CREATIVE DESTRUCTION AND FINANCE
Joseph Schumpeter is famous for coining the phrase “creative destruction”. He described it as a “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” This is a necessary component of capitalism. The strong survive and the weak die.
A new paper out of the University of Alberta by Claire Y. C. Liang, David McLean, and Mengxin Zhao finds that creative destruction has been on the rise in the USA over the last 50 years. Despite increasing concern over the size of our government and what many refer to as “central planning” the facts actually show that US companies are becoming more dynamic. They conclude:
“The rate of creative destruction among public firms increases in the U.S. during the period 1960-2009. We document statistically significant increases in big business turnover, changes in market share, the difference in growth rates between firms that gain and lose market share, and other measures that show an increasingly dynamic economy. The increase in economic dynamism is driven by increasingly fast-growing firms that exhibit increasingly high growths in total factor productivity, value-added, and profit margins, and have increasingly high R&D spending and patent grants. The type of firm that generates this creative destruction changes during the sample period. Creators are increasingly smaller and younger, and increasingly issue shares and debt; the average creator would have run out of cash by year-end had it not raised capital, and this financial dependence increases throughout the sample period.”
Perhaps most interesting in this discussion is the lack of creative destruction in the world of banking. I am generally in favor of deregulation, however, with regards to the financial industry I think a different approach is required due to the importance of this industry to overall US economic stability. As we now know, this industry has the ability to cause massive instability. And in one of the great ironies of economic history, deregulation led to what should have been massive creative destruction of our banking system in 2008.
Despite evidence showing that the US economy is becoming increasingly dynamic due to creative destruction, we have recently avoided this natural market process by saving the banks. And while Wall Street thrives, Main Street continues to struggle. Perhaps a bit more creative destruction in 2008 wouldn’t have been such a bad thing after all? Unfortunately, as a nation, we’ve decided that creative destruction is not allowed to occur for the Too Big to Fail banks. And that alone is the primary reason why they need to be strictly regulation.
You can’t have it both ways. If you’re not going to regulate them then you must allow the market to work and the process of creative destruction to play out. That’s clearly not an option and so regulation is the preemptive common sense approach. Unfortunately, the time for that appears to have passed. And so the boom/bust cycle continues. Since we have not regulated the banks properly it’s only logical that creative destruction will again impose its will on this sector at some point in the future. Next time, I hope we will be wise to utilize that event to fix this serious flaw in our economy.
The paper is attached in its entirety here.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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20 Comments
Agreed. Walter Bagehot said 150 years ago that “any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank”
And the evidence is that it is the small banks that do the lending, while the large banks spend their time doing – I don’t know what, apart from attending to their political connections. For the US see:
http://www.washingtonsblog.com/2010/03/kansas-city-fed-chief-in-2009-45.html
And for Germany, there is a letter in the Financial Times from Stewart Flemming, former Frankfurt correspondent for the FT, saying it’s been the same story in Germany recently. You need to pay for online access to the FT, but for those who have paid the annual subscription, see:
http://www.ft.com/cms/s/0/2b55b724-616f-11e0-a315-00144feab49a.html#axzz1N9RJbeQT
Off topic, but Mr. Roche, I just read your paper on hyperinflation on SSRN, and you honestly need to spread that across economic blogs like wildfire. It is absolutely ABSURD how much talk there is out there about how hyperinflation is coming to the US. After reading your paper, the arguments other people make are actually laughable.
For anyone who hasn’t read it…
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1799102
Once you get over the fear of the word ‘nationalisation’ there is a straightforward way to get rid of bad banks – you nationalise them, bail out the depositors, stick it to the investors and then run the bank out on a nationalised basis. Perhaps selling off whaevert bits other people want.
The state will take the loss over this. But it should since a failure of regulation causes the collapse and that’s what insurance is for.
Neil I tend to agree with you but get stuck on one thing. If the state run the banks do you not end up with politicians leaning on them as and when they need to. Part of the problem with the banks was that the Democrats leant on them to lend to those who shouldn’t have been leant to in an effort that everyone could own a house even if they couldn’t afford to.
Not sure I wish for corrupt politicans who have little idea about finance getting a hold of the piggy bank.
But I do believe that some industries should not have shareholders because of the complete contradiction of their drive to make profit.
Haven’t squared the circle really. I think proper regulation and rules and a minimising of profit maximisation and a realignment of incentives. That may weaken the banks vs competitors elsewhere but you know that those guys will in time go punto.
Nick:
I often see folks blaming the politicians (why only Democrats?), the Community Reinvestment Act, and ultimately, the country’s poorest citizens, for the housing bubble and ensuing crisis. I rarely see any real evidence of its truth.
Anecdotally, I made many loans under the CRA program, using various banks, and they were FAR better loans than the typical subprime loans that only went thru private hands (non Fannie/Freddie/FHA/VA).
The typical CRA loan that I originated was fully documented, fully amortizing, and a bit discounted from market rates, and allowed a fairly low down payment. The primary requirement was to be below the median income, or to purchase in an area that was below the median income, thus assisting people of less than average income to own a home.
