Successful Explanation of the Importance of Failure

by Don Boudreaux on April 3, 2009

in Complexity & Emergence

One of my brilliant young colleagues, Pete Leeson, splendidly explains the folly of government efforts to prevent firms from failing.  Here are critical passages:

When failing businesses are allowed to fail, producers learn how to combine resources in ways that create wealth.

We take it for granted that producers know what we want. But this
information doesn't appear magically. It has to be produced. The
profit-and-loss system produces this information – but only when
government lets failing businesses fail.

Profits and losses do for producers what traffic signals do for
drivers. They tell them when to “go,” “slow down” and “stop” their
productive activities. By communicating which resource combinations
consumers value most and which they don't, profits and losses direct
“economic traffic,” informing producers how to produce.

If government prevents ineffective producers from failing, the red
light on the “economic traffic signal” stops working. Production
continues and resources flow when they should halt, destroying wealth
instead of creating it.

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{ 40 comments }

MnM April 3, 2009 at 12:07 pm

Awesome. There is a typo though,

Here's are critical passages:

should be

Here are the critical passages:

John Jack September 11, 2009 at 11:38 pm


typo though

see if you can find my typo!


ineffective producers from failing, the red
light on the “economic traffic signal” stops working. Production
continues and resources flow when they should halt, destroying

Do we live in a padded cell type of world? Then all we need do is produce more and more. The world is not that safe not that padded. Do you remember what happened 8 years ago?

What to do? You can learn that in high school. What to not do takes much longer. Primum non nocere. First you got to learn what to not do. That takes an expert. Did Madoff fully understand what was not to be done? Was he allowed to fall early on? Hitler? Boss Tweed? Where do you find these guys. Ah! They are carefully hiding inside enormous corporations, organizations to large to investigate. You got to have a magnetic card just to gain access to their building.

When the paracytes eat out the insides of your bird-dog do you put him on life support just to keep the paracytes from dying?

U B Judge

vikingvista April 3, 2009 at 12:15 pm

"resources flow when they should halt, destroying wealth instead of creating it"

Impossible. Flow = GDP, and GDP is ALWAYS wealth creating.

Doug Stevens April 3, 2009 at 1:19 pm

Impossible. Flow = GDP, and GDP is ALWAYS wealth creating.

Is this true though? Using resources to produce things nobody wants instead of using them to produce things that people do want… couldn't that be considered destroying wealth?

Sam Grove April 3, 2009 at 1:33 pm

Vikingvista forgot to "/sarcasm"

Is that the thing with Keynesians, that they seem to hold that the numbers necessarily equate to reality in the production of goods and services?

They do not honor the creators of value.

The intersection of hubris and stupidity = the political state.

Brian April 3, 2009 at 1:52 pm

vikingvista,

I disagree. If GDP is always wealth creating, then what happens when GDP shrinks?

Leeson refers to Schumpeter's process of creative destruction and emphasizes the importance of the economic signaling mechanism that directs the allocation of capital to the greatest wealth producing venues. While Bernanke has argued that some producers are "too large to fail", Leeson reminds us about the opportunity cost of saving them.

TrUmPiT April 3, 2009 at 1:53 pm

Fortunes are made and fortunes are lost is true, but the conservative (fascist) state seeks to maintain the wealthy's prerogatives at the expense of the poor and struggling, and ultimately the stagnant, plundering rich engender the likely collapse of what they seek to save all for themselves.

I heard Joe Stiglitz on the radio yesterday discussing the folly, and greed at the heart of the changes to the bankruptcy laws that the Rethuglicans rammed through congress at the behest of the credit card companies and others. He emphasised that the attempts to squeeze the last penny out of the poor and indebted was a contributing factor in the recent economic and financial collapse. Stigliz says it is imperative that those onerous bankrupcy changes be undone asap.

