Wednesday, February 18, 2009

Of Bigness, And Failing

There's been plenty of discussion about the moral hazard issues that arise because banks (and some other corporations like GM) are too big to fail. If you know that the government has to to bail you out at the risk of widespread economic catastrophe, you may be more likely to take what would ordinarily be foolish risks, knowing that someone else will share the losses.

There's another problem that arises with enterprises the size of Citigroup and GM. Unlike smaller enterprises, they can create an enormous amount of chaos with large stupid decisions before they get removed from the economy.

Good arguments for capitalism don't assume that businessmen are inherently any smarter than civil servants. These groups can just be people of the same average intelligence. The point is that market forces provide a good way of eliminating poorly run enterprises. The mechanisms for getting rid of a poorly run government program are a lot more clunky -- you need to go through the electoral process or use public pressure.

This works quite well if you have a whole bunch of small enterprises. The bad ones vanish quickly, the good ones grow, and things get better. Among a large number of small businesses, there are going to be some doing a really good job, and they will come to serve more and more people as they grow. (I think the restaurant business more or less works this way. Don't nationalize the restaurant business.)

But suppose you have a small number of large businesses. If one of them ends up being poorly run, its substantial resources will allow it to linger for a long time, using resources inefficiently. And if nobody is doing a particularly good job, which is possible when the number of businesses is small, this situation can be fairly stable. Nobody grabs market share away from everybody else. Things stagnate. Low-quality vehicles are produced and nobody in the country builds an electric car.

Or, most everybody gets full of toxic mortgage bonds and there aren't enough smart firms with liquidity to buy up all the losers, even at fire-sale prices.
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