Nowhere did Congress insist that banks lend without documentation, without principle payments, or to make loans that did not even require full interest payments (Option Arms).
If you have a reliable study that shows that the CRA type loans or other government supported loan types for lower income borrowers (FHA/VA/USRDA) had a greater damaging effect than the deregulation of banking, I’d love to read it. If not, it just seems like regurgitated Fox News nonsense, blaming the country’s financial ills on poor people, instead of the out of control financial sector.
Do you want the government to decide who gets the credit and who doesn’t and at what price?
Like it or not private banks are required for a capitalist system.
I haven’t seen any evidence that the private sector can manage financial institutions any better than a government agency. Of course it takes a government agency to save the population from financial ruin (actually this has yet to be fully played out). What is NOT in question is that privately held financial institutions drove our country off a cliff and the only parachute these institutions had was issued by the US GOVERNMNET.
Perhaps you need to redefine capitalism as nothing more than government handouts.
> I haven’t seen any evidence that the private sector can manage financial institutions any better than a government agency.
Quark, this is because you haven’t seen a financial insitution run by a government agency. I lived in USSR where we had one bank – Sberbank. You could keep your rubles there or in a matrass and there was no such thing as a loan or a credit. If you wanted to buy a car (assuming you were allocated the car as a part of the 5 year plan, which meant you were one of the party bosses personal friends) you had to save for it 5-10 years, you couldn’t just take a loan and buy it.
I can picture very well coming to a government official for a loan and explaining my business plan. The only thing it will lead to is more corruption and favoritism.
Inject the story of demographics. We have a gazillion baby boomers retiring throughout the developed world. They use less stuff (manufacturing), need less space (housing), want to pay less in taxes as they use less services (excluding medical) etc. etc. This is a serious headwind that will take 26+/- years to run full circle. These are deflationary forces. Only large multinational businesses can thrive as they are able to exploit resources and profit from emerging markets. Small businesses (national) are trapped in the headwinds. They are also the largest employer.
Creative destruction is a term originally derived from Marxist economic theory which refers to the linked processes of the accumulation and annihilation of wealth under capitalism. These processes were first described in The Communist Manifesto (Marx and Engels, 1848). In the earlier work of Marx, however, the idea of creative destruction or annihilation implies not only that capitalism destroys and reconfigures previous economic orders, but also that it must ceaselessly devalue existing wealth (whether through war, dereliction, or regular and periodic economic crises) in order to clear the ground for the creation of new wealth. ( http://en.wikipedia.org/wiki/Creative_destruction )
One of the rare economic comments related to the ‘boomer effect’ predicted by Peter G. Peterson 10 years ago. See:
http://en.wikipedia.org/wiki/Peter_George_Peterson
The Japanese resist immigration and they also resist currency devaluation. I sympathize cause a strong Yen buys cheap oil, but something must give in Japan and here as well. Revamp immigration in favor of civilized (less radical) countries and open the flood gates.
> Creative destruction is a term originally derived from Marxist economic theory which refers to the linked processes of the accumulation and annihilation of wealth under capitalism.
Marx describes the process of “overproduction” where capialist enterprises will continue producing more and more in pursuit of profits but when the wages/waelth don’t catch up and demand stops growing the bubble pops and a crisis ensues leading to destruction. It seems it still works this way and the cycles are now are even bigger due to credit multiplier. It is intresting that Marx didn’t see that process as strength but rather as a weakness due to the human suffering involved because it is always the weakest who are the ones least able to protect themselves from the cycles.
I think at some point we have to acknowledge that as humans we are not as darwinian as we want to believe ourselves to be (at least in the US, europeans don’t think they are darwinian). Humans have compassion, it is one of the best human traits, animals don’t.
I hated it when I had to study Marx and Lenin in USSR but now I think it is a nice complement to balance the follies of the mainstream economic theories. Marx had an uncanny ability to see the weak points of capitalism and Lennin knew exactly how to exploit them. There are two sides to any story.
As for the lack of destruction in banking, it is exactly the same point. The banks are on top of the food chain in the capitalist system. In the crisis they will survive at the cost of the weak, it is the darwinian way.
Why do have LINKEDIN, FACEBOOK, & YOUTUBE? You got it! Creative Destruction. The late 90′s telecom Fiber buildup by the likes of WorldCom, Global Crossing, and other CLECS built up millions of unused Dark Fiber. When these companies went bust, all of that fiber was sold off at pennies on the dollar. This led to much lower fiber and bandwidth costs which generally benefited consumers and innovators alike. Failure brings opportunities to ones who behave in a sane manner. If these zombie telecom companies were allowed to perform business as usual we would probably not have YouTube or other content sharing sites. Fast forward to today with the banking sector and the extend and pretend business policy that is currently standard. There are trillions in bad loans floating around at prices near par that have no business being there. We need to extinguish this bad debt from the system so that new and better underwritten loans can thrive. Housing has ZERO price discovery at the moment so millions are simply not buying. When will the idiots in DC figure this out?
