Friday, February 26, 2016

Competing Economic Doctrines: ‘Creative Destruction’ vs. ‘Too Big To Fail’

In 1942, the economist Joseph Schumpeter earned a permanent place in history when he developed the phrase ‘creative destruction’ to describe how economic growth and innovation arise from the debris of failed enterprises.

On average, businesses which fail or go bankrupt are replaced by more successful companies. On average, a worker who is laid off eventually finds not only another job, but a better-paying one.

To secure the full benefits of Schumpeter’s principle, however, those who are in a position to intervene in the economy must exercise restraint. The sometimes counterintuitive implications of “creative destruction” may require regulators to stand back and allow the financial collapse of a business, or an entire industry, to play out.

The humanitarian impulse, of course, nudges the government to intervene on the behalf of failing companies for the sake of workers who might lose their jobs, or for the sake of investors who depend on dividends for their daily bread.

Yet the best outcome for workers and investors alike, over the long run, is to allow creative destruction to take its course. Bitter lessons of history show that, e.g., the 1979 bailout of the Chrysler Corporation did indeed keep the company alive, but only barely, and long-run effect was to extend the misery as auto workers coped with shrinking wages and investors found Chrysler to be less than fruitful.

Historians should not engage in speculation about counterfactual situations: so one may not confidently state what would have happened had the 1979 bailout not taken place.

However, the record shows numerous financial collapses and bankruptcies which ultimately led to new and larger business opportunities.

Opposing the doctrine of ‘creative destruction’ is the political notion that some enterprises are ‘too big to fail,’ meaning that they are too big to be allowed to fail.

This political approach argues that the government should intervene in the natural workings of marketplace to sustain large companies which might otherwise declare bankruptcy. Allegedly, this policy avoids a ‘domino effect’ or a ‘chain reaction’ of other business failures.

Both the administrations of George W. Bush and Barack Obama implemented this policy, despite purported differences between those two presidencies.

Two sectors received this attention: the financial industry and the automotive industry. General Motors Corporation and Chrysler Corporation received massive government support at a time when there was at least the possibility that they might have to declare bankruptcy.

Concerning the continuity of the two administrations in this policy, Paula Gardner, reporting Sandy Baruah’s analysis of Obama’s actions, wrote:

Politics also might enter the message. Baruah said, “He vastly underplays the role President Bush played in setting the stage. The U.S. auto industry would not have been saveable in 2009 if George W. Bush had not taken the action that he did.”

One must be careful not to confuse the “U.S. auto industry” with a collection of auto companies. One or two companies can go bankrupt, and in so doing, strengthen the industry. By “saving” a company, one can weaken the industry.

Had GM or Chrysler declared bankruptcy, it would not have been the loss of thousands of jobs. The physical facilities of those corporations would have been maintained, the companies would have been restructured or sold or broken up, and new owners would have happily invested, getting manufacturing equipment and buildings at a bargain price.

The result would have been an energized industry and a burst of economic activity.

The tension, then, lies between two competing and mutually exclusive economic doctrines: ‘creative destruction’ vs. ‘too big to fail.’

The question is whether to save a company at the expense of the economy, or to save the economy at the expense of a company.

The organic functioning of an economy includes as a regular feature the failure of businesses. That the businesses are large or small makes no difference. David Stockman, Director of the Office of Management and Budget from January 1981 to August 1985, reviews the recent history how individuals were willing to let the economy work its own course:

Certainly President Eisenhower’s treasury secretary and doughty opponent of Big Government, George Humphrey, would never have conflated the future of capitalism with the stock price of two or even two dozen Wall Street firms. Nor would President Kennedy’s treasury secretary, Douglas Dillon, have done so, even had his own family’s firm been imperiled. President Ford’s treasury secretary and fiery apostle of free market capitalism, Bill Simon, would have crushed any bailout proposal in a thunder of denunciation. Even President Reagan’s man at the Treasury Department, Don Regan, a Wall Street lifer who had build the modern Merrill Lynch, resisted the 1984 bailout of Continental Illinois until the very end.

Prosperity is the result of allowing individuals and businesses to trade freely, and allowing them to experience the consequences of those trades - for good or for ill. It is tempting to intervene, with the well-intentioned desire to alleviate the short-term financial turmoil brought about by bankruptcies.

But, in avoiding that short-term pain, one prevents the economy from maximizing its long-term gains. A worker might be spared a few months of unemployment, but he is now left to languish at wages lower than if he’d been laid off in bankruptcy and later rehired by a business which was more competitive than the original one.