Why are we so scared of letting businesses fail?


By Yogen Mugdal, BSc Accounting and Finance Student at Warwick Business School


In a recession, businesses that no longer fit into the new economic equation, fail. Any classical economist would argue that it is important to let these businesses fail so that the resources they would otherwise use can be channelled into more productive purposes. However, both in 2008 and in 2020, governments around the world have played a significant role in attempting to keep as many businesses as possible alive, in an endeavour to prevent spikes in unemployment or a depression-like downturn in economic output. Rescuing businesses can indeed be deemed as “strategically important” for the continued success of an economy and bailouts with massive capital infusions has become a mainstream, even necessary, aspect of both fiscal and monetary policy. 


Critics of state-sponsored bailouts argue that protecting weak businesses creates a host of “zombie” companies that keep dragging along, generating just enough to keep the firm as a going concern, but unable to invest in new technologies and growth. They point to the productivity crisis that has been evident since 2008 and argue that the market should be allowed to fix itself without any interference from the state. On the other hand, proponents of state intervention claim that most businesses fail during crises not necessarily because of inherent flaws, but because they operate in distressed sectors and have troubled balance sheets. They argue that businesses consequently need to be saved in order to protect jobs and any knock-on effect that their failure could have on the economy. 


It was expected that many firms would go out of business over a long period of time to avoid a huge spike around the 2008 recession. Nonetheless, cheap debt, excessive leverage and extreme levels of financial engineering have given them just enough firepower to avoid insolvency. Most estimates reveal that nearly one fifth of the businesses in the UK could be awarded the “Zombie” status and the figures hover around 16% in the US’s Russell 3000. Many believe that Europe and particularly countries like Germany face a worse problem thanks to their generous stimulus measures and wage-support schemes.


The “Zombie” company problem is no longer restricted to the developed economies in the west anymore. China, where, to maintain companies afloat, public-sector banks have been asked to forego profits to keep pumping cash, is perhaps the world’s biggest conglomeration of these living-dead firms. Moreover, state intervention to save businesses is no longer politically challenged by either of the major ideologies in the UK, US and across much of Europe. This almost eery bipartisan consensus, along with one of the longest economic expansions on record has created an army of Zombie companies that have become a huge drag on global economic output. 


The Covid-19 pandemic did not cause the zombie apocalypse, but it can be expected to substantially intensify it if the global aversion to business failure continues through the recession – particularly due to the kind of structural changes this crisis brings about in our economy. Since this is a self-induced downturn, there is a strong argument to be made for government support. Arguably, there was a strong rationale for government support in 2008 for the financial sector. No competent economist could say that governments and central banks shouldn’t rescue the largest banks in the world. However, no competent politician could face the electorate after rescuing Wall Street but letting local high-street businesses fail, which really puts the entire scenario into context.  


Governments around the world are unwilling to pick winners out of a recession because, as history suggests, central planning is very harmful for the economy. But, when stimulus is pumped in, it flows to all sectors, including those like retail and oil that are unlikely to have a bright future. It is becoming increasingly clear that both central banks and governments can no longer avoid this crisis. Marginally profitable businesses were the single most important factor in causing Japan’s lost decades and now threaten the same for much of the developed world. Perhaps the biggest question policymakers now need to ask is how, in the age of record-low interest rates and economies addicted to fiscal and monetary support, the market can safely be allowed to correct itself. 


The most potent argument is for fiscal support in particular, to be targeted at the workers instead of businesses and retraining and re-education programmes to be used more widely to allow swift transition of labour to where there is a skills shortage. It is still worth examining how rescuing business should play out. The kind of guaranteed rescue loans or business interruption loans that were commonplace at the peak of the health crisis should be viewed with great scepticism. It is not unreasonable to say that such schemes should have targeted only those establishments that were forced to shut down and only for a limited time span. For large corporates, like those in the aviation sector that have access to capital markets and restructuring advisers, the market should be allowed to ascertain their future. 


Given the unprecedented times that we live in, it is easy to seek, and for policymakers to deliver, huge bouts of stimulus. However, if Japan’s experience teaches us one thing, it is to swallow the painful economic pill and let the market do its job. Structural reforms in the economy need to be allowed to alter the dynamics of the labour market and composition of businesses just as they did in the 1980s. It is often hard to decide where and how much stimulus is adequate until it’s in hindsight. But that is not a reason to have a state that coddles faltering businesses and bails out the present by sacrificing the future. The decision on which firms should survive a recession needs to rest in the hands of investors and creditors to determine their viability in the new economy. Time and time again, we all have to kneel to the might of the invisible hand and acknowledge that the market is in fact, always right.


What do you think? Let us know in the comment section below!

Interested in writing for us? Click on the 'Write For Us' button at the top of the page!

Click here to visit WallStreetOasis.com