Saturday, January 24, 2009

Creative Destruction

For a capitalist economy to function, creative destruction must prune the weak and inefficient to enable the strong to survive. Unfortunately, years of monetary intervention and market manipulation by the Federal Reserve and U.S. government has sustained failing institutions and created an unsustainable dependence on cheap financing. It was inevitable that this charade would unravel as it was impossible for the Federal Reserve to sustain such low interest rates without fueling uncontrollable inflation. Efforts to save the people from the hardships of the tech bubble, which was at least in part sustained in its waning years by the Federal Reserve’s coordinated bailout of Long Term Capital Management’s dramatic implosion, extended the existence of companies doomed to inevitable failure. At the same time, people began to believe that, under the guidance of our super-human leaders, we have successfully tamed the business cycle and permanently eliminated the risk of recession. Counterparty risk was ignored, leverage was increased, and overconfidence abounded.

People continue to ignore the cruel hard fact that not everyone can be saved and that the status quo if often not the best outcome. Weak companies must be allowed to fail so that the strong and the innovators can survive. Similarly, individuals that utilized excessive leverage to speculate on real estate or maintain an unsustainably lavish lifestyle must not be rewarded for their lack of judgment. A clear relationship between risk and reward is what minimizes the potential for excessive speculation, over-investment in failing institutions, and painful economic downturns.

As Tom Petruno recently penned in Saturday January 24ths Los Angeles Times:

Technology workers, perhaps more than others, understand the concept of "creative destruction." The term was popularized by the Austrian economist Joseph Schumpeter to describe the forces perpetually at work in a healthy capitalist economy.

The idea is that an economy should be forever renewing itself thanks to innovation, albeit with considerable pain along the way. In other words, new technologies are wondrous -- unless you're stuck selling technologies made obsolete by a smarter competitor.

Here's a thought: One reason we're facing such a large Darwinian wave in the economy may be that the easy money of the last two decades delayed creative destruction that otherwise would have occurred.

As long as credit was more than ample, many businesses and technologies could hang on despite being under heavy attack from more innovative rivals.

Amid the financial-system crisis, credit has evaporated. That's a death knell for weak businesses, large and small, that were over-leveraged and are struggling with plummeting sales as consumer and corporate spending shrinks.

The relative lack of credit, however, also obstructs the "creative" part of the creative-destruction continuum: Many firms that should be survivors of this debacle can't get the basic funding they need to carry on and position themselves for an economic upturn, wherever it is on the horizon.

We must embrace the forces of capitalism and the creative destruction that ensues. Further attempts to prop up failing companies and individuals will just prolong the recession and postpone the necessary economic adjustments dictated by decades of excessive leverage and easy monetary policy.