Wednesday, July 6, 2011

Countries: too big to fail

Private companies sometimes fail, and that's no big deal. Actually, as economist Tim Harford points out, they fail very often:

In a complex world, things fail – a lot. According to the economist Paul Ormerod, 10 percent of U.S. firms go bankrupt every year.... A more rigorous attempt to look at this question, a study by Kathy Fogel, Randall Morck, and Bernard Yeung, found statistical evidence that economies with more churn in the corporate sector also had faster economic growth. The relationship even seems causal: churn today is correlated with fast economic growth tomorrow. The real benefit of this creative destruction, say Fogel and her colleagues, is not the appearance of “rising stars” but the disappearance of old, inefficient companies. Failure is not only common and unpredictable, it’s healthy.

This is an important point, yet not really that counterintuitive if we think about it. I often hear about small businesses set up by individuals with redundancy pay. The collapse of old businesses can spawn the birth of new ones.

(I'm tempted to compare this with the fall of a mature tree in a forest. The tree dies. But there is a gap in the canopy and light pours down to the forest floor. Saplings rise into the new space. The death of the tree rejunivates the forest. We need only be concerned if the entire forest is wiped out in one go.)

The collapse of a business can mean that individual investors lose money. But a wise investor will spread their investments out so that they won't lose everything by the fall of just one firm. Individual employees have to look for work, which is awful for them but their presence on the market may help other companies who need fresh labour. The tree falls but the forest continues.

But the collapse of a country is a disaster indeed. There, no wise investments make any difference, every taxpayer is stuck paying back debt that can last generations. The only escape is emigration.

The difficulties in Greece now perhaps show what happens when a government fails. There is no opportunity for Greeks to switch their investment from one high-risk company to another low-risk company: the only way to escape Greek debt is to abandon Greece. The panicked efforts by EU to negotiate a 'bailout' loan along with austerity budgets show that the bankruptcy of a state is much more difficult to handle than the bankruptcy of a private company.

In recent times there have been debates about those private firms so massive and significant that governments subsidise or nationalise them when they risk failure. Can private companies be 'too big to fail'? I don't know, but its seems countries can be.

One of the complaints about governments bailing out big business is that it creates moral hazard: by insulating businesses from the consequences of risky behaviour they encourage risky behaviour.

If states cannot be allowed to collapse, does this encouage risky behaviour by governments? I'm not sure if I'm understanding this properly. The implications also puzzle me. Should we keep governments small, on the grounds that any organisation too big to fail will become corrupt, complacent and will take risky behaviour? Do we empower governments to cut up huge companies to prevent them becoming 'too big to fail'? Any thoughts are welcome!

6 comments:

  1. I think the bailout of Greece (Ireland and Portugal) has been done not because these countries are too big to fail. In my opinion it's a cynical exercise. The EU is terrified of a domino affect taking down the whole of the single currency union. Iceland collapsed but no one bailed them out. They were fed to the wolves. When all the debts that have been incurred by these failing European states are repaid they will find that their friends are no longer their friends and that the game is up and they will find themselves in a similar boat to Iceland.

    The bailouts are cynical. They are not there to save the countries. They are there to save mainly Germany and France whose private banks provided risky loans to these countries and their private institutions (this is particularly true in Ireland's case as our biggest problem is our banking sector which has now been more or less nationalised and so has turned private debt into sovereign debt). The EU has given us a loan (not a bailout) to repay our loans to their countries. As Constantin put it, once these private debts have been repaid they will feed us to the wolves. Hopefully he's wrong.

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  2. Ah well the EU's not a charity, certainly! I wouldn't expect anything in international politics but cynicism.

    What interests me is that in business companies are constantly in a state of birth and destruction. Yet countries (states) are not. If the "churn" of companies benefits the wider economy, what are we meant to think about the stability and permanence of states?

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  3. Yes I'm always getting away from your point ;-)

    As I can't post links search for this interesting TED talk "Parag Khanna maps the future of countries".

    He talks about changing borders which might be of interest to you as this must have inevitable consequences to the nation state.

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  4. Cheers Dave! I think if you post a link it goes into a spam box but I get a message to my gmail inbox anyway so I should be able to restore it :)

    Will check it out, thanks!

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  5. I like what you say about immunity from collapse encouraging risky behaviour. To some extent, offering a blanket bank guarantee to all the Irish banks could have been in part related to hubris borne of overconfidence, but also blind faith in a supposed infrastructure of bailout mechanisms that would back up this impossible commitment.

    More pointedly, the low rate of interest on government borrowings encourages States to overborrow. If defaults became more common, then rates would increase and we would have more fiscally disciplined states. It's too easy for states like Italy and Greece to accumulate massive debts simply through complacent budgeting and cheap borrowing.

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  6. Hey thanks for the comment spikslow! Honestly I am pretty new to economics and I struggle to understand this stuff. My only consolation is that the experts seem to struggle with it too.

    Your idea that the blanket guarantee was hubris is interesting and plausible. A long period of impressive growth might have made Irish politicians feel wise and invulnerable. Now they are corrected.

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