“The dead walk among us. Zombies, ghouls—no matter what their label—these somnambulists are the greatest threat to humanity, other than humanity itself.” Max Brooks, The Zombie Survival Guide
Everyone surely hopes that zombies will remain confined to the growing list of horror movies. But unless we shut them down, insolvent firms can become economic zombies that suffocate innovation and growth.
As the COVID pandemic continues, policymakers will face some difficult decisions. Many businesses are coming under increasingly severe financial stress. Some, like dry-cleaning establishments that rely on laundering clothing for office workers, have limited prospects even after the pandemic subsides. But there are others that have a bright post-COVID future if they can hold on long enough. Without a way to distinguish these two groups, we face an unpleasant choice of either creating zombies or allowing viable firms to perish.
In our view, the solution to this problem is to reinforce and modify the bankruptcy process. This means ensuring that there are sufficient resources to restructure the debts of those whose expected future profits exceed their liquidation value, while allowing the remainder to close. In the case of large corporations, we can make use of Chapter 11. For smaller firms, if it is not already too late, we need a low-cost mechanism more tailored to their needs.
In the remainder of this post, we discuss these two related issues: zombie firms and the use of bankruptcy procedures to identify and sustain viable firms.
First, despite a faster-than-expected rebound, the U.S. economy remains weak. One in five businesses is still closed. Nonfarm employment and industrial production are nearly 8 percent below their end-2019 levels. Google mobility data suggests that one-third of people are not going to their traditional workplaces, while the number of travelers going through airport security checkpoints is down by roughly two-thirds.
To date, federal fiscal support to businesses—through the Paycheck Protection Program (PPP) and Economic Injury Disaster Loans (EIDL) to small businesses—has been unprecedented. There have been nearly 5 million individual PPP loans totaling over $520 billion, and 3½ million EIDL loans with a combined value of $188 billion. To put these numbers in perspective, total employee compensation in 2019 was $11.4 trillion, so these loans alone cover almost a month’s payroll for the entire economy. (See Blanchard, Philippon and Pisani-Ferry for a general description of the types of government support programs in the United States and elsewhere.)
The combination of a deep downturn and aggressive fiscal expansion has resulted in only a modest rise of bankruptcies so far. Through August 2020, filings are up 12% over their average for the same period over the past decade. By contrast, in 2009, there were nearly twice as many business bankruptcies as in an average year from 2001 to 2007.
It is clear why we should support businesses that governments order to close. A government that arbitrarily causes firms to fail deters entrepreneurial activity, reducing the dynamism of the economy. However, supporting businesses that become unviable (or wildly mis-scaled) because of the long-term economic and social changes wrought by the virus is no less damaging. The current mix of poor economic performance, generous public support, and low bankruptcy rates suggests that we risk creating a massive number of zombie firms.
When a business turns into a zombie, it consumes resources better used elsewhere. Economists know that there are many incentives to try and keep insolvent firms around. Owners and managers always hope for a rebound. Workers typically prefer to keep their current jobs than look for new ones (or at least to keep them while looking). Landlords may provide concessions in the hopes that they will eventually get paid. And, politicians are reluctant to disrupt the complex networks of economic and financial relationships that sustain their constituents.
Bankers also play a part in the creation of zombies. Rather than forcing a failing borrower into default and realizing a loss, lenders evergreen loans by adding unpaid interest to a loan’s principal. More generally, since 1999, debt to the nonfinancial corporate sector has increased steadily, rising from 125% to 155% of GDP in the advanced (G20) economies. Debt feeds zombies. When nominal interest rates are near zero, evergreening becomes particularly attractive. And, in places were interest rates are negative, there is almost no reason for lenders to force repayment (see Acharya, Eisert, Eufinger and Hirsch).
So, while we know that feeding zombies is a serious mistake, it is quite common. As the following chart from Banerjee and Hofmann shows, over the past 30 years in 14 advanced economies, there has been a steady increase both in the fraction of firms that are zombies (red line) and in the probability that a zombie remains “alive” from one year to the next (black line). Looking at the chart, note that the zombie share has a distinctly cyclical pattern. While the trend is up, recessions tend to dispatch zombies. This creative destruction—the restructuring that comes when inefficient firms die and innovative ones are born—is a silver lining of recessions.
Fraction and persistence of Zombie Firms, 1985 to 2017
Source: Banerjee and Hofmann, Figure 2.
