Why the Fed is to blame for the boom in zombie companies
When interest rates are at zero, creditors are encouraged to renew financing to unproductive companies
Andrzej Rzońca
© James FergusonZombie companies — businesses whose operating profits are persistently lower than their interest payments — have something in common with high global inflation.
Surprisingly, the root cause of both is the Federal Reserve.
How did we find ourselves in a situation where, according to a 2021 report, roughly 10 per cent of public companies in the US are zombies?
The 2008 financial crisis scared policymakers.
US and European central banks introduced unconventional monetary policies — ultra-low interest rates and large-scale asset purchasing programmes.
When Lawrence Summers, former US Treasury secretary, claimed that the “natural” interest rate was negative, and thus conventional policies were ineffective, this was an excuse for monetary policymakers to keep their feet on the accelerator pedal.
Focused on boosting demand, policymakers forgot about supply and started zombifying the economy.
So how can the Fed change a perfectly sound company into a zombie?
It can’t.
But it can create an environment where zombification is possible.
When interest rates are at zero, creditors are encouraged to renew financing to unproductive companies.
When interest payments are low, not much is needed to keep a zombie going.
Moreover, weak companies pay slightly higher interest — an important fact for investors desperately hunting returns in an ultra-low-rate environment.
It makes sense for creditors, but why do zombie companies not restructure?
This is simply unnecessary when rates are low and interest payments pose no threat.
Riskier projects usually reap higher profits so limited risk-taking depresses future productivity — but those effects happen beyond the average chief executive’s career horizon.
Such behaviour turns healthy companies into zombies and perpetuates existing ones.
Creditors and managers are fine with zombies when rates are low.
What about shareholders?
Our research suggests that by allowing zombies to live, investors may increase their expected returns.
As a result, neither creditors, managers, nor owners have any incentive to kill zombies when rates are ultra-low, so once they emerge they keep stumbling along.
In countries such as the UK, Belgium, Spain, Greece, Portugal, and Italy, zombie companies control more than 40 per cent of all assets.
Why is this a problem?
Zombies trap assets and employees, making life harder for start-ups, slowing innovation.
Moreover, their existence lowers margins, making investing in healthy competitors less attractive.
All these effects directly distort the crucial process of “creative destruction,” defined by Joseph Schumpeter as an innovation mechanism “by which new production units replace outdated ones”.
When it fails, resources (capital and people) are inefficiently allocated.
This in turn is a significant cause of slowing productivity growth, as observed in western countries over the past two decades.
Productivity increases are crucial for economies and explain around 70 per cent of their growth.
In Europe, ultra-low interest rates — through zombification and resulting misallocation — lowered productivity, slowing GDP growth by up to three per cent in the years following the financial crash, further denting stagnant European economies.
For more than a decade, central banks chased elusive lost demand.
By loosening monetary conditions they not only zombified countless companies and slowed output growth, but also precipitated rising inflation.
We do not know whether demand was missing, but the proposed remedy certainly hurt supply.
It is high time central banks stopped feeding zombies and returned to conventional policies.
The writer is a former member of the Monetary Policy Council in Poland. His co-author, Grzegorz Parosa, is head of equities at AXA’s investment arm in Poland and a doctoral student at Stanford University.
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