How Capitalism Will Save Us Page 10

  The economists believe that the media’s tendency to emphasize the negative—even in good times—may result from the fact that more than two-thirds of job destruction occurs in blocks, i.e., mass layoffs at companies that downsize by more than 10 percent in a quarter. Job creation occurs in blocks, too. But the media are predisposed to write about conflict. And in those terms, job loss makes for the better story.

  This churn is part of the economy’s process of reallocating people and capital. As economists W. Michael Cox and Richard Alm put it, the job loss that results is “the way the macro economy transfers resources to where they belong.”9

  What happens then? People take new jobs in high-demand sectors. Entrepreneurs emerge to meet the needs in underserved markets. Innovations are developed. More jobs are generated. The economy recovers.

  What does that mean for us today? As we’ve noted, the 2008–2009 recession was the result not of the economy’s normal creative destruction brought about by new technologies, but destructive government decisions. Nonetheless, spontaneous reallocation of resources still takes place. Two areas of the economy where, according to the Bureau of Labor Statistics, jobs continued to be created in 2008: education and health services.

  Whether or not maximum growth occurs in the future will depend in large part on what the government does, such as creating a strong and stable dollar, lowering taxes, enacting sensible regulation (no more mark-to-market distortions, for example), and instituting positive systemic reforms of health care and Social Security.

  As Alm and Cox explained in a 2003 op-ed in the New York Times, “It is the paradox of progress: a society can’t reap the rewards of economic progress without accepting the constant change in work that comes with it. Efforts to soften the blows, by devising policies or laws to preserve jobs or protect industries, will lead to stagnation and decline, the biggest threat to American workers.”10

  Alm and Cox’s intent was to reassure people that job growth would resume after the 2001 recession. It did. And what they said back then is just as true of the current downturn: “Facing unemployment and rebuilding a life can be hard on families, but the United States today is better off for allowing it to happen. … