Zombie Companies Live!… thanks to QE
Let me start by saying that I do not support the loose monetary policy of Quantitative Easing by the Federal Reserve.
Supporters of QE say that it is required because there is so much slack in the economy. They say that we are far below the CBO projection of potential real GDP. Thus, the monetary policy must find a way to lower real interest rates to encourage investment. My problem with this view is that effective demand will put a limit on real GDP below the CBO projection of potential real GDP. (see prior post) In my view, the business cycle will end much sooner than economists think. The benefits they see from pushing loose monetary policy are much more than what I see as possible. The risks of QE are therefore relatively greater.
Supporters of QE also point to high unemployment. The implication is that we need to support business in any way possible to create jobs. I have a problem with this view too. From my calculation, unemployment will be between 6.5% to 7.0% on a quarterly basis when the effective demand limit is reached. Unemployment will stop declining at the effective demand limit. The perceived benefits of QE to lower unemployment below 6.5% are not attainable in my view.
On the other hand, people who do not support QE normally point to the danger of high inflation. I don’t agree with this view either. There simply isn’t enough wage growth to provide demand for higher inflation. Also there isn’t enough upside to capital utilization to support an increasing inflation. Capital utilization will also be limited at the effective demand limit in the 79% to 80% range.
So then what is my problem with QE? What harm can it do? I will refer to William Emmott for an explanation. He is a former editor for the Economist magazine. There is a short video of his view on the problem with QE. (link to video).
His view is this… Accommodative monetary policy “distorts investment decisions”. It “subsidizes certain forms of activity”… “In the long-run you get an inefficient allocation of capital”.
He talks about how low interest rates distorted investment in Japan leading to weak economic growth. He says that the United States has a better chance of escaping this problem than Europe, but the problem is still present.
Mr. Emmott says that “Zombie companies, zombie sectors, are being kept artificially alive by accommodative monetary policy” and that this is “slowing down the process of creative destruction”. I would do more than just point to certain zombie companies, I would say that even healthy companies have become more inefficient from low-interest rate subsidization and from doing business with the zombie companies. Loose monetary policy is a disease that is weakening the interconnected vitality of the economy overall.
These zombie companies are less productive, less marginally profitable, thus less able to raise wages at a time when wages need to be raised. Zombie companies justify lower wages for all companies. Keeping these zombie companies alive is a weight dragging down the demand side of most advanced countries.
At the end of this current business cycle (not the end of QE since the end of the business cycle will come before the end of QE), when the economy starts to contract, these zombie companies are going to present symptoms of a disease which will begin to affect other companies. That is when the recession will come.
QE is making the economy weaker by not allowing creative destruction.
Let me make an analogy of creative destruction to the physiological process of building muscle. Muscles are analogous to companies in business sectors. Here is a brief explanation of how we make our muscles stronger.
“The process starts with what is known as the ‘stimulus’ – this is the training itself. We stimulate the muscles, which causes ‘trauma’. This is the term for muscle damage – it is the breakdown of the skeletal muscle tissue. This breakdown forces the muscle to restructure and grow, returning bigger and stronger under the correct nutritional and recovery conditions.” (source Total Fit blog)
In order to make our muscles (business sectors) stronger, we must first be in training. Training means challenging our muscles on a continual and gradually tougher basis. During proper training, we will damage our muscles. We will traumatize them… break them down. Remember, what doesn’t kill us, just makes us miserable, just makes us stronger.
In economics, we have to traumatize businesses in order to make them stronger. The crisis was a trauma… yes. My model shows that the Fed rate should have gone to zero % after the crisis. But the Fed rate has been near zero % too long now.
We should actually be in training to get stronger at this moment. We should be gradually challenging business to restructure, be more efficient and more productive. If we don’t, business will never be efficient enough to raise wages. Anyway, loose monetary policy has stopped the training. It took away an advantage of more efficient companies to compete with zombie companies. Muscles fibers (companies) that were breaking down have not been replaced by stronger muscle fibers. Companies have been “babied” by many policies, including tax policy.