This trend of rising zombies is a clear drag on the economy, reducing the efficiency of capital allocation and lowering growth. Caballero, Hoshi and Kashyap highlighted that this pattern already was evident in Japan in the 1990s. And, in a more comprehensive examination of advanced economies, Adalet McGown, Andrews, and Millot conclude that increases in the prevalence of zombie firms undermines productivity growth by reducing investment and employment growth in healthy firms and fostering barriers to entry. Banerjee and Hofmann estimate that the 10-percentage point increase in the share of zombie firms over the past 30 years could be responsible for as much as a one-percentage point slowdown in the annual growth of total factor productivity (TFP). This highlights the importance of guarding against the further proliferation of zombies.
Returning to the current environment, we support the aggressive fiscal response to COVID. But that response necessarily has limits, so we need a plan for what to do next. That plan must accept the public’s role in the plunge of business revenues: when the government orders a firm to shut down for several months, it raises the probability of failure. Critically, this is no fault of the people running the firm.
As a result, there is no moral hazard from what some people might call a bailout. We are conditioned to think that government bailouts are bad because they create poor incentives. Someone who knows that the government (or anyone else) will bail them out if they suffer losses in the ordinary course of business is going to undertake ventures that increase the risk of failure. However, the losses arising from COVID restrictions are beyond the control of business managers and owners, so there is no incentive problem.
The question is: which businesses should we keep alive? In theory, there is a straightforward answer to this question. Any firm whose net present value of future profits exceeds the liquidation value of its assets should not be shut down. (If the firm creates external benefits for society, we should add those into the profits.) Put another way, any firm that, with its pre-COVID balance sheet, can operate profitably in the post-COVID world, should remain in business.
Implementing this rule is easier said than done. To see why, think of the case of a local restaurant or retail store. Once the threat from the coronavirus diminishes sufficiently, people will return to restaurants, entertainment and in-person shopping. So, while many businesses will surely be viable in the new normal, to survive, a large number probably will have added to their debts in an unsustainable way that requires some restructuring. Importantly, since the future profits exceed the firm’s liquidation value, it will be in the interest of the lenders to restructure the debt, provided that they can coordinate effectively (rather than race to seize and liquidate the firm’s assets).
This brings us to bankruptcy procedures. In the United States, Chapter 11 is designed to coordinate the creditors of large firms, allowing for continued operation even as debts are written down. Successful restructuring requires a whole host of things. Under Chapter 11, experts assess both the prospects of the firm and its liquidation value, determining whether some part of the firm is worth saving. Courts can stay the seizure of assets and impose debt write-downs. And, if the bankruptcies are not too large in the aggregate, private creditors can supply debtor in possession (DIP) financing to keep viable firms operating until they exit the bankruptcy process.
Sorting through the insolvent large firms will be a huge task that will test the capacity of both the courts and the lenders. Solving the first problem probably means adding judges—Iverson, Ellias and Roe suggest that we may need as many as 250 temporary bankruptcy judges in addition to the roughly 400 that are there now. To solve the second problem, the Federal Reserve can offer to lend against DIP loans on special terms (DeMarzo, Krishamurthy and Rauh propose something similar).
The case of small firms is different. The high fixed cost of bankruptcy procedures creates a bias toward liquidation. This means that we need a low-cost, virtually automatic administrative process for resolution and a different standard. As a model, consider Chapter 12 of the bankruptcy code designed for small farmers and fishermen. The Chapter 12 approach ensures that creditors do at least as well as they would in liquidation, while allowing for the necessary debt restructuring that will keep the business operating. This approach makes sense especially where the owner is critical to the operation, as is common in small business.
Of course, bankruptcy is no panacea. There always will be uncertainties about the present value of future profits, and whether it exceeds the liquidation value of the firm. As a result, there are always going to be errors in both directions—firms that are reorganized but should be liquidated, and vice versa. Looking forward, uncertainties about the contours of the post-pandemic economy are considerable. This suggests that as we recover from the COVID recession, policy should err temporarily on the side of keeping firms alive, giving a preference for reorganization. But, with each passing month, it will become clearer which firms are truly viable. Consequently, to preserve the economy’s long-run growth prospects, that policy bias should erode reasonably quickly. Eventually, we should restore bankruptcy standards at least as high as we had in the past—before the rising zombie trend.
Returning to where we started, the COVID shock creates an enormous challenge for policymakers: Which firms should we keep alive and which ones should we allow to expire? The answers depend on the structure of the post-COVID world. It seems unlikely that we will need as much airline, hotel or cruise ship capacity when we reach the new normal. We also probably will need less office space. But what about services like dry cleaners?
No one really knows. What we do know is that if we breed firms that are only able to operate with artificial support—if we create more zombies—this will gradually sap the economy’s vitality. So, to ensure an environment where innovation can thrive and the economy can grow, we need increasingly to focus business relief on firms that are truly viable.
Acknowledgement: We thank Ryan Banerjee and Boris Hofmann for helping us to understand zombie firms and sharing their data.