THE BEAR'S LAIR The importance of destruction
By Martin Hutchinson
The Austrian economist Joseph Schumpeter in his 1942 masterpiece Capitalism,
Socialism and Democracy described the process of capitalist wealth
creation as being one of "creative destruction". It's a lesson that
policymakers have not taken sufficiently to heart, largely because they have to
answer to sentimental democratic electorates.
Creation sells well to an electorate whose instincts, as demonstrated by the
"Occupy Wall Street" crowd, are largely socialist. But destruction doesn't poll
well. It is therefore ignored, not only in the bloviating speeches of
politicians seeking election but also in their policies when they have taken
office. Throughout the world, the lack of sufficient attention to destruction
is a major
part of today's economic problem.
The late lamented Steve Jobs exemplified this principle perfectly. While his
succession of Apple products exemplified creativity at its finest, he was never
afraid to destroy previous generations of hard-won product territory. Each
generation was engineered for its own sake, not for compatibility with previous
generations. Thus while Microsoft's Windows and Office software was engineered
so that it could cope with programs derived from previous generations, no such
attempt was generally made at Apple. The result was a Windows sequence that by
the Vista generation was vast and buggy compared with Apple products that
remained slim, both physically and intellectually.
Truly free market capitalism involves a considerable amount of destruction
along with the creativity. When new businesses arise, old ones are killed. In
the tech sector, the Palm Pilot was a decade ago the gadget everybody had to
have, then it became RIM's Blackberry, then Apple's IPhone and now the iPad.
Thus in this sector, the multiples of 30, 40 and even 100 times earnings that
gullible investors award their favorite companies are absurdly high. Because of
the pace of creative destruction, tech sector companies should sell on four or
five times earnings, reflecting their likely lifespan plus possibly a modest
residual value at the end from the patents.
New products very often involve the destruction of their slightly inferior
predecessors, as Henry Ford discovered when his Model T became obsolete and RIM
is now discovering to its cost. Sometimes the destruction can be encompassed
within one company, as Ford was able to do by shutting down his production line
for a year and re-tooling to make the Model A. Sometimes the destruction
involves the entire enterprise, as happened to Polaroid and may now be
happening to Kodak.
Two forces have in recent years hampered this necessary process of destruction,
loose money and governments.
Loose money prevents destruction, because there is no force forcing bankruptcy.
Companies can run for years increasing their borrowings, repaying them with the
occasional stock issue if they can find a compliant accountant. The premier
example of this is Japan in the 1990s, where banks continued increasing their
loans to real estate companies that were hopelessly insolvent, given the 70%
drop in real estate prices from their 1990 peak. For a few years under
Junichiro Koizumi (2001-06), rates were tightened and the banks were made to
write off the worst of their bad debts, as a result of which Japanese economic
conditions began to improve.
Since Koizumi's departure however, incipient recessions have been met with
public spending sprees and further monetary easing, with the result that the
Japanese "zombie companies" have proliferated and economic recovery has gone
into reverse.
Now following the Fukushima reactor disaster we learn that its owner Tepco is
also to be kept in operation through a banking system bailout, with no attempt
made to liquidate its vast collection of "non-core assets" and ensure it is
efficiently run which, given that Japanese utility tariffs are set on a
"cost-plus" basis, it most certainly is not.
Europe has always been bad at allowing destruction, but in this recession it
has got even worse. The Belgian bank Dexia was a model of sleepy inefficiency
when I used to visit the Belgian savings banks from which it was formed in the
1970s and early 1980s. Since it had excessive ability to leverage and no proper
asset generating capability, we made very nice money arranging Belgian franc
private placements for foreign government borrowers, all of which were placed
with the same half dozen institutions.
As it has since proved; our fees were well earned since we exercised a modest
quality control on the borrowers - if we had provided them with duff paper our
nice Belgian franc placement business would have been kaput!
