America’s Zombie Economy
For a variety of reasons, a once-thriving Japanese economy entered into a prolonged slowdown beginning in the early 1990s, resulting in what has been described as the “lost decade”. One of the features of that lost decade and the years following was what came to be known as “zombie companies”, firms that are basically do not generate enough cash to cover their debt financing costs but still manage to survive. These companies were abetted by Japanese banks who were happy to roll over loans, agree to renegotiate existing loans, or even offer new loans in order to help deal with the companies’ debt servicing costs so that they could avoid having to declare the extent of the bad debts they were actually holding.
As one investment manager describes them, “Like the characters after which they are named, zombie firms are creatures that really should have shuffled off to the next realm some time ago. Instead of embracing death, they soldier on, usually wreaking havoc on the rest of society”. Zombie firms are less productive and end up crowding out investment and employment in more productive firms, as well as stifling innovation.
Here in the US, the historically low interest rates that have been in place since the financial crisis of 2008 have fueled an explosion of corporate debt. Total corporate debt has more than doubled in the decade-plus since 2008, rising from $4.1 trillion at the end of 2007 to nearly $10 trillion in late 2019, now equaling a little less than half of total US GDP. In 2017, for every dollar lower rated corporations had in cash, they owed eight dollars of debt. That cash-to-debt ratio for speculative grade corporate debt was even lower than the prior low of 14% reached in the midst of the financial crisis. Unsurprisingly, then, his debt explosion has created an increasing number of zombie companies in America.
In 2018, ill-advised Fed rate hikes raised borrowing costs, further endangering the credit rating of these lower-rated companies and threatening some well-known companies with having their bonds downgraded to junk. Such an event would force big institutional investors to dump those bonds as they are required to hold only investment grade bonds and, correspondingly, would raise the borrowing costs for those corporations even further. There were real worries that well-regarded but now highly leveraged companies like GE and AT&T could actually see that happen. More importantly, those worries were indicative of just how many companies had come to rely on low interest rates and their associated low borrowing costs in order to sustain their business.
While those fears never came to pass in 2018, the problem remained and the COVID-19 pandemic threatened to finally make it a reality. The Fed’s unprecedented decision to buy corporate bonds was made explicitly to prevent the cascading effects to the debt markets of having an enormous number of these lower-rated bonds suddenly get downgraded to junk and create selling panic among institutional investors. The Fed’s action also protected these lower rated companies from having even higher borrowing costs if they were finally downgraded to junk and perhaps saved some of them from actual bankruptcy. Incredibly, today, it is estimated that nearly 20% of US companies do not generate enough cash to even pay their borrowing costs. And the Fed’s intervention in the corporate debt market has not only buoyed the equity markets but convinced equity investors the Fed will bail them out as well. As economist Mohamed El-Arian warns, we not only have a large number of zombie companies but the Fed is creating the conditions for so-called zombie markets, “markets that are completely mispriced, they’re completely distorted”.
Paradoxically, the idea of creating zombie companies by putting the economy into an induced coma in order to contain the coronavirus was the proper response to the COVID-19 pandemic. And, thanks to the emergency aid that Democrats demanded in the form of PPP and the extra $600 in unemployment, the economic carnage of that induced coma is not nearly as severe as it could be. As Paul Krugman notes, “The saving graces of the situation, such as they are, are that (a) while there is immense economic hardship, it’s not nearly as severe as you might have expected given Depression-level unemployment and (b) the employment slump has so far been mostly limited to contact-intensive sectors. That is, the crisis hasn’t — yet — spilled over into a crash of the economy as a whole. Both these saving graces, however, are the result of emergency aid — the safety net hurriedly put in place in late March, largely at Democrats’ insistence. This safety net alleviated hardship while allowing the unemployed to maintain spending and encouraging businesses to maintain their payrolls”. Incredibly, in the midst of unemployment numbers not seen since the Great Depression, it is estimated that these extra benefits actually drove the poverty rate down by over 2% in the lockdown months of April and May.
