Yesterday’s FT announced (£) that the ‘BoE fears zombie companies haunt the road to recovery’, claiming that ‘the idea that zombie households, companies and banks are holding back the recovery will gain further weight in the quarterly inflation report today when the central bank will present research showing most productivity weakness is presented in smaller companies’. The analysis, based on a preview of yesterday’s Inflation Report, maintains that a large number of British businesses are struggling under a debt burden which is holding back investment decisions and making businesses highly susceptible to insolvency as soon as interest rates start to rise. The worry is that this means we are stuck with an underlying stock of unproductive companies which should have gone bust during the recession, but have been supported to survive by low interest rates. Proponents of this thesis are concerned that these businesses will hold back the recovery as they fail, and that in the mean time they are sucking resources away from new start ups that could drive strong growth.
But is the outlook really this bleak? Have we lost far more capacity than anyone previously imagined? And do the data in the Inflation Report actually support this thesis?
In fact, the Bank’s analysis is somewhat more circumspect, and so is worth repeating.
To start with the Bank concludes that (emphasis my own):
On the one hand, the weakness in demand itself may have meant that measured productivity has been weak. In that case, productivity could rebound sharply as demand recovers. On the other hand, factors such as the financial crisis may have reduced growth in underlying productivity — the amount of output that a given amount of labour could produce if demand were not a constraint on output. In that case, productivity will depend on the extent to which those impediments — which may also have been associated with weak demand — dissipate.
The report then goes on to consider ways in which both weak demand and lack of access to finance could be holding productivity back.
Firstly, the Bank consider that some companies may have been unable to cut employment below a minimum needed to keep the business in operation, that others may have held onto staff in anticipation of a pickup in demand and that some may have to devote more effort to generating custom, reducing their overall output. In these cases, they conclude that productivity should pick up as demand rises, or will remain depressed until the economy is supported to bounce back.
The Bank then goes on to consider constraints on underlying productivity growth, concluding that:
The financial crisis has probably impeded underlying productivity growth: international evidence indicates that past financial crises have been associated with pronounced and persistent reductions in the level of productivity. Most directly, the tightening of credit conditions following the crisis increased the cost of working capital and reduced its availability. That may have prevented some companies from producing output, or reduced the efficiency of businesses’ production processes — for example if they have had to operate with smaller buffers of stocks.
Further constraints on underlying productivity growth are also provided – weak business investment (potentially caused by the poor outlook as well as by credit conditions, given the scale of current large corporate surpluses – with small businesses more likely to be affected by the former) limiting innovation and new capital stock, the potential that finance is not being reallocated to its most ‘productive use’, limited bank lending to new and riskier ventures and (finally) the conclusion that :
One potential impediment to the effective reallocation of capital relates to forbearance. In particular, forbearance by banks on existing loans, coupled with the low level of Bank Rate, may have allowed businesses that will face lower demand in the longer term to continue trading. Although such forbearance may have allowed some viable businesses to remain in operation through a temporary period of weak demand, others may find it hard to compete in their markets. It is difficult to judge how significant this effect has been.
The report then concludes:
It is unclear whether the shortfall in measured productivity has arisen mainly because weakness in demand has meant that measured productivity has been weak or mainly because underlying productivity growth has been weak. Some pieces of evidence support both explanations. For example, data from companies’ accounts suggest that most of the weakness in productivity growth has been accounted for by small and medium-sized businesses. That could be related to the weakness in demand, since smaller businesses may be more likely to be affected by minimum staffing requirements. But it could also be because smaller businesses are more reliant on credit.
My analysis of the Bank’s research is that it suggests both weak demand and underlying supply constraints are holding the recovery back – with the evidence suggesting that access to finance is the largest supply side problem, rather than large numbers of businesses operating with large debt overhangs. As repeated business surveys have demonstrated that access to credit is a real challenge to the recovery – and the need for meaningful government action to resolve this issue and deliver a banking system that truly works for British business is, as Duncan has repeatedly shown (pdf), pressing.
While we’ve had fewer insolvencies this recession than in previous recent downturns companies also entered the recession in a far better state (pdf) and have been able to contain their labour costs through wages restraint and hours reductions far more than in the 80s and 90s. Profitability is rising and corporate surpluses remain healthy. Of course there is a risk that when rates start to rise some small businesses (and potentially many more individuals) will find that they cannot afford to pay their debts, but it also seems likely that many more will benefit and grow if demand can rise. My view is that while poor productivity remains a significant risk for the economy it is a consequence and not a cause of our ongoing stagnation. The challenge for Governments is finding the economic policy solutions which will boost demand and improve access to finance. The evidence that zombie companies are our biggest problem simply doesn’t stack up.
This argument is important – as it comes down to whether there is or isn’t scope for the economy to significantly expand without facing supply constraints, how much capacity the recession has lost us and how big the debt burden we are facing is. If we are over run with zombie companies, with no prospect of regaining lost ground, then our economy is far smaller than we think and the structural part of our deficit significantly larger. But the evidence in the Inflation Report doesn’t support this analysis – on the contrary it suggests that if we can strengthen demand, in part by sorting out access to finance (and also by boosting household incomes and keeping inflation low) – there is every chance of a stronger recovery. Of course our current period of economic stagnation continues, there is every chance of more permanent economic damage – further strengthening the case for immediate action to boost demand and get banks lending.