Look at the reaction of business when they freaked out for a couple weeks over the Fed talking about maybe tapering QE later this year and China at the same time tightening its interest rates. The Fed backed off. Businesses and investors have hung their investment decisions on slack monetary policy. Investments in Zombie entities are not going to be challenged. and There will be adverse effects in the long-run from supporting this inefficient allocation of money.
Bottom line: We all want a strong and productive economy that can provide good-paying jobs. Good-paying jobs will revive demand. We are not going to get that by coddling business with accommodative policies at every turn. There is wisdom to challenging business through a creatively destructive process, which includes continually and gradually tightening monetary policy through the business cycle. Ultimately real wages will have a fighting chance to increase. The Fed needs the courage, the foresight, the backbone and the stomach to challenge zombie businesses.
Edward:
What sectors of business are you talking about or identifying as being zombie-like or parasitic?
“business will never be efficient enough to raise wages” ???
Do fast food companies have to get more efficient before the minimum wage can be raised — I mean doubled! — just to use the simplest of all comparisons. The minimum wage could be doubled tomorrow.
http://ontodayspage.blogspot.com/2013/07/will-real-obama-or-hillary-please-stand.html
Average income has almost doubled since 1968 while the median wage has stagnated (not to mention the minimum is now $3.50/hr lower!!!).
Businesses could benefit by the advice of the article I’m sure — but they are able to raise wages substantially any time the bargaining power in the American labor market is rebalanced. Did someone say legally mandated, sector-wide labor agreements?
Raising the minwage is just the kind of trauma companies need to have inflicted on them in order to generate the incentives for labor-saving innovations , or – for those who fail to innovate – creative destruction.
The best time for a big minwage hike was when we started QE , which would have been perceived as a compensating benefit. Now that we’re talking about ending QE , resistance to any mandated wage hikes will just be that much more extreme.
Run,
Within each industry or business sector, there are companies that are marginally less profitable. Normally a higher Fed rate will help suppress their influence on their industry. A higher Fed rate would benefit more efficient companies. You can look at the retail sector and see that wages have fallen over the years. You can look at GM when it was going bankrupt. Remember how people said that GM had not innovated, it had not developed energy efficient cars? Its production facilities were outdated, etc. It was a zombie company that was brought to light by the trauma of the crisis. GM then lowered wages among other changes in order to survive. But now Detroit is turning into a zombie city.
Look at universities and colleges, they are having to raise tuition rates in order to survive.
As time goes on with loose monetary policy, more industries become less efficient overall. The low efficiency becomes a self-reinforcing dynamic at very low interest rates. If the Fed rate ever rises, we will see lots of zombies come to light.
Check out this article on bankruptcies…
http://www.kauffman.org/research-and-policy/myth-of-disappearing-business-bankruptcy.aspx
Many bankruptcies are going unreported. They are being classified as consumer bankruptcies.
Here is another link…
http://investor.equifax.com/releasedetail.cfm?ReleaseID=751634
Look at these links. Many of the consumer bankruptcies were actually small businesses trying to get started.
http://keywestproperties.com/blog/chapter-7-vs-chapter-13-bankruptcy/
http://jan.blog.ocregister.com/2012/08/06/business-bankruptcies-continue-to-fall/80603/
The bankruptcy rates fell in 2006 after the law was changed to limit bankruptcies. There is now less incentive to go through bankruptcy. So many companies continue in business making marginal profits. Monetary policy is keeping these businesses alive.
There is a complication of low demand from low labor income and stagnant productivity.
People say that many cities and even countries are zombies, Japan for instance. If interest rates rise, these cities and countries will not be able to make interest payments without making big cuts in services.
Denis,
Some fast food places could raise wages. Other that are less profitable are very resistant to raise wages. The companies that are enjoying low wages can keep paying low wages, because the less profitable companies have to pay low wages and they are being kept alive so the more profitable companies make more profits.
