Thursday, September 18, 2008

Apocalypse Now?

If a picture speaks a thousand words, this one encapsulates the fallacious Marxian theories of historical cycles. What may be worse are the parallels between what is written on the gentleman’s sign above and conventional understanding of the relationship between business failure, the market process, and the role of government.

A market process theory of capitalism necessarily requires that firms that make poor decisions (not to name names…eh.. Lehman Brothers et al) collapse and fail. Failure by some is fully consistent with a well working capitalist system. Losses serve the important role of disciplining agents in the market. Losses indicate that using resources in a particular manner is undesirable to the rest of society and unsustainable in accordance with others’ plans. Sometimes (particularly as a result of distortions in crucial price signals) losses mean that large pockets of mal-investment have occurred and will require liquidation.

The process is painful for employees and those whose assets are tied-up in the mal-investment. Nevertheless, the pain is temporary and limited barring any additional government intervention. Resources are freed up by liquidation to be used in profitable undertakings elsewhere, ultimately fueling economic growth throughout the economy. This is part and parcel to the capitalist system, not the ultimate indication of its demise.

Bailouts, not failures, weaken the overall market order. The bailouts of Fannie, Freddie, and AIG are not only unhelpful in current recessionary period, but ultimately harmful and damaging interventions that impede and cripple the market process. Unprofitable allocations of resources and investments persist. Growth for all is curtailed for the protections of the few. More regulation, greater controls, and more government oversight is the immediate recommendation. However, it is not surprising that giving banks money in times of crisis allows for fewer failures in the short run. Example, here. These interventions produce expectations of future bailouts that lead to more risky and unprofitable behavior in the future. Call me crazy, but if the sign read “AIG’s bailout points to a crippling attenuation of capitalism” I would be inclined to agree, even if it was with the crazy man shouting on the corner.


Justin M Ross said...

Terrific post, welcome to TPS Emily.

Thomas said...

Can you clarify what you think the market impact of AIG defaulting on all of its CDS contracts is?