A key feature of capitalism is Failure – Not stability

2011-12-17

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We almost always associate capitalism with the maximization of profit, as indeed that is what drives individuals in a free market economy to produce their goods and offer their services. After all as Adam Smith, the great Scottish philosopher of the 18th century wrote in his book The Wealth of Nations:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.</p>

Profit is indeed fundamentally important in a capitalist system, just as private property, individual liberty and freedom to choose, are. Yet the most important feature of capitalism, one that allows for fair competition, innovations and progress is Failure no matter how odd that might sound at first.

Individuals in a real capitalist society are free to make their own decisions, if they succeed in their ventures they gain all the profit, but if they fail for whatever reason the cost falls on them. These are the key principles in capitalist economic thought.

In recent times we see that deviations from these principles are becoming the new rules. The reason is that mainstream economists, who are willing to develop any sort of model or laboratory experiment to “predict the future”, naively assuming that they can intervene in the economy just like a doctor conducts a surgery, are responsible for coming up with ideas that do not allow for Failure. Such are the “too big to fail” dogmas we have seen time again taking material form in the years of the current crisis, by means of public bailouts to bankrupt banks and other big corporations. Preventing failure to ostensibly save jobs or avoid a “calamitous” domino effect, leads to a series of distortions that in the end will do more harm than the intended good.

A state that prevents failures means that it socializes the loses of private corporations. So regardless if those loses were the end-result of bad management, profligate spending, of an inability to calculate risk etc. the taxpayers will be called to supply their taxes to prevent that private enterprise from going bankrupt as it should. This first of all leads to unfair competition, since only big corporations benefit from such support. Second it causes moral hazard, meaning that others will seek to do the same, effectively perpetuating the source of the problem. Third it creates a distorted allocation of resources, thus sustaining a bottomless black hole or creating a vicious cycle as good money is thrown after bad. All three combined will in the long-run bring about more problems, since the market will not function in accordance to its rules leading to other distortions, the public will be burdened by debt transfered from the bailed out corporation, the cause of the disease will not be cured, since big private interests will know in their back of their minds that there will always be a public safety net “eager” to absorb their loses – so it will happen again and the recent decades ever since 1970 tell us exactly that, as we witness it today, in the harshest of forms.

Such failing policies have characterized the actions of European (and not only) policy-makers ever since 2008. They bailed out bankrupt banks, then they bailed out bankrupt states so that they could in turn pay back their creditors, in fact indirectly bailing out again these same banks. All those billions of taxpayer money have done nothing at all to contain the crisis, as things continue to get worse – and they will never succeed in the long-term, since the structural malignancies of the system cannot be addressed with such measures.

What is the alternative? Here is what the London Banker has to say (emphasis is mine):

So what would I promote instead? Resiliency and resolution. Resiliency means the ability to withstand stresses and shocks which will unavoidably arise in global, competitive markets. Resolution means the dispersion of assets to creditors – and competitors – when banks fail, in hopes the assets and enterprises will be better managed by other managers than the same ones that led the bank to failure. Together these two principles – if made the basis for public policy – would do more to restore sanity to global banking than anything else I can think of. Resiliency will favour more and better capitalisation, with a focus on marketable assets with transparent price discovery (e.g., traded on transparent markets and recorded on balance sheet). Speedy and certain resolution of failed banks will make management and shareholders conscious of the risks of failure falling first on them, then on unsecured creditors and bondholders, and never on the taxpayer.</p>

We are a long way from adopting principles of resiliency and resolution, as demonstrated by the EU’s continued efforts to forestall defaults while protecting incumbent managements and bondholders. Our policy makers continue to chase the chimera of financial stability, and make bad policies worse along the way.

And here is what I wrote in one of my previous articles titled “Deflation, haircuts and the ECB printing money to prevent them”, when I was arguing about the benefits of deflation amid a crisis, since allowing for failure implies that deflation will kick in:

Deflation is the phenomenon whereby prices start falling. For mainstream economists this is disastrous. They fear falling prices as nothing else. Though their phobias could be discussed and justified in periods of growth, are completely groundless in economic crises, as they omit one very interesting effect of deflation: it works as a shock absorber. To understand this one needs to grasp the effects of a crisis in the capital structure. A crisis forces the dislocation and reallocation of capital, since foreclosures, bankruptcies, failures, layoffs etc. force certain businesses out of the market opening new opportunities for others to step in. So this is one thing we need to remember. The other is that in a crisis prices fall. The prices of capital goods, of land, of raw material, of labor fall. But not all prices fall equally, since the prices of consumer goods (of necessities) remain relatively stable or fall at a much slower rate, exactly because they are necessary for every consumer. These dynamics of dislocation of resources and lower prices actually open up profit opportunities, since the difference between the cost and the total price of consumer goods is widening. And where there are profit opportunities there will be entrepreneurship (also caused by the lack of any other option, since when people do not work they think of ways to survive). If we have new businesses opening up prices will stop falling effectively concluding the process of reallocation of resources, serving as the shock absorber mentioned above. So deflation is not as bad as mainstream economists think, since the shock of the crisis is absorbed by the dynamics of deflation. </p>

The current crisis is the end-product of decades of bad economic policies that allowed for malivestments and distortions in the capital structure, leading to the establishment of corporations that functioned as time-bombs in the foundations of an ill-designed architecture. To deal with the fundamental causes of this great crisis we need to rediscover the key principles of capitalism, with Failure being one of them. Otherwise we will always live in stagnant growth, increasing inflation, perpetual debt that in the end destroy the finances of the average worker and consumer and prevent the genius of the individual entrepreneur to be put to work without obstacles.

When our European leaders speak of stability they in fact imply that they will fight tooth and nail to preserve the current malignant system as it is. What we need is not stability at a sub-optimal level, but allow for the failed to meet their fate and let the more adept take over, so that the natural order of things will be restored thanks to the dynamics that will take place in the free enterprise system.