You have the answer, bargaining power of labor will put some businesses into bankruptcy, only to be replaced by more profitable businesses that can ultimately pay the higher wages.
Marko,
Agreed… it would have been much better to raise the minimum wage at least a year ago. The growth rate of business profits is declining this year. Here is a good link that supports this view of zombie companies being kept alive in the economy.
http://www.forbes.com/sites/robertlenzner/2013/04/10/the-14-rate-of-corporate-profits-will-eventually-revert-to-the-mean-spoiling-the-party/
Edward,
I don’t know if everybody keeps track that if you raise the minimum wage to what happens to be the median wage (I get different figures but $15 isn’t too far off) half the workforce gets raises percentage-multiples of what employers would have to pass through.
For example, if Wal-Mart employees lowest wage were raised from $10/hr to $15/hr that would not even raise Wal-Mart prices 5%. This may be why Felix Salmon called raising the minimum wage to $15/hr a “win-win-win-win-win-win.”
http://blogs.reuters.com/felix-salmon/2013/06/20/the-minimum-wage-stimulus/
In fact the minimum wage — which would have been $14/hr in 1978 (!) if double-indexed for inflation and per capita income growth for the previous ten year — may have fallen to such low extreme that there may be no companies too inefficient to suffer from the $15/hr raise. !!!
I call this the “black-hole theory of the minimum wage”, when it has fallen so far below what the market would bear that the normal laws of supply and demand break down. 🙂
I appreciate your theory that keeping zombie companies going either by fiscal jockeying OR LOW WAGES actually makes the economy much less productive. (I especially like the low wage part.)
Denis,
Just want to point out where I get the theory from… The work of Bruce Kaufman… He gets his theory from the 100 year tradition of the institutional school of economics.
http://digitalcommons.ilr.cornell.edu/cgi/viewcontent.cgi?article=1458&context=ilrreview
He gives the basic model to show how a higher minimum wage can raise productivity and efficiency. He accepts that some firms can go out of business, but ultimately that benefits society more.
or companies fire even more and accept the lower level of growth. You are making assumptions.
John,
A higher minimum wage “causes firms to cut back on production and employment to the efficient level that would prevail if the labor market were truly at competitive equilibrium.”
page 447 of this link…
http://digitalcommons.ilr.cornell.edu/cgi/viewcontent.cgi?article=1458&context=ilrreview
Think of this… labor has costs to maintain themselves as a productive, educated and healthy factor of production. If wages do no cover those costs, labor is subsidizing lower prices to consumers and businesses benefit. The negative externality of low wages is a weak labor force.
Raising the minimum wage is like putting a Pigouvian tax on businesses that are not incorporating the cost of negative externalities into their prices. Production should slow down in these businesses as a result.
In the case of Walmart, they could pay higher wages, but they play hardball to control their input costs. They would fire people just to replace them. And we see how they reacted in Washington DC to a living wage idea.
Have you considered that there is a demand constraint on the economy at the moment? If wages rose, businesses would see more demand for their production. It’s just that no one business wants to raise their wages. They have to do it in mass. Raising the minimum wage is an “in mass” action.
You assume that business would see lower levels of growth. But that implies that they would not respond to an increase in demand. I would assume that they would respond to the growth by maintaining their staff.
However, if the business is already on the edge as far as efficiency and profitability, it is not socially beneficial. It is dragging down better businesses to a lower standard.
Edward:
I would suggest that Direct Labor wages is a much lower percentage of the total cost than put forth. The argument on why not to raise Minimum Wage is a red herring.
Run,
Thanks for reminding that wage increases don’t play a prohibitive part of price increases.
Edward:
That was not meant for you. I already know you know this.