Don Boudreaux April 3, 2009 at 2:24 pm

I sincerely hope that no patrons of this Cafe are foolish enough to take seriously, much less respond to, TrUmPiT. He (or she) is best left utterly ignored.

Chris O'Leary April 3, 2009 at 2:30 pm

"Impossible. Flow = GDP, and GDP is ALWAYS wealth creating."

…but not necessarily efficiently or as productively as is possible.

Paying people to dig holes and fill them back up again will create jobs, but there are better alternatives.

What your describing is entropy; flailing around disguised as productive work.

Who else encourages action, any action, over just sitting still?

Doug Stevens April 3, 2009 at 2:51 pm

Vikingvista forgot to "/sarcasm"

D'oh. You got me.

vikingvista April 3, 2009 at 3:09 pm

"Vikingvista forgot to "/sarcasm""

;->

vikingvista April 3, 2009 at 3:14 pm

"Paying people to dig holes and fill them back up again will create jobs,"

Net jobs? Net wealth? What you are talking about is wealth transfer to wasteful ends. Everyone would be better off if you just handed the diggers a welfare check instead of a "paycheck".

But then I forgot. The Keynesian MO is to fool the public. Fool them into spending against their best interests. Fool them into thinking they are getting productive work instead of welfare.

Flash Gordon April 3, 2009 at 3:56 pm

vikingvista: The real Keynesian MO is to give politicians a way to look as if they know what they are doing when they don't have a clue.

Chris O'Leary April 3, 2009 at 4:57 pm

"The Keynesian MO is to fool the public. Fool them into spending against their best interests. Fool them into thinking they are getting productive work instead of welfare."

In other words, to lead people to equate, and mistake, action with progress.

Randy April 3, 2009 at 5:34 pm

I imagine that the Keynesians believe they are maintaining the national work ethic by putting people to "work" in government jobs. If so, the term doesn't mean what they think it means.

Ray Butler April 4, 2009 at 10:39 am

You make it sound as if government is interfering with the markets (specifically banks). The banks are, in fact, complicit. They have a choice and they've chosen to take the government money and thus government control. THEY are resisting the alternative (the market correcting itself by contracting or ending some businesses).

The alternative seems utterly obvious and reasonable, but no one in banking or politics can stomach it. Bankruptcy and prosecution.

vikingvista April 4, 2009 at 2:08 pm

"They have a choice"

They had a choice to vocally oppose and suffer the consequences, but TARP was not a voluntary program for the large banks. CEO's of some of the solvent banks haver further expressed regret that they were ever made to participate.

Chris O'Leary April 4, 2009 at 5:30 pm

"They have a choice and they've chosen to take the government money and thus government control."

No they didn't.

When this first got started, the CEOs of the biggest banks were gathered in a room and it was made clear that they couldn't leave until they signed up for the program.

TrUmPiT April 4, 2009 at 8:25 pm

http://www.npr.org/templates/story/story.php?storyId=102656683

You can listen to Stiglitz yourself talk about the "$1 Trillion Agreement Reached At G-20 In London". It's on NPRs Talk of the Nation dated 4/2/09. In response to a callers question, Stiglitz talks a bit about bankruptcy and bankruptcy laws as it pertains to the current economic crisis.

indiana jim April 5, 2009 at 1:08 pm

For a more expansive disussion of "Learning from Failure" see:

http://www.bsu.edu/mcobwin/majb/?p=38

gappy April 6, 2009 at 6:05 pm

I did not find the arguments in the article of Prof. Leeson too persuasive. It paints a very simplified picture of reality, to the point of becoming useless. The role of the price mechanism as an information discovery device is not under discussion, and it is correct *most* of the time. However it could fail in some cases, either because information is acquired too slowly, or because it is distorted by externalities and regulation, and finally because the failure of a company, industry or sector threatens the stability of the economy as a whole.

It makes sense to let the carmakers fail. It made sense to let Lehmann fail. What would have happened if AIG defaulted? What if AIG, BAC, WFC defaulted? I am not sure the standard arguments apply.

vikingvista April 6, 2009 at 7:44 pm

"What would have happened if AIG defaulted?"