I swear…is the world completely full of idiots in academia who spend their time collecting and spewing out data then analyze the data in a vacuum. Common sense thrown out the window.
A few facts that can be observed by reading a Sunday newspaper over the past 50 years…
1) Moorse law
2) Removal of the gold standard
3) Increase in the money supply
4) Deregulation
5) Financial fraud on a grandoise scale
6) Until recently an increase in the velocity of money increasing
You’ve heard of the dumbing down of America, well there is a dumbing up of America as well.
Dumbing down is programmed through TV and institutionalized (least common denominator) education.
Dumbing up is accomplished by tenure, politics and seniority.
I rest my case:
http://www.economicpolicyjournal.com/2011/05/economist-who-advises-on-nevada.html
LOL!
On bank nationalization:
It is not necessary that a pre-packaged bankruptcy of insolvent financial institutions (bank and non-bank) cost the taxpayers much of anything. In essence, all that would happen is to:
1. Take over the bank and retain it as an ongoing operating entity
2. Wipe out shareholder equity
3. Fire all management
4. Satisfy outstanding claims with remaining assets
5. Bondholders take whatever haircuts are required
6. Sell the bank assets into the private sector
The shareholders obviously get nothing since equity capital is gone, but that is nothing special. Therefore, what happens in a bankruptcy/nationalization (just like any other bankruptcy really) is that the BONDHOLDERS take the losses. And since customers do not lose anything, and the taxpayers are not buying the business, it is the bondholders that stand to lose. So there inlies the problem.
Instead we: a) protected management b) protected shareholders and c) protected bondholders all at taxpayer expense and with the unintended consequence of making the banks bigger, increased moral hazard, and wasted resources on the status quo/latest bubble.
All in all, a stupendously stupid strategy. Of course, some argued that these institutions were too complex to unwind. If that is the case, they should have broken them up first, and then taken the individual pieces through bankruptcy.
Going forward should we not be considering an ounce of prevention?
A liquidationist approach to the TBTFs and the housing market would have been extremely painful in the short run; like cauterizing a large wound without an anesthetic. Bailing out Main Street with income stabilizers PLUS big payroll tax cuts at the same time would have invested the big money in the real economy rather than supporting phony real estate and stock prices, and kept the patient stable until healing in the real economy could begin. The corrupt TBTFs should have been liquidated, or nationalized until they could be turned over to honest management. A goodly percentage of Wall Street should have been put before a Grand Jury and indicted, and then turned on each other in a plea deal auction. The resignation of every Fed member should have been demanded.
Instead we have a massive new entitlement dependency: Wall Street and the banksters on welfare, courtesy of its enablers at the Fed, while a cynical Administration runs out the clock on the statute of limitations for securities fraud. We also have an economy in a state of suspended animation; everyone seems to be waiting for the zombie to topple over.
The solution? Reinstate mark to market valuations; let asset markets clear via a new RTC; reenact Glass Steagall; break up the TBTFs; bring Wall Street to heel; bring the Fed back to reality; and look Main Street and regular people in the eye and convince them that they and the real economy are what truly matters. Absent such shock therapy, a slow and steady decline, punctuated by bursts of QE (the Japanese model), seems to be inevitable for the USA.
Credit money is too sqishy. You squeeze it one place and it balloons in another. A wise generation introduces glass-steagal, and a corrupt one dismantles it with Graham Leach Bliley. The lure of riches by gaming the system with levereage is too hard to resist.
The real fix is to nationalize the money and keep banks private. Once money issuance is nationalized, then its volume can be controlled. Wouldn’t nationalized money eventually draw corruptive influence? History shows that Congress has never exceeded its authorization levels. Even the Continental did not get printed in excess. It was massive British Counterfeiting that caused the Continental to drop in value. Massachusets Bills, and Greenbacks were only issued in amounts authorized, and no extra.
So, when you get right down to the nub of the problem, it is the law that matters with money. The money power really needs to be wrapped up with vault like Constitutional law.
Allowing the State authority to control credit via a state bank is dangerous. Stalin proved that… a State bank can encourage Statism, or rule by a plutocratic elite. Our current reality is one of a growing plutocracy where Wall Street calls the shots.
The State can decide who the winners and loosers are. Issuing real money by spending into the economy, or spending it down into individual states based on head count, is an entirely different matter. In the latter case, where Greenback type money is issued in accordance with the people’s needs, private banks still perform their needed function of matching up creditors with those who want a loan (debtors). All the government does is issue money in accordance with the economies requirements…and they are bound by the law. Private banks need to have credit creation power removed. Private banks with 100% reserve have all liabilites covered as the money already exists. The borrow short to lend long problem can be overcome with special mutual fund like entities. Banks should only operate like a Savings and Loan, and not create new credit money via double entry ledgers. Debt money (credit money) carries around tremedous costs that get buried in every transaction. We become debt peons and serfs and know not the mechanism.
Mark to market is what helped precipitate our current balance sheet recession. Credit figures on bank ledgers no longer matched declining housing values. To get out of the problem banks wanted to be bailed out e.g. their credit money backed up by new base (vertical) money issued from the treasury.