Let Them Fail

The market economy is a profit and LOSS system.  Imprudent decisions do require correction --- if not by the individuals themselves, then by others who enter into the market in the hope of realizing the profit opportunities others are mistakeningly leaving on the table.  This is how markets work; this is how markets self-correct.  The self-correction properties of the market economy is perhaps the most important lesson of economic science (not an issue of faith) that must be communicated to the general public.  Unfortunately, this fundamental truth of economic theory is one of the first casualty of crises.

Firms enter and exit all the time in a vibrant market economy.  During my days as an economist/Sovietologist one of the factoids I peppered my public talks with was the number of bankruptcies in NYC in one month in 1995 versus the number of bankruptcies in all of Russia from 1991 to 1995.  The number in NYC swamped the number in Russia.  Firms get driven from the market, executives who made poor decisions lose their jobs, and industries that no longer meet consumer demands become obsolete.  Was it a crisis for water-carriers to be driven from the market by the innovation of indoor plumbing, or for the whaling industry in New Englad to be displaced when electric light became wide-spread.

Resources do not disappear, they get reallocated.  The market process is a mechanism for the continual re-evaluation and re-shuffling of scarce resources among alternative uses.  This is what is meant when we refer to the market as a dynamic process of entrepreneurial discovery and learning.

The most important "wisdom" of market process theory is to get out of the way of the process of adjustment.  The poor decisions in one period must be penalized, the malinvestments made by businesses must be cleaned out, and the opportunities for hitherto unrecognized profit opportunities must be allowed to be exploited.  Bailouts, regulations, taxes, redistribution, and inflation only hinder the ability of the market to self-correct.

Besides the economics, there is also constitutional and ethical issues that should be considered when such sweeping legislation is proposed.  Consider the classic essay "Not Yours to Give" by Davey Crockett.  There is also a consequentialist issue at stake.  A free society works best when the need for the policemen (read in this case regulator) is least.  Individuals must be equiped to embrace the troubles of thinking and the cares of living if they are to live free as a self-governing citizenry.

The consequences of our current policy path are dire in terms of economics, politics, and freedom.

Comments

[PCLE]

Professor: I understand your point from the perspective of economic theory. But economies are embedded in a polity. So as a counter-argument: If we did let them fail, and say the disruption led to significant social convulsion leading to even more government intervention along the lines of perhaps 1930s Germany, would that be acceptable to you?

[Grant]

Or, what if the incentives shaped and created by our regulatory and central banking structures create an environment where future failures are inevitable? What would be the point of letting everything fall down just to have it built up in the same unstable manner again?

[Allen Dalton]

I hope I'm not beating a dead horse when I point out that Pete's wording here, to wit, "The poor decisions in one period must be penalized..." is exactly the point I am trying to highlight in the Executive Compensation thread. How are "bad decisions being penalized" when the CEOs who made the bad decisions are rewarded with golden parachutes?

[Rafe Champion]

There is going to be a convulsion of some kind whatever happens, but the real economy of the nation will remain sound, the productive infrastructure, the skills and the people will still be there. As someone said "There is a power of ruin in a nation". The question is whether the institutional framework and the incentives that are in place after the convulsion will promote productive and prudent decisions, or whether the incentives will remain perverse and result in more of the same thing, along with inflation and a few other downsides.

There used to be a joke doing the rounds about the stages of innovation in the firm. One of the early stages is "Wild enthusiasm". Then it all goes wrong, and the final stage of the process is "Persecute the innocent and reward the guilty".

[Nick]

Pete - good post.

Also, further to Steve's post about Jonathan Sacks saying that: "It is through exchange that difference becomes a blessing, not a curse."

Sacks was on UK Radio 4's "Thought for the day" this morning sticking up for markets as the best way to organise and ensure cooperation. There aren't many voices doing this in the UK at the moment, which made it even better to hear. Well done Sacks.

[DPrychitko]

Let them fail?

We do -- all the small businesses and lower-level corporations. They often ask for extra credit, but even with that, they fail.

But the big boys, well, they're in the Ivy League. They've paid so much to get in, now they expect to pass with an A grade, or at worst a B. The government is increasingly willing to inflate grades, from manipulating the terms of trade to manipulating taxes, credit, and budget constraints.

A freshman at a small, rural state school dies after a night of drinking, it makes the regional papers and we say it's a shame. A freshman at a great private college dies and it's national news, and we say my goodness what a tragedy, he had so, so much potential. What a great loss for us all. Let's make sure it never happens again.

[DPrychitko]

I was going to add something about organ donation, and those assets shifting to higher-valued uses, and something about toxic assets, too. Then I realized this is just too gruesome and the analogy has been fully drained of any of its usefulness.

[kio]

The money were not lost in aconomic activity, but stolen. So, the bailout is an insurance issue not economic.

[Stuhlmann]

I am always amused by the use of the Davy Crockett story as a lesson on why the government shouldn't help out individuals. As a Congressman, Davy Crockett's biggest legislative interest was in getting the government to sell Federal lands in Tennessee to the farmers/settlers at little or no cost. This would have been a major benefit to the people in his district - and to himself. So why not vote money to some widow if you are willing to vote land for farmers. A government handout is a government handout.

