Are too many businesses failing, or not enough?

Before the pandemic set in, about 67,800 Australian businesses that employed people failed each year. Was this a problem? Not really. Although we lost 67,800 employing businesses each year, we typically saw another 93,500 created.

It might sound cruel, but this churn of failure and creation is a good thing. In economic terms, "creative destruction" is constantly replacing uncompetitive businesses with new, innovative and more productive ones. While the transitions can be difficult, the net effect has been positive for society.

Creative destruction is a fundamental source of the productivity growth that drives growth in our long-run living standards. The reason for this is straightforward. Because we have limited resources - capital, labour, energy and materials - with which to produce things, we want to make sure we are using these resources as productively as possible. We want these resources to be employed by cutting-edge businesses that expand our economic frontier, rather than by relics of the past that take us nowhere.

But COVID-19 has created a predicament. So far, it's not that too many businesses have failed, but rather too few. If we look at Australian companies (since we don't yet have data on the entire business community), we normally see an average of 8570 companies enter external administration each year, according to ASIC. In 2020 that number plummeted to just 4943, a fall of about 42 per cent. At least 3600 companies are alive today that ordinarily wouldn't be.

These "zombie firms" are the downside of the government spending and low interest rates that supported the economy during COVID-19. This is not to say that those supports were a bad idea; in fact, they were exactly what was required. After all, creative destruction is about replacing old, unproductive businesses with new, innovative ones, not letting perfectly healthy and productive businesses fail because of a once-in-a-century event.

But the figures raise tricky questions about what comes next and how we respond. As government supports come to an end and businesses run down their savings, we are likely to see an increase in the number of businesses failing. If these are the businesses that would normally have failed anyway, there is no cause for alarm. But if these were competitive, productive businesses that would have continued to function normally had it not been for COVID-19, then we might be more worried.

How do we know if the "right" number of businesses fail? Economists are typically less concerned about the number of businesses that operate in any given market and are more concerned about whether, and how quickly, a failing business could be replaced, either by existing businesses that expand production or by a new business entering the market. In economics jargon, we are interested in market concentration (how many alternative suppliers exist), the barriers to expansion (the extent to which alternative suppliers can increase production) and the barriers to entry (the extent to which new businesses are blocked from entering the market). On these measures, there are a few reasons to be concerned.

First, we know that most of Australia's markets are unduly concentrated, meaning there are few alternative firms. More than half of Australia's markets qualify as concentrated, according to one study, with the four biggest firms controlling at least one-third of the market. It's worse in many industries, from banking and health insurance to beer and baby food, where the four biggest firms control at least 80 per cent of the market. If a business fails in these markets then the availability of alternative suppliers is, by definition, smaller than is the case in markets that are less concentrated, such as construction or agriculture. The failure of a firm gives the survivors more market power, which isn't a good thing either.

Second, we know that barriers to entry are high in many markets, meaning it is difficult for new firms to enter in the event of a business failure. These barriers can take the form of regulations (like the zoning laws that stop supermarkets from opening new stores and the laws that stop more pharmacies being opened), structural factors (like the major capital costs required to start an airline) or strategic obstacles (like when an established firm uses a price war to deter start-ups).

While no studies have looked at barriers to entry across the economy as a whole, an imperfect proxy is to look at whether a sustained increase in profits in a particular industry is correlated with an increase in new businesses entering that industry over time. If profits go up, and stay up, and new firms don't enter, this could be a sign of high barriers to entry. For the Australian economy, the correlation between sustained profits and new businesses entering markets is suspiciously low.

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Finally, all this talk of old businesses failing and new businesses taking their place hinges on how quickly capital and workers can be redeployed from the former to the latter. Recent changes to insolvency laws will mean capital can be withdrawn and redeployed faster than was once the case. But what about workers?

The problem is that people are much less mobile than they used to be. The proportion of Australians changing their state of residence fell by 20 per cent between 1981 and 2016. Movement between regions within states fell by even more (25 per cent).

This lack of mobility means workers may be less likely to shift from a failing business to a new one, unless that new business happens to be located where they live. It's little wonder that unemployment varies so widely across Australia. It helps explain low wages, too. Treasury's Nathan Deutscher found that a one-percentage-point increase in the rate at which workers switch jobs is associated with a 0.5-percentage-point increase in the growth of average wages. Having more people working from home might help, but it's unclear if it will be big enough to plug the gap.

Few things have been certain when it comes to COVID-19, but one thing is clear: as government spending falls, savings run down and central banks ease their supports, more businesses will fail. Making it easier for people to start new businesses and expand existing ones, and helping workers move from one to another, has never been more important.