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Why the Fed is to blame for the boom in zombie companies

The writer is a former member of the Monetary Policy Council in Poland. Its co-author, Grzegorz Parosa, is head of equities at AXA’s investment division in Poland and a doctoral student at Stanford University

Zombie companies – companies whose corporate profits are persistently lower than their interest payments – have something in common with high global inflation. Surprisingly, the main cause of both is the Federal Reserve.

How did we get into a situation where, according to a 2021 report, about 10 percent of public companies in the US are zombies? The 2008 financial crisis scared policymakers. US and European central banks pursued unconventional monetary policies: ultra-low interest rates and large-scale asset purchase programs. When former US Treasury Secretary Lawrence Summers claimed that “natural” interest rates were negative, meaning conventional policies were ineffective, it was an excuse for monetary policymakers to step on the gas. Focused on stimulating demand, policymakers forgot about supply and started to zombie the economy.

So how can the Fed turn a perfectly healthy company into a zombie? It’s not possible. But it can create an environment where zombification is possible. When interest rates are at zero, creditors are encouraged to renew the financing of unproductive companies. When interest payments are low, it doesn’t take much to keep a zombie going. In addition, weak companies pay slightly higher interest rates – an important fact for investors desperate for returns in an environment of ultra-low interest rates.

It makes sense for creditors, but why don’t zombie companies restructure? This is simply not necessary when rates are low and interest payments are not a threat. Riskier projects usually yield higher profits, so taking limited risks weighs down future productivity – but those effects occur outside the career horizon of the average CEO. Such behavior turns healthy companies into zombies and perpetuates existing ones.

Creditors and managers can deal with zombies just fine if the rates are low. What about shareholders? Our research suggests that investors can increase their expected returns by allowing zombies to live. As a result, neither creditors, managers nor owners have any incentive to kill zombies when rates are ultra low, so once they show up, they keep tripping. In countries like the UK, Belgium, Spain, Greece, Portugal and Italy, zombie companies control more than 40 percent of all assets.

Why is this a problem? Zombies trap assets and employees, make life harder for start-ups and slow down innovation. In addition, their existence reduces margins, making investing in healthy competitors less attractive.

All these effects directly disrupt the crucial process of ‘creative destruction’, defined by Joseph Schumpeter as an innovation mechanism ‘by which new production units replace obsolete ones’. If it fails, resources (capital and people) are allocated inefficiently. This, in turn, is a major driver of the slowing productivity growth observed in Western countries over the past two decades.

Productivity increases are crucial for economies and explain about 70 percent of their growth. In Europe, ultra-low interest rates – through zombification and the ensuing misallocation – reduced productivity, slowing GDP growth by up to three percent in the years following the financial crash, further hurting stagnant European economies.

For more than a decade, central banks hunted elusive lost demand. By easing monetary conditions, they not only bombarded countless companies and slowed production growth, but also accelerated rising inflation. We don’t know if the demand was lacking, but the proposed remedy certainly hurt the supply. It is high time central banks stopped feeding zombies and returned to conventional policies.

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