Merging these banks, giving them an expensive new headquarters and allowing
them to compete for the dozier forms of lending with much sharper-clawed banks
in the rest of the European Union, without friendly merchant banks exercising
quality control, was a recipe for disaster, and disaster has duly occurred.
EU government paper was readily available - Greece would take any money you
could lend it, at the low rates prevailing - and naturally Dexia filled its
boots. The bank serves no useful purpose, and while very large it should
certainly not be regarded as central to the European financial system.
Belgium, a gigantic beneficiary of the EU's Brussels headquarters with vastly
excessive public debt and not much of a non-bureaucrat economy except for some
nice restaurants, certainly does not need its own banking system and Belgian
taxpayers should not be milked to subsidize one.
The central cause of the EU debt problem, as of the US subprime loan problem,
is of course government regulation. In this case the regulation concerned is
the monstrous Basel Committee regulation that says that holdings of
Organization for Economic Cooperation and Development (OECD) government paper
could be weighted at zero when calculating banks' capital requirements.
Naturally, overleveraged banks in Europe have taken advantage of this provision
to fill their balance sheets to the gunwales with dodgy government paper.
The OECD membership requirement imposes a little quality control, but as Greece
has shown, not much; without it, we would have doubtless seen massive
multi-billion dollar financings replicating the notorious 1822 bond issue for
Poyais, a country that did not exist.
This absurd subsidy to the public sector (because holding capital costs money,
and is priced into the cost of loans that require it), has been increased with
the recent central bank requirements to raise extra capital, against which
government debt is STILL not counted. It is the principal cause of the PIIGS
(Portugal, Ireland, Italy, Greece, Spain) government debt glut. Without it,
bank appetite for the paper of gluttonous governments would have been far less,
and interest rates on that paper would have soared even before the 2008 crisis.
The solution is to reduce or ideally eliminate the preference for government
paper in calculating bank capital requirements, while throwing Greece, entirely
uncompetitive at its current wage rates, out of the euro altogether. Banks will
be forced to take writedowns against their holdings of Greek paper, and, in
order to satisfy the new capital requirements, to sell other countries' paper
to institutional buyers. (Their immoral threats to stop lending and crater the
European economy if forced to hold more capital should be treated with the
contempt they deserve.) The banks that thereby become insolvent should be
liquidated forthwith.
Thus the necessary destruction will be accomplished. Witterers who moan about
"contagion" to other PIIGS or other banks should be quelled; one of the saddest
results of the current attempts to pour yet more money into the Greek rathole
has been the collapse of the fine Slovakian government, and its likely
replacement by the bunch of not-very-ex communists and kleptocrats that form
the opposition.
As Ireland has shown, it is possible to climb out of a banking crisis hole in a
remarkably short space of time - and Ireland would have still fewer problems if
it hadn't foolishly guaranteed bank obligations in the first place. An
equivalent austerity, perfectly possible under the capable Silvio Berlusconi
and the incoming Spanish government would save Italy and Spain, although alas
possibly not Slovakia, where the damage is probably done. Portugal also seems
likely to save itself, but if not, it must share the fate of Greece.
Finally, here in the United States, bank balance sheets are endangered by the
failure of the foreclosure process on underwater homes to proceed as it should
and, still worse by the government's conspiring with the trial lawyer lobby to
make the banks responsible for a problem that was largely the fault of the
government and the witless borrowers themselves. Instead, the government has
kept the utterly damaging Fannie Mae and Freddie Mac in business and has
attempted to force still money to go into the over-invested US housing sector.
The great Andrew Mellon in December 1929 is alleged to have said "Liquidate,
liquidate, liquidate". With the statist Herbert Hoover in the White House, they
didn't do it then, and suffered a decade of depression as a result. We should
be wiser now, in Japan, in the EU and in the United States. Subsidizing failure
should no longer be an option.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found on the website www.greatconservatives.com -
and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley,
2010). Both are now available on Amazon.com, Great Conservatives only in
a Kindle edition, Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com.
Copyright 2005-11 David W Tice & Associates.)
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