The largest zombie industry is the financial sector which is being propped up by low interest rates which allow huge levels of leverage at very low cost. This is subsidizing all sorts of bad stuff. For a long time I considered low interest rates important for an economic recovery, but now I have my doubts. It’s not as if the low rates are being passed on to consumers or businesses. Most of the businesses I know are raising capital from cash flow, by selling discounted future merchandise, by hitting up angel investors or some combination of these. Bank loans are basically not available.
Meanwhile, the financial sector is using low interest rates to fund a corner in a variety of commodities markets and to cover other financial mischief. If the Fed raised rates, most businesses would barely notice. If you are using your credit card for the 30 day float, it is irrelevant. Otherwise you are already paying 18% or whatever. If you are using an alternate financial method, Federal interest rates are already irrelevant. It’s like the dark pools. We no longer have a unified financial sector, so the Fed is barely relevant.
Yes, I can think of a lot of downsides to higher interest rates, but we are seeing a lot of the downsides to lower interest rates. It’s not as if the economy is growing. Maybe it’s time to try something different.
P.S. I’m not 100% sure I believe this, at least not quite yet. Each year though, I find myself increasingly drawn to the idea.
Kaleberg,
You make some very good points. The low rates are not being passed on.
I was thinking about the financial sector for zombies, and it is a mixed bag. Financial planners are struggling to find yield for their clients. Slim pickings at the moment.
But then many banks have positioned themselves with great control over the markets. Those banks are far from being zombies. Like you say, they are ” being propped up by low interest rates which allow huge levels of leverage at very low cost.” It seems they are taking way too much advantage of the situation, yeah?
In the video you post Bill Emmott, former editor of The Economist magazine, discusses the likely long-term impact of the coordinated effort by Central Banks to pump their economies with liquidity with Royal Fidelity’s Joe Euteneuer. However at no point in the video do Emmott or Euteneuer ever mention QE.
Emmott mentions that zombie companies were a problem in Japan in the late 1990s and are a problem in Europe today. But Japan did not do QE until 2001, and as the ECB has repeatedly stressed, the eurozone has never done, nor do they any plans to do QE.
A good proxy for QE is the expansion of the monetary base. Since August 2008, the month before large scale expansion in the monetary base began in the US, the monetary base has expanded by 288% in the US:
http://research.stlouisfed.org/fred2/series/SBASENS
but by only 41% in the eurozone:
http://sdw.ecb.europa.eu/quickview.do?node=2018802&SERIES_KEY=123.ILM.M.U2.C.LT01.Z5.EUR
The fact that zombie companies may be a problem in the eurozone and not the US is supported by the fact that among the 12 eurozone nations for which such figures are easily obtained, corporate insolvencies reached record levels in Belgium, Ireland, Italy, Luxembourg, Portugal and Spain in 2012 Page 3:
http://www.creditreform.cz/fileadmin/user_upload/CR-International/local_documents/cz/Presseartikel/Corporate_insolvencies_in_Europe_201213.pdf
And they increased in Austria, Finland and the Netherlands from 2011 to 2012 .
In contrast business bankruptcies fell from 60,837 in 2009 to 40075 in 2012 or by over a third in the US:
http://www.uscourts.gov/uscourts/Statistics/BankruptcyStatistics/BankruptcyFilings/2009/1209_f2.pdf
http://www.uscourts.gov/uscourts/Statistics/BankruptcyStatistics/BankruptcyFilings/2012/1212_f2.pdf
Corporate leverage (the sum of loans and debt securities as a percent of GDP in the financial corporate and non-financial corporate sectors) peaked at 233% of GDP in 2009Q2 and has only fallen to 229% of GDP in 2013Q1 in the eurozone :
http://sdw.ecb.europa.eu/browse.do?node=2019184
In contrast corporate leverage as a percent of GDP has plunged from 200% of GDP in 2009Q1 to 162% of GDP in 2013Q1 in the US:
http://research.stlouisfed.org/fred2/graph/?graph_id=131821&category_id=0
So in contrast to your claim, zombie companies are most prevelant where QE is nonexistent and are far less common where QE has actually been done.