Market needs to self-correct without bailout

One of our favorite New Yorker cartoons has a picture of a small vendor, “Tip Top Variety,” holding a going out of business sale. In the window of the store appears a large sign, which reads, in part, “Slapped-by-the-Invisible-Hand-of-the-Marketplace-Sale.” While the cartoon can be understood as commentary on the harsh and ugly side of capitalism, it reminds us that capitalism and the market economy are based on a system of profit and loss.

Imprudent decisions by business owners, whether it be the owner of “Tip Top” or the executives of Washington Mutual or Lehman Brothers, require correction. If the correction does not come about by the owners improving their firms, then it should come from other investors looking to enter into the market in the hope of realizing the profit opportunities others are mistakenly leaving on the table.

Allowing for bad ideas to be cleaned out is how markets self-correct. The self-correction principle is, perhaps, the most important principle of economic science. The fact that an overwhelming majority of Americans oppose the bailout suggests the general public understands this principle at a basic level. Unfortunately, this principle is forgotten by politicians whenever a crisis arises.

In a vibrant economy, firms enter and exit all the time. To illustrate the benefits of a dynamic market economy, it is sometimes best to compare it to another extreme where businesses are prevented from failing. During the early days of post-communist transition, the number of bankruptcies in New York City in one month in 1995 exceeded all the bankruptcies in the entire Russian economy between 1991 and 1995. In New York, firms were driven out of the market; executives responsible for poor decisions lost their jobs; and industries no longer meeting consumer demands became obsolete. In Russia, by contrast, low-quality and corrupt firms continued to operate. Consumers suffered and the economy remained stagnant.

Bailing out lending agencies is a dangerous step down the road towards socialism. The bailout completely distorts market incentives and thwarts the dynamic process of creative destruction, which is so crucial to market economies. We ask readers to consider the following: Was it a crisis for water-carriers to be driven from the market by the innovation of indoor plumbing, or for the whaling industry in New England to be displaced when electric light became widespread? While there were thousands of jobs lost when these industries failed, there were more efficient and better businesses right around the corner.

Though there is plenty of talk of black holes and credit freezes, resources do not disappear; instead, they get reallocated. The market process is a mechanism for the continual re-evaluation and reshuffling of scarce resources among alternative uses. This is what is meant when we refer to the market as a dynamic process of entrepreneurial discovery and learning. The most important “wisdom” of market process theory is to get out of the way of the process of adjustment. The poor decisions in one period must be penalized; the poor investments made by businesses must be cleaned out; and the opportunities for unforeseen profit opportunities must be allowed to be exploited. Bailouts, regulations, taxes, redistribution and inflation only hinder the ability of the market to self-correct.

In addition to the perverse economic effects created by the bailouts, there are also constitutional and ethical issues in play when such sweeping legislation is proposed. At the most fundamental level, the bailout money is not the politicians’ money to be giving away; such blatant redistribution from average individuals to elites in investment banks is wrong. In addition, despite all the talk of the government “turning a profit” on the bailout money, the government’s role has never been to be a for-profit investor. We both cringe at the thought of government trying to act as entrepreneurs.

A free society works best when the need for the policemen — in this case, regulator — is least. Individuals must be equipped to embrace the troubles of thinking and the cares of living if they are to live free as a self-governing citizenry. The consequences of our current policy path are dire in terms of economics, politics and freedom.

• Scott Beaulier is chairman of economics in the Stetson School of Business and Economics at Mercer University.

• Peter Boettke is the BB&T Professor for the Study of Capitalism in the Economics Department at George Mason University.