The aftermath shows us what happens when the balance sheets of households and banks are impaired. The “negative equity” for homeowners and financial institutions creates incentives for perverse behavior, including asset substitution3 and underinvestment (debt overhang). The literature on corporate finance tells the story of desperate equity holders engaging in highly risky transactions with negative present value (NPV) as a way to gamble in an attempt to get out of the hole (asset substitution). At the same time, low risk positive NPV projects are forgone because equity holders do not benefit from modest increases in asset/enterprise value; instead equity holders may prefer to erode asset value through self-enriching schemes.4 These sub-optimal patterns of behavior are precisely why “zombie” banks and households are undesirable and growth inhibiting in an economy.
As the undead wander the social and economic landscape, investors are loathe to put in fresh capital, not only because lending to perversely motivated zombies is generally a bad idea, but also because their investments can be diluted if government policies designed to protect moribund banks channel new money to past capital claimants whose investments failed. The uncertainty about future government policy further discourages the capital market from injecting fuel and much needed new stewardship to rekindle and shepherd growth.
Note that when the recession is driven by a balance sheet crisis, instead of a liquidity crisis, providing more liquidity will not drive real investments and growth. Healthy financial intermediaries are simply not interested in extending credit to zombie entities. Having the government direct liquidity toward these zombie entities by fiat would only be throwing good money after bad. Stimulus spending, on the other hand, has a limited effect in resolving the primary problems: it quickly restores the equity value of zombie banks and households. Of course, it can accidentally stimulate economic activity in areas where no inducements are needed.
Restoring Economic Activity Means Making Hard Choices
There exist various solutions for eliminating zombie households and banks and restoring economic activity. But all the options are painful. The Japanese model is one where zombies and their creditors and investors are protected (and often receiving welfare in the form of social and corporate subsidies) until their balance sheets are restored. Under this approach, it can take decades to nurse zombies back to life, and anemic economic growth is experienced throughout the period of convalescence. In this model, the significant transfer cost is dwarfed by the cost of the growth drag imposed on all citizens due to the zombie entities.
The Swedish model, in which balance sheets are rebooted through bankruptcy and orderly default, can take effect more immediately, writing down debts for households
and salvageable financial institutions while eliminating poorly functioning banks by wiping out their investors and creditors. In the U.S. tax code, these actions are known as Chapter 11 and Chapter 7 bankruptcies, respectively. The Swedish model is the textbook prescription for eliminating zombies, and it illustrates the benefits and usefulness of orderly bankruptcy. The cost is an immediate recognition of substantial losses concentrated entirely on equity and bond investors. While personal bankruptcy generally leads to a fresh start and greater future growth in the standard of living, it can be psychologically traumatizing, and this solution is shunned by some households.
The Finnish model involves rapid (but often temporary) currency devaluation. This approach has proven to be effective for other countries like Mexico, Argentina, Thailand, and other Southeastern Asian countries. The massive devaluation can be interpreted as a marking down of all domestic assets and debt in global currencies—a decline of 30% in currency value, in one fell swoop, reducing the debt burden by 30% in international terms and at the same time increasing the international rent on exportable factors of production. This method reduces domestic consumption in favor of exporting, pushes internationally uncompetitive wages down, subsidizes the export oriented industries, and marks down savings and the inflated nominal wealth that has been stored in real estate. This sequence of “price” re-alignment through the currency channel eliminates the “economic drag” associated with downward rigidity in wages and real estate prices (both of which result from the domestic real estate bubble underlying the balance sheet crisis). At the same time, the Finnish model significantly resets the debt burden of the zombies. The depressed currency and therefore the subsidy from holders of domestic cash and assets to debtors and exporters (firms and workers) will continue until the impaired balance sheets are repaired.
Each of the possible solutions is harrowing: the housing price decline destroyed wealth, and there is simply no magical government program for restoring wealth painlessly. Moving money from asset rich households and firms to subsidize the indebted does not increase overall wealth and can often exacerbate the problem, especially if it means prolonging the zombie apocalypse. While the government does not get to create wealth out of thin air through transfers (much as it might like to claim such a magical ability), it does get to choose when and to whom the pain will be allocated.