The financial crisis of 2008 led to the “meltdown” that brought on “the Great Recession.” Faced with immediate economic failure, large businesses were bailed out by the government, with the justification that they were Too Big To Fail (TBTF) — Because these businesses were so large and integrated into the rest of the economy, their demise was predicted to have a catastrophic effect.
This policy approach is a potential threat to free market capitalism, and therefore one that businesses must make sure they do not count on in the future.
Smart Business spoke with Walter Simmons, Ph.D., professor of economics and chair of the Department of Economics and Finance at the Boler School of Business at John Carroll University about the dangers of TBTF.
Why is TBTF a bad practice for society?
Government should not be in the business of selecting which businesses succeed; the market does a much more efficient job and avoids an outcome in which profits are privatized and loses are shared by taxpayers.
The inherent instability of the free market is the very catalyst of its survival and sustainability. Business cycles are an innate feature of the market and provide the dynamism and motivation for individuals and firms to innovate and invent. Those pursuing their own self-interest behave in a socially responsible manner in competitive markets, and thus outcomes are determined by competition and not by government selection. The free market encourages resources to be used in the most efficient manner, creating a situation in which no one may be made better off without anyone being made worse off.
Why is TBTF a bad policy for big businesses?
The expectation that a firm should not be allowed to fail because it is very large and embedded in society creates a moral hazard and weakens market discipline. If companies and their affiliates believe that the government will bail them out from losses, they have less incentive to monitor risk because they are protected from the negative consequences. Thus, businesses that benefit from TBTF policies may be tempted to exploit their advantage and engage in high-risk behavior because they are able to leverage the risk against the governmental protection.
Why has free market capitalism succeeded while socialism has failed?
Big, inefficient governments; bureaucracies that maintained a bloated system built on pseudo-patriotism and subsidized welfare; and the limitations and subversion of rights led to the disintegration of socialism. Of course, the free market is not perfect and is subject to situations of market failure, but it is generally believed to be the best economic game we have in town. Even communist countries such as China realized and have adopted it on their path to economic growth and prosperity.
Why is TBTF a threat to free market capitalism?
Economic stability is not an enduring characteristic of the free market. And the life of a company in a capitalist economy is one of struggle. Any competitive advantage is relatively short lived. Companies must adapt or die. Barnes and Noble and Netflix have succeeded while Borders and Blockbuster have failed.
The difficulty with a ‘bailouts’ approach is that one can only learn whether a firm’s failure would tend to be disruptive if it is allowed to fail. Once a firm has been rescued, there is no way of knowing how disruptive its failure would have been.
What does the future hold?
The government had no explicit policy to rescue TBTF entities and it only became an issue for policy makers after the financial crisis. Systemic risk mitigation polices, such as the Dodd-Frank Act, limited the size and scope of activities of financial institutions that were already in place. They recognized the desire to avoid potential or moral hazard issues. This implies that ultimately it is the responsibility of companies to manage the inherent risk within the free enterprise system. Companies should have a strategy to benchmark their ability to take risk. In general, for the free market to allocate resources efficiently, companies must be financially rewarded for making good use of resources and, although they may not like it, punished when they do not. •
Walter Simmons, Ph.D., is a professor of economics and chair of the Department of Economics and Finance at the Boler School of Business at John Carroll University. Reach him at (216) 397-4659 or firstname.lastname@example.org.
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