In his excellent book, The Origin of Wealth, Eric Beinhocker argues that it is markets, not individual companies, which are most effective at allocating resources. This apparently subtle distinction is important – if the economic landscape changes, large companies tend not to be good at adapting. Dynamic, better-adapted companies are likely to expand their market share at the large companies’ expense.
This insight has profound implications for governments’ reactions to the financial crisis. Until recently nationalisation and subsidies have been deeply out of fashion. The bailing out of unprofitable, inefficient industries using taxpayers’ money was seen as a deeply suspect activity.
With the current financial crisis, however, governments have been willing to risk a seemingly infinite amount of money propping up the banking sector. They are pursuing this activity with no apparent limit on spending, no metric to assess the success of the policy, no consideration of the residual risk and no public scrutiny of the cost and risk of alternatives. Why is this?
There is one main reason: some of the functions that banks perform are vital to the economy. Governments fear that if they failed there would be economy-wide systemic collapse.
However, the problem with this argument is that in spending huge amounts of taxpayers’ money, the government has only partially avoided systemic failure – it is true there have not been widespread runs on deposits, but only because of the perception that governments are effectively guaranteeing these deposits.
On the other hand, even with massive intervention, banks have ceased lending to each other and to the ‘real’ economy. However, by bailing the banks out, governments have introduced other risks; for example, moral hazards. Banks are now less likely to reform because they expect to be bailed out if things go wrong.
I argued in a previous posting (as did Willem Buiter) that the UK faces a potential solvency crisis due to the government’s implicit backing for failing banks. At best, taxpayers face years of higher taxes to pay off the huge government debts that are accruing.
With hindsight, we can see that many large banks have failed business models. They did not understand risk, they have a hugely overpaid and inefficient workforce, and they have internal systemic decision-making failures.
Even with massive government support, they are probably no longer capable of performing their basic functions. Beinhocker’s insight is that, as large institutions, most of them will be unable to adapt to the new environment, especially with heavy state involvement skewing their priorities and with the moral hazard introduced by government bailout.
What is the alternative? Perhaps they should be allowed to fail. If the government believes that some of the functions of banks are vital to the survival of the economy, it should take on these functions directly – for example by guaranteeing savers’ deposits – until private sector organisations emerge that can take over these functions again.
And emerge they will. This is the magic of capitalism. There will still be a demand for credit and other financial services, and the skills and infrastructure exist to service this demand. A new industry will emerge from the ashes of the old one. This industry will be adapted to survive in the new environment, in a way that the old dinosaur banks are patently not.