Wednesday, 21 November 2012

Zombies causing havoc (with monetary policy)

Halloween has come and gone this year but stories of zombies are still haunting the dreams of some.  One person in particular is Mervyn King who is the governor of the Bank of England (the central bank in the United Kingdom) and the walking dead are making the difficult job of guiding the economy through a weak recovery into something even more treacherous.

Nothing is ever too exciting in economies so rather than brain-munching corpses, zombies instead refers to companies who are saddled with excessive levels of debt which should drive them into bankruptcy but who are artificially kept alive by lower interest rates.  But firms closing down is a necessary part of the functioning of an economy and here’s why. 

During periods of growth, an economy can expand so rapidly that not all funds are put to good use – too many firms may be making too much of the same products.  So, a recession is normally a time where the less successful are weeded out.  As part of a process which is referred to as creative destruction, some firms go bust and this frees up money and workers that can be put to better use elsewhere.  While it sounds a nasty prospect, it is crucial to the vitality of an economy.  Think of a jungle where no animal would die - eventually the jungle would be overrun and even the strong would struggle.

The Bank of England (BoE) released data last week showing that, while three out of ten firms in the UK are losing money, the number of firms going under is low compared to other recessions.  This could be seen as a good thing in the short term – fewer workers out of jobs mean that the slump in the economy is milder than it might have been.  It also means that companies which have viable businesses but are going through a rough patch can stay in business and go on to prosper in the future. 

However, the effects over the long term are less benign.  Zombie firms take business away from better run companies which hampers the expansion of successful businesses and hurts investment which is already sluggish as firms try to navigate a high degree of uncertainty (for more details, Tale of Two Recessions).  The rise of the walking dead has been given as a reason why the BoE now predicts that economic growth in the United Kingdom over the next few years will be slower than predicted with the economy not expected to reach the same levels as before the global financial crisis until 2015.

Like in the movies, zombie companies also have a weak spot – interest rates.  Because the zombies typically have large amounts of debt, higher interest rates increase the costs for these companies and act as magic bullet that will send them to their graves.  But increasing interest rates also makes everyone else suffer and hurts the economy in the short term.  This leaves Mervyn King and the BoE with a dilemma.  The current low interest rates are prolonging the lives of businesses that need to be put down but the harsh measures required to do this could kill off hopes for a recovery.  Such a conundrum and talk of zombies would be enough to keep Your Neighbourhood Economist awake at night.

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