The Bear’s Lair: Escape from the zombie economy

According to statistics collected by the Financial Times, the number of zombie companies, those that do not earn enough to service their debts, has increased steadily since 2010. What is more, the probability of those companies remaining “zombie” has also increased steadily. This is not surprising; 25 years of artificially low interest rates and easy money will increase the proportion of zombie companies, whose life would otherwise end in bankruptcy. However, zombification isn’t capitalism, and it will have the same dire long-term effect as other non-capitalisms have historically had.

Joseph Schumpeter (1883-1950) propounded the theory of “creative destruction” that capitalism would only succeed if bad companies representing poor allocations of capital were allowed to go bankrupt, thus replacing the poor allocation of capital with a better one. Interestingly, and less well-known, Schumpeter like Karl Marx believed that capitalism would eventually collapse. However, in Schumpeter’s view it would not collapse through its own failings, but because intellectuals, who have most power to affect the course of events, would increasingly oppose capitalism and attempt to replace it with failing corporatist measures. In an age when the Fed has signed on to the “green” allocation of capital, this appears increasingly prescient. Well done, old boy!

“Zombie” companies were first recognized as a problem in 1990s Japan. During the crazed bubble of the late 1980s, many Japanese companies had created “tokkin” funds that speculated in the ever-rising stock market, boosting their profits thereby. When the bubble burst in 1990, the tokkin funds ceased to be profitable, and in most cases made large losses. Hence, even though leverage in Japan was not excessive in 1990, and interest rates were at conventional levels in the early 1990s, many companies found themselves with huge losses, combining the natural difficulties of a downturn with the tokkin losses.

In the usual Japanese way, banks were “guided” by the Japanese authorities not to use normal credit standards when deciding whether to continue lending to these companies. The problem was worsened by Japanese real estate companies, which showed large losses and often capital deficits when the Imperial Palace ceased to be worth more than the state of California. These too were allowed a continued existence in the middle 1990s. Western observers, generally critical of Japan and enjoying the “schadenfreude” of watching its massive bubble burst, coined the neat “zombie” designation, noticing that these companies continued to exist and employ resources when they would economically be better dead.

In 1998, with a succession of global financial crises, the problem appeared to solve itself. A major Japanese bank, Long-Term Credit Bank of Japan, went bankrupt, as did Yamaichi Securities, one of the “Big Four” securities houses (investment banks). A credit crisis was only averted by an injection of funds from the government. Many of the zombie companies began to be liquidated.

All would have been well, and Japan would have recovered fairly quickly thereafter, had a Princeton economist named Ben Bernanke not visited Japan, and convinced the Japanese authorities that interest rates should be kept close to zero indefinitely, in defiance of market forces. As a result, an 8-year downturn in Japan has become a 30-year downturn and zombification has continued far beyond the end of its natural life. The Bank of Japan and the government pension fund between them own 15% of Japanese industry, government debt is rising towards 300% of GDP, and there is very little entrepreneurship in the Japanese economy. Only the egregious Softbank (OTC:SFTBY) a sprawling speculative conglomerate with negative net worth, a zombie of zombies, represents the tech sector; it has a market capitalization of $140 billion and an economic value of less than zero.

The effect of Japanese zombification was beautifully illustrated in the 2007 classic time travel movie “Bubble fiction” in which a brilliant, affluent young graduate of 1990 is shown rejoicing in his new job with Long-Term Credit Bank and is next seen in 2007 as a small-time debt collector for the yakuza. Zombification of companies and the economy involves much blighting of promising careers of this kind; their talents are wasted in the value-destroying companies and they can only get jobs in the underworld once those companies have finally gone bust.

In the U.S. today as in Japan from 1990 onwards, zombie companies have proliferated. According to the FT, using figures from the Bank for International Settlements, the percentage of U.S. companies that are zombies, around 5% in 1990, started rising in the 1990s, as monetary policy became artificial after 1995. It reached 8% in 2000 despite the long economic boom of that decade, and then continued to increase, declining only slightly from its peak of 16% in 2010 and then pointing sharply upwards in mid-decade (there are as yet no post-2017 figures). The probability of companies remaining zombie has also increased in parallel, before spiking upwards since 2010, from 65% in that year to 85% in 2017.

This is not surprising. Easy money and artificially low interest rates have suppressed the “destruction” of Schumpeter’s “creative destruction” in the United States, as they did in Japan after 1990. The only difference is that U.S. banks did not receive “guidance” from the Ministry of Finance as they did in Japan from 1990 to 1998, but the maintenance of artificially low interest rates for a quarter-century has had the same effect. Moreover, as monetary policy has grown more extreme since 2010 the probability of permanent zombification has steadily increased, so that now there are very few companies escaping from zombie status. I would guess that events since 2017 may have reversed this trend during the brief more sensible monetary policy of 2018, but that the intensification of funny money since that date, and the 2020 pandemic, have made things very much worse.

So who are these zombies? Some of them are in old industries, which have been disguising their zombiehood by an insane indulgence in stock buybacks. Companies like Boeing (NYSE:BA) and McDonalds (NYSE:MCD) have now bought back so much stock that they have no book net worth. That in itself is a statement that they can find no attractive investments that meet their capital “hurdle rate” – in effect, they are liquidating themselves. For Boeing, if not for McDonalds, that liquidation may now not be far distant, as they are only able to continue borrowing thanks to the indulgence of the banks and the over-liquid capital markets – a situation very like that of Japan’s zombie companies of the early 1990s.

The giants of the tech sector and those that work there are now doubtless thinking complacently at this point that their policy of “move fast and break things” prevents them from falling into the zombie category. Not so. Many tech companies, such as Uber (NYSE:UBER), Lyft (Nasdaq:LYFT), AirBNB (Nasdaq:ABNB) and Snowflake (NYSE:SNOW) have never made a profit and show no sign of ever doing so. However high their stock market valuation, they are clear zombies, fit only to be liquidated. Even the mighty Tesla (Nasdaq:TSLA) with its $620 billion market capitalization, only occasionally makes money and has a return on equity of only 5% — a zombie until very recently, it only barely escapes zombification today and could easily fall back into it.

If the likely forthcoming Biden administration’s plans are put into effect, zombification will only increase. As more and more money is pushed towards “clean energy” and “climate change” sectors, that money will form new pools of zombification, as it did in the solar panel and wind energy sectors under President Obama. The stench of putrefaction in the U.S. economy will grow ever stronger, its capacity for growth and innovation progressively weaker, as infinite resources are devoted to the dead at the expense of the living. This effect extends not only to the zombie companies themselves, but to the people working for them. More or less by definition, jobs for zombie companies are “bullshit jobs” in the terminology of David Graeber’s 2018 book, that do not add economic value and destroy the work and creativity of those undertaking them.

The Covid-19 pandemic has made this worse; subsidies have been given to large publicly quoted zombies such as United Airlines (Nasdaq:UAL) often with low returns on capital and poor prospects even before Covid-19, while small but intrinsically profitable privately owned companies go bankrupt in their thousands.

The small business sector, which finances itself primarily from the entrepreneur’s own resources and those of the people who know him best, is generally the key to growth, employment and innovation and is very rarely zombified – how could it be, subject as it is to the full rigors of the market with no “easy money” bond issues, bank lenders or private equity magnates scrambling to fund it? That sector was recovering under President Trump until January 2020; it will go into permanent decline under the zombie management of the Biden administration.

The zombies need to be killed off. Now! This can best be done by raising interest rates, suffering through the inevitable stock market collapse, and devoting any remaining resources to nurturing new small businesses, some of which will innovate. At this stage, however, that is probably only a distant dream for the next administration but one.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)