Finance: Research, Policy and Anecdotes

There is an intense debate among economists on zombie firms.  In Germany, this has been framed  as a renewed conflict between Keynesians and ordo-liberals (for non-Germans: card-carrying membership in schools of economic thoughts is still seen as important among some German economists, but even more so in the press). But for obvious reasons, this debate will come across the globe, as we look beyond the COVID-19 recession. Many firms entered the crisis overleveraged and have added further to their debt due to fiscal support schemes and low interest rates, primarily with the objective of surviving. And as revenues in some industries are still depressed and/or highly volatile, large parts of the revenues have to be used for interest and principal payment. It is clear, however, that there are important differences across industries and firms: some will emerge out of this crisis as (if not more) efficient and with as much (if not more) demand as before, while others will not – the walking zombies. How can we distinguish between the two and what is to be done with the latter?

On the one hand, if all firms are being supported for an extended period, independent of their survival chances, this does not only increase the overall costs for society, but also prevents the necessary resource allocation, i.e., Schumpeter’s creative destruction. Subsidising unviable jobs and locking capital in unviable companies delays reallocation of labour and capital to industries and firms that will drive the recovery process.  On the other hand, there is the hysteresis argument: withdrawing support in the middle of a crisis can cause long-term damage in the form of long-term unemployment and, more generally, idle resources.  Support across industries and firms is thus not only necessary for social reasons, but also for economic efficiency.

At the core of the tension is – beyond philosophical differences on the role of government – uncertainty. One, nobody knows when this crisis will be over. When can the market resource allocation process function again? When will the market again allow for the necessary signals? Two, no one really knows what the structural change will look like once the pandemic is over and how it will interact with many other factors that drive structural change, including climate change and a changing international trading environment.

Withdrawing support now seems the wrong moment; the world is still in the middle of the pandemic and (non-financial) markets are certainly not even close to functioning properly. Take the labour market as example– how easy is it to interview and hire new employees, how easy is it for people to move across borders within the Single Market? And who is willing to make long-term investments before the dust of the COVID-19 turmoil has settled?

However, it is also clear that now is the time for preparation to deal with a wave of necessary insolvencies of unviable firms in the near future. It seems unlikely that the regular insolvency regimes can deal with this. And even if they did, not all overleveraged firms are unviable; restructuring (as under chapter 11 in the US) might be more efficient than liquidation (as under chapter 7 in the US). As discussed by Martin Sandbu in a recent FT article, there are different ways to go about this insolvency wave. One would be to convert emergency loans – either direct ones or bank loans guaranteed by the government – into grants; however, this would be costly and might be mis-targeted. A more targeted measure would be government equity support for viable but overindebted firms; however, this will be difficult to manage given the large number of firms and the limited if not negative track record of governments to pick winners. A third  option would be a bank-based restructuring process, as especially for smaller firms in Europe the largest part of their debt will be bank loans, so that banks have the right information and capacity to restructure debt; the doubt I have is whether banks have the right incentives to undertake this role in the societally most efficient way; provide too much debt relief and borrowers might jump ship to other banks afterwards, provide too little and you have the walking zombies, but tie clients to your bank. Regulatory rules (as well as taxation) might influence banks’ actions. Having a central role for banks in this process, however, might also divert their resources from the necessary funding of new companies and thus the economic recovery process. Asset management companies have therefore been proposed; while they have been successful in some cases (e.g., Sweden with mortgage loans), it is uncertain whether they can deal efficient with the heterogeneous bank portfolios of SME loans, especially as it might be unlikely that these assets – unlike real estate – will increase in value back to pre-crisis levels.

Which brings us to the next complication. Corporate overindebtedness and insolvencies will be reflected in non-performing assets on banks’ balance sheets. Allowing banks to delay the recognition of these losses can lead to zombie lending as we have seen it in Japan in the crisis of the 1990s (and will again prevent the necessary reallocation of resources). Forcing them to recognise these losses, however, can result in undercapitalised if not failing banks.  Are regulators and resolution authorities ready for this shock?  I will leave the question of bank resolution to another blog entry.

This points to an important coordination problem awaiting policy makers in 2021: withdrawing fiscal support measures will inevitably result in corporate distress, which in turn can result in banking distress. This interdependence of sectors and interaction of policies requires coordination between governments, legislators/court systems, and regulators. And given the limited fiscal space in some euro area countries, there is also a strong case for coordination on the EU or euro area level.   

Finally, this discussion brings us to the broader question on loss allocation. Aggressive fiscal policy has helped stabilise aggregate consumption while income has plummeted, with the result of rapidly increasing debt levels (primarily government and corporate). Who will bear the losses of this crisis and how will they be allocated? One principle of banking crisis resolution is to “recognise losses, allocate them and move on”. For economies to come out quickly from this crisis (and thus avoid further losses), we need a similar approach. Forcing banks to work out large number of non-performing loans to unviable firms and/or providing perverse regulatory incentives to  roll-over and keep lending to the zombies will prevent banks from supporting the recovery process. While now is not the time to panic about corporate, bank and government debt, now is the time to prepare for the day of reckoning.

Overview