Too Big Not to Fail

In my last post in this series, I concluded:

I believe that the best kind of stimulus is drastically cutting military spending and spending the money instead on infrastructure — energy infrastructure (including alternatives to oil), education, transport, science, construction, food security. This can be done both through government spending, and by returning some money to the poor and middle class taxpayer to invest or spend. Achieving that would give us all something to be optimistic about.

Eliot Spitzer, the former Governor of New York writing for Slate in 2008 concludes much the same thing about the blockbuster financial aid package received by banks in the heat of the last crisis:

Vast sums now being spent on rescue packages might have been available to increase the intellectual capabilities of the next generation, or to support basic research and development that could give us true competitive advantage, or to restructure our bloated health care sector, or to build the type of physical infrastructure we need to be competitive.

Spitzer then gets into the crux of the issue:

It is time we permitted the market to work: This means true competition with winners and losers; companies that disappear; shareholders and CEOs who can lose as well as win; and government investment in the long-range competitiveness of our nation, not in a failed business model of financial concentration and failed risk management that holds nobody accountable.

A couple of years ago, I came up with a definition of a “free market”:

A free market is an economy which allows for the unlimited and unconstrained testing of ideas. It is a place where good ideas will succeed and where bad ideas will fail in a continuous cycle of creative destruction.

There are many estimates to how much money was injected into the economy during the Crash of 07-8, all of them in the trillions. But claiming that this is a good thing fundamentally misunderstands the nature of the crash. The crash was a result of systemic failures:

  1. Hyper-connected global Super-Banks creating trillions of dollars of extremely complex financial instruments that they themselves did not fully understand or could properly value and then trading these without any real regulation.
  2. Excessive borrowing (by governments, firms and individuals) creating excessive risk, and reducing financial flexibility due to payments of interest, meaning that any credit contraction would almost necessarily mean a crash.
  3. Artificially-low interest rates triggering excessive borrowing, and producing credit bubbles, resulting in cycles of bad investments.
  4. The failure to develop alternative energy, combined with the failure to keep oil cheap, resulting in rising energy prices.
  5. The failure of large corporations to properly value their assets, leading to excessive asset valuations, resulting in the capability to borrow excessively.
  6. Consumer banking firms acting as hedge funds and leveraging their customers’ assets in global derivatives and equity markets.
  7. The failure of government and industry to develop an alternative employment model for the West as industrial and  (and increasingly also service industry) manufacturing jobs were exported to China and the East.
  8. The stagnation of individual and household savings in the West, meaning the long-term capital accumulation required for the investments we need is not met.

Of course, that isn’t an exhaustive list. I am barely scratching the surface. But the key theme is that these are structural and systemic failures, and not ones that can be addressed by panicking and “saving the system”. No matter how much money we inject into markets, unless bad ideas are allowed to fail, and good ones to prosper, unless bad investments result in losses, and good ones in gains, unless bad decisions result in failure, and good ones in reward, then all of that money is wasted. If anything, we need bad systems to break. We should take the consequences, and start rebuilding more robust systems.

Professor George Selgin, of the University of Georgia notes:

Genuine recovery from a post-boom crash calls not just for adequate spending, but for a return to sustainable production – production purged of boom-era distortions caused by easy money… An unsustainable boom is one after which some things really do need liquidating. The straightforward recipe for the revival of healthy investment following the 2008 crisis was to liquidate. Liquidate Bear Stearns! Liquidate Fannie Mae and Freddie Mac! Liquidate, in short, the whole sub-prime bubble-blowing apparatus that was nurtured by easy monetary policy. That would have meant letting insolvent banks that lent or invested unwisely go bust. But instead our governments chose to keep bad banks going and that is why quantitative easing has proven a failure. Quantitative easing failed because almost all the new money the government created has gone to shore up the balance sheets of irresponsible bankers. Now those banks sit on piles of idle cash while other businesses starve or cannot get started for want of credit.

Amen to that, brother!

The great danger of a bailout culture — and more generally of corporatism — is that new ideas get overlooked and underfunded, bad ideas prosper, and failures can rise to the top. And that is a recipe for disaster and stagnation.

That’s all for now.


14 thoughts on “Too Big Not to Fail

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