a zombification of the economy? From a financial stability perspective, banks need to be forced to publicly report bad loans. This could be done, for example, within existing bank stress-testing procedures.
Further, if there is evidence that the financial sector is weak, that is, if banks are under-capitalised, a targeted recapitalisation program, similar to the Troubled Asset Relief Program (TARP) in the US, is highly effective and can shorten the recovery after the Covid recession.
Zombification also supports to use expansionary fiscal policy over a longer period of time, as it increases aggregate demand which addresses the excess capacity created by zombie firms.
Understanding and monitoring the unwanted side effects of accommodative policies is important for monetary and fiscal policy-making. Policies need to be designed and implemented to ensure that we avoid lost decades with low economic growth as in Japan.