That is something that has never received enough attention, least of all leading up to the TARP vote. The presumption is that the subsequent widespread institutional failures would've plummeted the US into a Great Depression. The details of this theory are so sorely lacking that you could just as well assert that that would not have happened.

One thing is for certain. There is a limit to the size of a market correction this government is willing to tolerate without intervention, and the mere act of having intervened will always be presumed to have resulted in a preferred outcome.

gappy April 6, 2009 at 8:42 pm

We probably live on different planets, since the size and type of market positions held by AIGFP are largely known. Since AIG was net sell on $2.5-3Tn of notional value from CDSs alone, it is not difficult to imagine what would have happened. Capital requirement for those holding the CDS and the underlying bonds would have shot up, with possible insolvency for several banks. In addition, one has to consider CDS written on AIG itself, and the impact on its commercial insurance branch. We could have been lucky, but then we could have been VERY unlucky.

My point is that in the presence of extreme uncertainty and very large shocks the traditional Hayek-lite argument doesn't hold.

vikingvista April 7, 2009 at 1:25 pm

"My point is that in the presence of extreme uncertainty and very large shocks the traditional Hayek-lite argument doesn't hold."

It is not that so much that it doesn't hold (Austrian analysis is particularly useful in those circumstances) as that the interventionists and their political support do not believe that it holds.

Those who consider it to be "extreme uncertainty" assume that intervention somehow adds certainty. But since the unpredictability of intervention has been observed time and time again, such a belief is religious at best and delusional at worst. It is part of a fundamental belief, underlying more than just economic uncertainty, that all things equal, intervention is better than nonintervention.

gappy April 7, 2009 at 6:28 pm

"Those who consider it to be "extreme uncertainty" assume that intervention somehow adds certainty."

The "interventionists" were a) the former CEO of the most reputed Investment bank in the world; b) a scholar of the Great Depression in the line of Friedman and Schwartz; c) a republican president; d) the overwhelming majority of Congress, independently of ideological affiliation.

The thesis that the "interventionists" did it, to justify their policies ex post doesn't stand up to analysis. It is slightly conspiratiorial. Feel free not to believe that AIG's collapse would have thrown the financial world into a state of chaos. Or, don't even believe that it would have been *extremely* risky. I develop default risk models for a manufacturing company with a large (> $30B) commercial portfolio, and talk regularly to other practitioners. Everyone was seriously scared of a complete, permanent gridlock. I think taking over AIG was the right thing to do. On the other side, guaranteeing Bear's debt, or subsidizing the carmakers' failure wasn't, for the reasons you mention.

Just giving us the boilerplate "discovery and efficiency" spiel (Leeson's article) under the current conditions doesn't work for me. I think we live in a very different world than 1900-1930. Incidentally, does Hayek mention risk explicitly in his work? I don't recall it.

bobby b April 7, 2009 at 7:36 pm

" . . . the conservative (fascist) state seeks to maintain the wealthy's prerogatives at the expense of the poor and struggling . . . "
- – - – - –

"The State" has neither mind nor ego, and simply consists of the combined and averaged-out will of about 18% of the people – i.e., the winning voters.

So, please be clear about this: there is no "state" seeking to trample you underfoot, looking to use you up and spit you out when all profit has been extracted, denying your humanity and value and viewing you solely as a commodification of horsepower.

It's me and all my rich friends who are doing those things.

