Friday, January 2, 2009

Bailouts Are Bad, Markets Are Good

I think one of the most common misunderstandings of the free market is in understanding why competition is good. Competition is not good because it makes businesses "try harder." Competition is good because only a business which produce goods and services that are more in demand than the goods and services which the business consumed to produce them does not go bankrupt. It is not because individual entrepeneurs are induced to try harder to give consumers what they want that competition is good but that those entrepeneurs who produce goods and services which are less in demand by the market than the goods and services consumed to produce them are bankrupted. This minimizes waste by constantly transferring resources from less valued uses to more valued uses.

In biology, there is a concept called "lamarckism." From Wikipedia, lamarckism "is the once widely accepted idea that an organism can pass on characteristics that it acquired during its lifetime to its offspring." For example, a body builder might pass on the genetics for large muscles in a lamarckist view. Aside from being quite silly on the face of it, all evidence contradicts the lamarckian view of biology.

I think that the misconception that market competition is good because it induces people to try harder is an analogy to lamarckism in biology. Organisms that work hard can improve the genetics which they pass on to their offspring. This is important because - if true - biological evolution is not guided only by reproductive success. If the primary benefit of market competition is making people "try harder" then the market is not improved solely by the survival of producers which supply products that are demanded by the market. Rather, producers are themselves improved by the fear of business failure and so go on to succeed and not go bankrupt.

If this is the case, then central planning through measures like bailouts should be an improvement over the market because the incentives facing businesses can be engineered, rather than left to the ad hoc vagaries of the market. Rather than waiting for entrepeneurs to fear business failure to provide some safety device or product disclosure, we can threaten them with government sanction ahead of time. This engineering improves the marketplace by giving entrepeneurs an incentive to try harder on things that the public has indicated through the political process that it wants the market to try harder on. Direct ownership and management of business by the government could also be an improvement since competition between the bureaucracy and the competition for funds from the public purse similarly induces the heads of government owned and operated business to try harder.

But market competition does not improve efficiency by giving businesses an incentive to try harder. It improves efficiency by bankrupting those businesses that do not produce goods and services that the market demands more than the goods and services consumed to produce them. Once bankrupted, the CEOs, board members and other directing individuals of the business no longer have the power to misallocate more valuable resources to the production of less valuable products.

Bailouts frustrate this process by keeping failed businesses alive so they can continue to misallocate resources. The reason for the bailout is that the business has been consuming resources which are in greater demand to produce goods and services which are in less demand. Propping up a failed business only ensures that this will continue. Allowing the business to fail frees up the misallocated resources to be put to more productive uses.

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