[mt]

It seems to be not so much about penalizing failure. Failure is part of the learning process and has its own reward. If I put my hand on a hot stove the burn is not a punishment. It is rather the natural result of working with a faulty model. Penalizing would be to send me to my room for putting my hand on a hot stove. What the government officials are doing is buying me chocolate to soothe me and to take my attention from the mistake. It would be like telling me that it was their fault for leaving the stove on in the first place.

[Richard Ebeling]

In "An Economist's Protest" (1927), English economist Edwin Cannan remarked, "Modern civilization, nearly all civilization, is based on the principle of making things pleasant for those who please the market and unpleasant for those who fail to do so, and whatever defects this principle may have, it is better than none."

Ultimately there are only two ways for men's activities to be coordinated in the social system of division of labor: through either enforced command or voluntary cooperation. Under enforced command, the political authority, regardless of the ideological label under which it justifies itself, dictates and directs the use of labor and resources according to a plan devised by those controlling the coercive powers of the state.

Under voluntary cooperation, men are left free, in a political system limited to the protection of the citizenry's life and property, to enter peacefully into exchange relationships with one another on the basis of mutual agreement and anticipated mutual gains from trade.

But a system founded on the premise of voluntary cooperation is also one in which each participant must accept the fact that his success or failure is dependent upon whether he has succeeded or not in producing and offering for sale something that others in the society value sufficiently for the seller to earn a return in excess of the costs he has incurred in bringing it to market. If he has misjudged what the consumers want and the price they are willing to pay for what he brings to market, he suffers a loss rather than earns a profit.

But his failure, his suffering of a loss, is in fact the market's feedback information that tells him that he has devoted his efforts in the wrong direction; he learns either that consumers prefer some other commodity more than the one he has offered to them, or that others have succeeded in devising ways of marketing that product at a lower price than the one at which he can sell it.

Whatever the reason, his failure to earn as much as he had expected or his actual suffering of a loss is telling him that he needs to adjust his behavior. He must either shift into making something consumers prefer more or creatively think of ways to match the competition by offering a better or cheaper version of the product.

Explaining this principle was done back in 1994 by Dwight Lee and Richad McKenzie in their book, "Failure and Success: The Bright Side of the Dismal Science." The central idea that they tried to convey is that an economic system that allows individuals to fail and bear the consequences of their mistakes in the market is a social arrangement more conducive to the economic prosperity of all than is a political arrangement in which the state can be drawn upon to protect an expanding number of individuals from the negative effects of the miscalculations that have produced financial losses or lost employment.

Every innovation and improvement in the quality and available quantities of the goods brought to market involves a disruption of the status quo. New technologies replace old ones; new products on the market displace some that were previously purchased. New patterns of consumer preferences increase the demand for some goods and decrease the demand for others. The employers' demand for certain types of labor increases for the goods now in higher demand, and the demand for certain types of labor decreases in the industries experiencing a decrease in consumer demand.

If an economy is to adapt to these types of changing circumstances, and with the greatest ease and rapidity, every individual experiencing these changes in his respective corner of the market must be willing to respond appropriately to what the market dictates as the revised course of action that each participant should now follow.

But this "dictation" by the market does not involve either the use of force or its threatened application. Rather, it is merely a changing set of monetary rewards that the market offers for different activities performed; and each individual is left free to adjust and respond as he considers best and most profitable in the new environment of changed supply and demand conditions.

There are several dangers when people turn to the state for protection and security from the winds of peaceful market change. First, the only source from which the state can provide subsidies to support loss-making producers is through taxing those who are successful and profit-making. This has at least two negative effects: it weakens the incentives of those who have been successful to be as industrious as before; and it redistributes resources away from the production of products that consumers actually want and are willing to pay for.

Second, once the state becomes a mechanism through which political protections and privileges may be received, individuals will have incentives to devote their time and wealth to the acquisition of favors from the state, instead of using them to manufacture things that consumers on the market desire to buy.

Third, those who are meant to be the recipients of assistance from the state often end up being harmed rather than helped by this endeavor to save them from their own failures and mistakes. Such assistance creates a politics and psychology of dependency that traps many of these people in the very poverty and low-income status that state support was meant to cure.

What, then, can and should the state do? Lee and McKenzie replied in their book that "the single most effective government poverty program consists of government doing nothing more than establishing an environment that facilitates market exchanges." That is, to leave the market free, open and unregulated, so that men are left free to compete freely to attain their various and mutual ends

Richard Ebeling

[mt]

I like the following quote by Jeremy Bentham (in his critique of Smith, Defense of Usury):

“The career of art, the great road which receives the footsteps of projectors, may be considered as a vast, and perhaps unbounded, plain, bestrewed with gulphs, such as Curtius was swallowed up in. Each requires an human victim to fall into it ere it can close, but when it once closes, it closes to open no more, and so much of the path is safe to those who follow.” (XIII.30) “To tie men neck and heels, and throw them into the gulphs I have been speaking of, is altogether out of the question: but if at every gulph a Curtius stands mounted and caparisoned, ready to take the leap, is it for the legislator, in a fit of old-womanish tenderness, to pull him away?”(XII.34)

(this passage references a Roman myth, where a noble Roman sacrificed himself to save Rome. By throwing himself into an expanding hole in the ground, the gods closed the hole behind him.)