And we resent how you're always trying to take the credit away from us for doing so.

indiana jim April 7, 2009 at 7:56 pm

gappy,

I posted a link to a more expansive discussion (relative to Leeson's)of "Learning from Failure" above; I think it gets so the uncertainty issue you are concerned about.

pfp April 7, 2009 at 8:03 pm

brian:

you make the same mistake as many others from the American Left. historically, fascists in italy (and their axis allies in germany) were socialists. indeed, the german "fascists" made up the "national socialist" party. the tendency of some to (incorrectly) link fascists (i.e., socialists) with U.S. conservatives (i.e., capitalists) is completely inaccurate as a matter of history.

pfp April 7, 2009 at 8:16 pm

brian:

for example, benito mussolini was a socialist – see here:

http://www.lycos.com/info/benito-mussolini–socialist-party.html

so, again, associating fascism (a term first used by mussolini's socialist party in italy) with U.S. conservatives (capitalists) is historically inaccurate.

John Skookum April 7, 2009 at 9:24 pm

Trumpit, regarding "the changes to the bankruptcy laws that the Rethuglicans rammed through congress at the behest of the credit card companies and others," I would remind you that one of the biggest supporters of the bankruptcy reform was our current (Democratic) vice president. The "Rethuglicans" had a fair amount of help from Democrats in thrall to the large financial services corporations.

gappy April 7, 2009 at 10:50 pm

Indiana Jim: thanks for the link to the article. It seems very interesting.

pfp: "historically, fascists in italy (and their axis allies in germany) were socialists." is a fantastic misreprentation of Fascism. Mussolini was socialist in his youth, but more of the Bakunin/anarchist variety (as many Italians were, including those immigrating to the US). When in power, he annihilated the Socialist Party and had his leader Giacomo Matteotti killed. The founder of the Communist Party, A. Gramsci, was jailed. Italian Fascism didn't nationalize industries, nor redistributed wealth. The heads of the large companies were heavily favored by the regime. For a definitive study of the italian flavor of Fascism, please read the books of Renzo de Felice. Do your homework.

Fascism was neither capitalism nor socialism. But it had much in common with Daniel Klein's "People's Romance" (hence modern liberalism) and with social conservatives' authoritarianism and demagogy.

pfp April 8, 2009 at 12:20 am

gappy:

I respectfully disagree.

I suggest you read "Liberal Fascism" by Jonah Goldberg:

http://www.amazon.com/Liberal-Fascism-American-Mussolini-Politics/dp/0767917189/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1239163395&sr=8-1

"Bolshevism" or Soviet communism sought an international type of communism under which the state would "wither away." International communism – and not nationalism – was the focus.

Italian Fascism under Mussolini, and National Socialism in Germany, were – conversely – strongly nationalistic brands of socialism. Indeed, the name "National Socialist Party" describes it quite accurately and succinctly.

Mussolini and Hitler both disagreed and fought with other political factions which were socialistic, it's true. But this conflict was the conflict between one socialist political party and another socialist political party – not a conflict between opposite ends of the spectrum. This latter claim is a comfortable and wholly inaccurate conceit of the Left.

"Mussolini … declared that he was fighting the Socialists, not because of their socialism but because they were anti-national and reactionary".

See: http://frontpagemag.com/Articles/Read.aspx?GUID=4F727F1C-01F2-44AA-93B1-ECCB922B38C3

OregonJon April 8, 2009 at 1:15 am

What would have happened if AIG had failed? Almost certainly next to nothing. There are hundreds of AIGFP counterparties who would have needed to cope with their own lack of risk management. Learning that actions have consequences is a useful lesson. The government could have then dealt directly with any counterparty who might have posed a systemic threat, but the guess is there would have been no one fitting that category. Better to have spread the losses amongst the private players that have socialized those losses via AIG's bailout.

LarryH April 8, 2009 at 5:59 am

"Efficiency" is the significant concept. Five men could drag a sled down the gravel road, but two men could do it with a wheeled wagon. The other three could even ride along, rotating the pulling assignment, or the three could accomplish some other additional activity. In which case is more "work" being accomplished?