Krugman, in fact, was surprisingly bullish on the possiblity of a V-shaped recovery from the pandemic. Said Krugman, “My take is that the Covid slump is more like 1979-82 than 2007-09: it wasn’t caused by imbalances that will take years to correct. So that would suggest fast recovery once the virus is contained. But some big caveats. One is that we don’t know how long the pandemic will last”. Indeed, initially the induced coma and expanded safety net looked like they were providing the time needed to control the virus. The initial epicenters of the pandemic, primarily coastal blue states, were seeing both infections and deaths decline. Trump and red-state Republicans had time to put in the testing, tracing, and isolation measures that could contain the virus. A quick recovery actually seemed possible.
But no, Trump refused testing because that would show an increase in infections. Red state governors apparently thought that only their higher density, largely Democratic areas would be badly affected by the virus. Or maybe the GOP mantra that government must always be the problem, never the solution, drove their inaction. Whatever the case, social distancing and mask wearing, the easiest path to containment, became a partisan issue for Republicans. Those predominantly red southern and southwestern states clearly opened too soon, most in defiance of the Trump administration’s own recommendations, and are now becoming the epicenters of a continuation of the first wave. Businesses, like Apple, that had opened are now closing again. And a quick nationwide economic recovery is no closer than it was in March, despite the pretense from Trump and red state governors that the pandemic is largely behind us.
The PPP loans only covered a specific time period, either the original eight or the extended twenty four weeks. For some early PPP recipients that choose the eight week option, the covered period is soon coming to an end. There are now abundant indications that employers will formally terminate employees who had been essentially furloughed in order to receive the original PPP loan when their covered period ends. In addition, it is now abundantly clear that PPP loans missed an enormous swath of minority owned business, perhaps because of their lack of business banking relationships. According to a National Bureau of Economic Research report, black-owned businesses declined by 41% in the first three months of the pandemic, with Latino-owned ones declining by 32%. That number was just 17% for white-owned businesses.
Those businesses will probably never come back. Worse, those businesses were probably important resources in underserved communities. Most restaurants can not survive on take-out only, or in-house dining at only 25% or 50% capacity. And most of these failing businesses represent a small portion of the retail apocalypse that has just begun. Big name retailers like Pier 1, JC Penney, Nieman Marcus, J. Crew, and Hertz have all filed for bankruptcy. That will put even more pressure on mall owners, who were already predicted to see 25% of their properties close by 2022 even before the pandemic hit. Bankruptcies in 2020 are expected to overwhelm the system, with some experts calling for the rehiring of retired bankruptcy judges and an increased budget in order to expand the bankruptcy system’s capacity. Experts warn that without such an expansion of the system, “we anticipate that a significant fraction of viable small businesses will be forced to liquidate, causing high and irreversible economic losses. Workers will lose jobs even in otherwise viable businesses”.
The extension of the PPP’s requirement to rehire employees to 24 weeks possibly postpones that day of reckoning beyond the 2020 election. And now there is increasing pressure even among Republicans to enact some kind of extension to the additional unemployment benefit as well. That extra benefit currently is designed to end at the end of July and everyone seems to recognize that letting the benefit expire is a cliff no one wants to go over. Right now, Republicans want to reduce or eliminate the added benefit, believing it reduces the incentive to work, while floating some sort of “return-to-work” weekly bonus payment. But that bonus payment only makes sense if there are jobs to go back to and that the jobs to go back to are safe. In large swaths of this economy, neither of those conditions exist. Even so, my guess is that the final agreement in Congress for another round of pandemic relief will provide a combination of the two approaches, probably with another end-of-year expiration. As always, however, it is impossible to say what Trump will do.
What this means is that Biden and the Democrats may be facing a reprise of 2008 all over again. It seems likely the pandemic will still be strong, perhaps even in a second wave, when they take over next year. But the programs that will have mitigated absolute economic carnage will be expiring and Republicans will have very little incentive to extend them again, instead potentially reverting back to their approach of sabotage and obstruction during the Obama years. That situation might even create an early test of the viability of eliminating the filibuster in the Senate. But even in the best case scenario where a vaccine becomes available in early 2021 – something that Fauci was cautiously optimistic about in his testimony today – and the economy actually recovers, Democrats will still have to deal with the zombies who didn’t survive the economic damage of the pandemic and the zombies, particularly the financial ones, that still remain.