Zombification is a real, not a monetary phenomenon: Exorcising the bogeyman of low interest rates

Ulrich Bindseil, Jürgen Schaaf 10 January 2020

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Low nominal interest rates have worried central bank critics for different reasons over the last decade. First, calls for pre-emptive interest rate increases were motivated by fears of a return of excessive inflation. Then, they were said to fuel financial bubbles, and therefore to eventually lead to a collapse of financial markets. Now, a new accusation against the ECB is gaining ground: the ECB’s low interest rates keep ‘zombie’ businesses alive artificially, thereby obstructing structural change, weakening economic growth, which eventually leads to a vicious circle of low growth and low interest rates. We argue that this accusation is theoretically and empirically doubtful – and leads to harmful policy recommendations. 

While the term ‘zombification’ was first coined by Caballero et al. (2008) for Japan, it has recently become particularly popular in Germany’s ordo-liberal circles in relation to the euro area.1 Ordo-liberalism attributes a strong role to the state in creating a proper legal framework for the economy to maintain competition but is rather critical about active economic policies, and in particular about mixing policy responsibilities across public institutions and economic actors.  

The zombification thesis relies on two related arguments: 

First, low interest rates lead to a ‘zombification’ of the economy because unproductive, highly indebted businesses2 would be kept alive artificially through cheap loans. These would bind scarce resources – capital and labour – which could be employed more productively elsewhere. Thus, prosperity-enhancing competition would no longer take place. The process of creative destruction would come to a halt. 

Second, at zero interest rates, investments hardly need to generate a return any more. Businesses therefore put money into technologies or plants that are barely profitable. Productivity therefore falls because there is no pressure to be innovative and more efficient. 

Supporters of this logic suggest that the ECB should increase interest rates to deprive zombie firms of access to the cheap and hence life-sustaining credit. This would then clear the way for structural change and growth, and eventually contribute to rising real interest rates, and thereby allow the higher nominal rates to be sustainable. In this sense the rate increase would be self-validating, in the same way as the low rates would be. 

On closer inspection, the accusation is dubious: all firms potentially benefit from the low central bank interest rates. More investment projects pay off; all firms have an incentive to invest more. This logic applies regardless of business model, size or level of indebtedness. If the water level sinks, so do all boats, large and small, quick and slow alike. 

Still, the absolute level of interest rates per se may influence the relative competitiveness of firms. Spread compression through loose monetary policy might be more effective where higher risk premia prevailed before. Hence, the low interest rate could be of particular benefit to firms which are considered credit risks.  But small and innovative firms are typically high-risk firms, while less innovative large firms may have easier access to capital markets. This is why start-up firms often rely on various form of private equity funding.  At least, it is not clear that non-innovative firms benefit more than high-risk innovative firms from a possible ‘hunt for yield’.   

And lending in the real world does not work quite as seamlessly as in economics textbooks. It is not the central bank that grants loans to businesses; credit institutions do so. Banks and savings banks, which know their customers and the customers’ business models, can allocate loans more efficiently than a central authority. Credit institutions have the knowledge to deny loans to doubtful firms or to add adequate risk premia to them. 

It could therefore be argued that firms with credit restrictions benefit less from the low interest rates than more financially sound firms (Midrigan and Xu 2014, Liu et al. 2019). According to this argument, sound firms and in particular industry leaders should benefit disproportionately from the favourable financing conditions.3 But that is precisely the opposite of what the disciples of the zombie hypothesis claim. 

Empirical studies of the interest zombie hypothesis come to ambiguous, and partially contradictory conclusions. The Bank for International Settlements (BIS) suggests a connection between low funding pressure, which it attributes in part to low interest rates, and zombification (Banerjee and Hofmann 2018). However, Banerjee and Hofmann introduce an own definition of zombie firms;4 applying the standard definition does not show congestion effects, i.e. that locked resources could crowd out the growth more productive firms. 

Obstfeld and Duval by contrast have shown that before the financial crisis (and still today) the picture in the countries of the euro area with regard to capital tied up in zombie firms was so varied that the single monetary policy can be ruled out as a cause (Obstfeld and Duval 2018). Similarly, according to Adalet McGowan et al. (2017) the share of capital sunk in zombie firms in the euro area in 2013 ranged from 28% in Greece, 19% in Italy and 13% in Germany to 7% in France. In Belgium the share of zombie firms between 2007 and 2013 rose from 6% to 9%, in Spain from 3% to 10%, in Italy from 2% to 6% and in Finland from 2% to 3%. Remember that all these countries share the same central bank interest rates. 

The allegation concerning the process of creative destruction goes back to the Austrian economist Joseph Schumpeter. According to him, in the competition for scarce resources, innovative businesses drive the weakest out of the market. The creative element of innovation is accompanied by the collateral damage of failing competitors, which is, however, compensated for by higher aggregate productivity and rising prosperity. In essence, the ‘zombieists’ are turning the logic of the creative destruction on its head thinking that just allowing established businesses to fail or their active destruction through interest rate increases would lead to new, innovative businesses being founded. Schumpeter would probably turn in his grave at the thought.

Moreover, the creative productivity increasing element of the Schumpeter process is carried by start-up firms. These typically lack access to bank loans because the risk of default is high but the return would be capped at the level of the interest rate. That is why dynamic new businesses are often financed by various forms of equity: family and friends, venture capital, equity crowdfunding, business angels, to name but a few. The rationale is obvious: one outperforming unicorn can compensate for many failures in an equity-financed portfolio.

In the current environment, which is one of pronounced weak investment, it cannot be argued that the demand for loans among weaker debtors is crowding out the demand among better ones. Too little is being invested overall. The young, dynamic businesses are not being crowded out – they are simply not there. Alas.  

