Time to escape from purgatory

The following comment by me appeared in the latest Fund Strategy (13 April).

Purgatory in Catholic theology is a condition of temporary punishment for those not entirely free of sin before they enter heaven. The concept could be worth adapting to help understand the response to the economic crisis.

On both sides of the Atlantic there is a market reluctance to let troubled businesses go under. Many financial institutions and car companies have received huge amounts of state largesse as a result.

There are two main reasons given for such bail-outs. The most important, particularly in relation to banks, is that allowing them to fail would have devastating systemic consequences. A secondary reason is that employees could suffer as a result of allowing such firms to go under.

Yet there is a fundamental problem with these actions. The way capitalism rejuvenates itself is through a Darwinian competition in which weaker firms go under. Through this process stronger and more innovative firms emerge victorious. It is a process that Joseph Schumpeter, one of the greatest economists of the 20th century, called “creative destruction”.

Although it is possible to resist this process in the short term it usually has damaging consequences in the longer term. It can lead to huge amounts of state spending to shore up chronically weak enterprises. Eventually the disruptive effect is likely to prove greater than if the short-term pain had been accepted instead.

Arguments against rejecting such bail-outs are generally overdone. It is unlikely the systemic consequences of allowing many financial institutions to go under would be as damaging as many suggest. It is more likely that politicians are simply afraid of accepting that large parts of their previously prized assets are insolvent. They would like to present the financial markets’ troubles as temporary problems related to insufficient liquidity.

It is even harder to imagine the failure of car companies, even ones as large as General Motors, having such a destructive systemic impact. No doubt many suppliers would suffer too but, for better or worse, that is how capitalism advances.

If job losses are a problem there are ways round that. Those who have lost their jobs could be helped to find work in more dynamic firms and sectors.

Of course, it is possible to reject the notion of capitalism advancing through creative destruction. But such a rejection means either accepting a chronically bloated and lethargic capitalism or suggesting another alternative.?

Purgatory, whether in economics or theology, can only be a temporary state. Eventually there will be no choice but to move on in one direction or another.