Creative Destruction: Time To Make Companies Small Enough To Fail

from the channeling-schumpeter dept

The news is filled with stories of the latest bailout: this time of the US auto industry, and for some reason it has me thinking about Joseph Schumpeter. Schumpeter, as (hopefully) many of you know, was an economist in the first half of the 20th century, who today is probably most well-known for two things: his championship of the concept of "entrepreneurs" and ongoing innovation as the process of economic growth, and the creation of profits, as well as the idea of "creative destruction" brought about by those entrepreneurs, taking down old industries with new ideas, new products and new processes. There is much that Schumpeter got wrong in his analysis (in general, I'm not a huge fan of much of Schumpeter's work), but throughout it all, there were some very important ideas that have been proven time and time again.

It's important to revisit his work, as we're seeing a sudden influx of economic philosophy "battles" between different schools of economists over how to deal with the financial crisis. The new Keynesians still believe that through government tweaking, we can guide the economy to some sort of "soft landing." The more free market-focused economists fear the end result of such tweaking. The split in schools of thinking has become significantly less pronounced than in the past, and ideas seem to permeate back and forth among these and other economic philosophies, but some core beliefs are common across most economists, and they've been shown to be correct time and time again.

Competition and Innovation

Innovation, driven by competition, is the core of economic growth. Competition drives companies to keep innovating, creating better and better products (often for less and less money). Companies that rest on their laurels get beaten in the marketplace, and that's good for everyone (except, temporarily, employees and shareholders of those companies). It gives the public better products, made more efficiently, and it keeps companies from becoming burdens.

Encouraging competition should be a key goal of government, but in most cases that means staying out of the way. Unfortunately, things don't always work out that way, and the government has often been much more involved than necessary, later causing problems. This is often seen in a rush to send antitrust lawyers after a company for being successful, but not when it's doing any actual harm on the market, or preventing any real competition from happening.

We also see it as a problem in the government's intellectual property policies, which often do little to encourage innovation, and plenty to hinder it by creating defacto monopolies.

If the government should be involved at all, it should be to enable (not create) the infrastructure that's necessary for further innovations. It should be enabling the next generation of entrepreneurs to be creating the next great businesses.

Too Big To Fail

But, rather than doing that, we see the government looking to prop up non-competitive, non-innovative behemoths that are being called "too big to fail." These are companies that, often with the help of government regulations and subsidies, have become so intertwined in the economy, that a failure on their part really would cause significant ripples throughout the rest of the economy. While there are some who suggest they should be allowed to simply fail anyway, the economic risk in doing so is quite large -- in part, as a result of bad gov't policies for many years, abused and exploited by these companies.

Simply giving these companies more money and new regulations isn't going to make a difference. It only puts off the inevitable, and potentially will make things even worse when the problems resurface. The regulations and "oversight" will seem like a good deal at first, but over time the companies will twist the regulations to their advantage. They'll create new and larger loopholes, and the regulations won't do what they're intended to do, but will instead have created massive new problems. It's what almost always happens.

Creative Destruction

So perhaps it's time to go back to Schumpeter, with a big twist. If we grant the premise that some of these companies are too big to fail, and they absolutely need gov't bailouts to make them work, then why not set the terms of the bailout as being that they need to use the money to become small enough to fail? That is, they can get the money, one time only, and then need to look at breaking themselves up into separate pieces (even competitive pieces) that, by themselves, are no longer too big to fail.

The end result is that you aren't left with the same terrible situation, while also creating a new generation of "spinoffs" that can innovate and compete against both older firms in the space, and new upstarts that can more readily enter the market, rather than face a few giants. That way we're enabling more competition and innovation, leading to economic growth, while dismantling the structure of "too big to fail."

It's not quite that simple, of course. But, on the whole, it makes absolutely no sense to be "bailing out" companies that are too big to fail while leaving them as too big to fail. The end result is just going to keep sucking in more bailout money and wasting it, rather than encouraging innovation and competition.

A Cold Douche

This, obviously, is not the "creative destruction" that Schumpeter was talking about at all. In fact, at times he toyed with the idea that companies too big too fail were where the market would eventually end up. But, he also recognized the power of destroying old industries and setting the path for new innovations -- and he knew that the process was often messy, tied to business downturns.

In economist Robert Heilbroner's excellent The Worldly Philosophers, Heilbroner recalls sitting in Schumpeter's class at Harvard during the Great Depression:

When he lectured on the economy at Harvard in the midst of the depression, Joseph Schumpeter would stride into the lecture hall, and divesting himself of his European cloak, announce to the startled class in his Viennese accent, "Chentlemen, you are vorried about the depression. You should not be. For capitalism, a depression is a good cold douche." Having been one of those startled listeners, I can testify that the great majority of us did not know that a douche was a shower, but we did grasp that this was a very strange and certainly un-Keynesian message.

And, indeed, this economic restructuring is a good cold shower (though, some may prefer douche), but we don't get that sort of restructuring when the government is propping up exactly what needs to be restructured.

So, let's repurpose creative destruction with a clear plan: if you accept government bail out money because you're too big to fail, then that money needs to be used to make you small enough to fail.

Filed Under: automakers, bailout, creative destruction, financial crisis, joseph schumpeter, too big to fail