Ultimately, zombies must be exorcised by a policy mix tackling the underlying causes. In an environment of anaemic growth, timid private investment and low inflation, this policy mix must embrace supply-oriented competition policy, the lowering of market entry barriers and more flexible labour markets. On the demand side more public investment would lift the demand for capital and thus the real equilibrium interest rate; likewise it would increase aggregate demand and thus contribute to an inflationary impulse. Public investment in future-oriented infrastructures works via both sides, demand and supply: the long-term growth path of the economy will be increased and the complementary capital demand of the private sector follows suit.

What about the role of banks and central banks in this context? 

Obviously, it cannot be ruled out that troubled banks will hesitate to cap credit lines to ailing firms, particularly after deep recessions or financial crises. Out of concerns about booking losses when loans are completely written off, they might extend loans again and again. This ‘evergreening’ can in fact obstruct the issuing of new loans. Indeed, the zombie metaphor was originally coined addressing the negligent attitude of Japanese banks which tended to roll over sour loans instead of cleaning up their balance sheets in the economic crisis of the 1990s (Caballero et al. 2008).

In the euro area, the large banks had built up almost €1 trillion of non-performing exposures in 2014. Since then this mountain has almost halved in size. The proportion of bad loans in the total loan volume fell from around 8% to, most recently, 3.6%. That is a considerable improvement, even if the ratio is still above the level before the crisis and significantly higher than in other large industrialised countries.

It is disputable how quickly the evil of non-performing exposures needs to be mastered. However, it is clear that this is not a question that should be answered by monetary policy. A central bank should stay out of other policy areas and – in accordance with the first priority of monetary policy – concentrate on ensuring price stability. 

In the case of the ECB, price stability is defined as a rate of inflation below, but close to 2% in the medium term. However, the inflation rate in the euro area has remained too low since the financial and sovereign debt crisis. Therefore the ECB has significantly reduced the funding costs of the real economy through low interest rates and a package of unconventional measures to provide stimulus for investment and get the economy going again.

Monetary policy has, on the one hand, supported productivity during the crisis by, through looser financing conditions, mitigating the setbacks in investment activity and preventing an even stronger slump in aggregate demand. The threat of ‘hysteresis effects’ was also mitigated. These occur when recessions permanently damage growth potential; i.e. damage that is not resolved by a cyclical economic recovery. 

Key interest rates will rise again when economic growth speeds up again and/or the rate of inflation returns to normal. The ECB’s monetary policy contributes to this, but the process of normalisation takes time. Preventative interest rate increases, however, are bound to be counter-productive – they would damage the economic dynamics and result in a disinflationary effect.

The best weapon to exorcise the evil of zombie businesses is stronger economic growth. Implementing structural reforms, removing market entry barriers for young businesses, further improving banking supervision and resolution, and establishing more effective and harmonised insolvency law for the winding-up of ailing firms and functioning markets for non-performing loans would be appropriate means for and approaches to raising growth potential. 

All of these measures are outside the possibilities and the mandate of monetary policy, just like the allegation of zombification through monetary policy is unfounded and flawed. 

Authors’ note: The views expressed here are not necessarily those of the ECB.

References

Adalet McGowan, M, D Andrews and v Millot (2017), “The walking dead: zombie firms and productivity performance in OECD countries”, OECD Economics Department Working Papers 1372.

Andrews, D, C Criscuolo and P Gal (2016), “The Global Productivity Slowdown, Technology Divergence and Public Policy: A Firm Level Perspective”, OECD Productivity Working Paper 5.

Banerjee, R N and B Hofmann (2018), “The rise of zombie firms: causes and consequences”, BIS Quarterly Review, September: 67 – 78.  

Caballero, R, T Hoshi and A Kashyap (2008), “Zombie lending and depressed restructuring in Japan”, American Economic Review 98 (5): 1943–77.

Midrigan, V and D Y Xu (2014), “Finance and Misallocation: Evidence from Plant-Level Data”, American Economic Review 104(2): 422-58.

Liu, E, A R Mian and A Sufi, A (2019), “Low Interest Rates, Market Power, and Productivity Growth”.  

Obstfeld, M and R Duval (2018), “Tight monetary policy is not the answer to weak productivity growth”, VoxEU.org, 10 January.

Schumpeter, J A (1950), Capitalism, socialism and democracy, 3rd edition, Harper. 

Schwarz, M, J Gerstenberger and S LoBosco (2018), "Sorge vor Zombie-Unternehmen im Mittelstand unbegründet", KfW Research - Fokus Volkswirtschaft, July.

Endnotes

[1] Strangely enough, in Germany the phenomenon of zombie business cannot be observed. At least for German small and medium-sized enterprises (‘Mittelstand’) the national development bank Kreditanstalt für Wiederaufbau cannot find any sign of zombification (Schwarz et al. 2018).

[2] The OECD follows the definition Adalet McGowan et al. (2017) according to which zombie firms are companies older than ten years and with an interest coverage ratio below one over three consecutive years. 

[3] Andrews et al. (2016) find evidence of a significant widening of productivity gap between “frontier and laggard firms” in 24 OECD countries between 2001 and 2013.

[4] Banerjee and Hofmann (2018) only cover listed companies and add the requirement that zombies should have comparatively low expected future growth potential. Zombie firms are required to have a ratio of their assets’ market value to their replacement cost that is below the median within their sector in any given year.

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Director General of Market Operations, ECB

Advisor to the Senior Management of Market Infrastructure and Payments, ECB

CEPR Policy Research