"The Importance of Failure" alludes to "the Efficiency of Failure."

gappy April 8, 2009 at 8:17 am

pfp:

as a matter of fact, I *have* read "liberal fascism". Is that the source of your knowledge on Fascism? If not, can you please list all the scholarly books you have read on the subject? As for Goldberg's book, it takes a credible preexisting thesis (Sowell's "Vision of The Anointed") and forces on it very implausible intellectual precedents to modern liberalism. Its interpretation of Fascism is heavily distorted and superficial. The inspiration to Fascism was a romantic version of roman history, and the thought of early 19th century writers like Fourier and Carlyle. The Fascist state was a paternalistic one, but not one engaged in reallocation/ redistribution or resources or planning. Incidentally, I am Italian, so I have my share of formal and first-hand education on the subject. Until 1993, an italian party (Movimento Sociale) existed that was the direct discendent of the Fascist Party. My grandfather was a member of the party.

If you want to read about the precedents of modern liberalism, read Sowell. Goldberg is a partisan polemist, and a fantastically ignorant one at that. His prominence is what makes me think that classic liberalism doesn't stand a chance in modern conservatism.

David Drake April 8, 2009 at 11:48 am

Those who equate "conservative" with "fascist" know as much about either as those who call President Obama a "communist." That is, next to nothing.

gappy April 8, 2009 at 1:12 pm

David,

I completely agree. Dropping an alphabet soup of words ("N", "F", "C", "S", etc.) is not informative, and goes to show that the debater has a caricatural view of historical events.

vikingvista April 9, 2009 at 12:54 am

"The "interventionists" were a) the former CEO of the most reputed Investment bank in the world; b) a scholar of the Great Depression in the line of Friedman and Schwartz; c) a republican president; d) the overwhelming majority of Congress"

And, your point? (BTW, why do you think Friedman would support TARP?)

"Everyone was seriously scared of a complete, permanent gridlock."

Especially those going down, undoubtedly. Their precious microcosm looks like the whole world to them. It's the same sickness that leads Hank Paulson to think Goldman must stay while Lehman falls. And that Goldman must get 100% of its AIG claims while other "less important" institutions get only a fraction.

In the meantime, a thousand well-financed institutions, insignificant to Paulson, are denied the opportunity to gobble up the pieces of the failing giants.

gappy April 9, 2009 at 8:33 am

a) My point was that the proponents and supporters of TARP were policy-makers in favor of market-based policies;

b) Friedman is dead. If you can get his opinion, let me know. If I have tried, to no avail;

c) The consequences of letting Lehman fall were a gridlock in commercial paper and interbank lending. With an AIG default, good luck;

d) Regarding Paulson and GS: GS didn't need to be saved; it was *forced* to receive $5B of TARP money it didn't need, and committed to return them as soon as (legally) possible. It did not receive preferential treatment with respect with other credit-holders with similar positions, and Paulson did not play any role in the settlement of these positions.

I am not going to reply to further replies. I reiterate the point of my initial post, which is a question for Don Boudreaux.
Don, do you really think that market feedback loops must be kept for *all* institutions and for *all* contingencies, or that some exceptions are allowed? If so, which ones?

vikingvista April 9, 2009 at 11:10 am

"a) My point was that the proponents and supporters of TARP were policy-makers in favor of market-based policies;"

It would appear, by supporting TARP, that they are not.

"b) Friedman is dead. If you can get his opinion, let me know. If I have tried, to no avail;"

Look Goofy, you're the one who brought him up. If you can't defend your words, then don't spew them.

"d) Regarding Paulson and GS: GS didn't need to be saved; it was *forced* to receive $5B of TARP money it didn't need, and committed to return them as soon as (legally) possible. It did not receive preferential treatment with respect with other credit-holders with similar positions, and Paulson did not play any role in the settlement of these positions."

All of the big institutions were forced. I'm talking about the decision makers, and one of them was Paulson, when he decided to bail out AIG. Having been GS CEO in 2006, you really think he did not have a clue about GS's stake in AIG? Perhaps if he'd been a recent Lehman CEO instead, AIG would not have had the same importance to him.

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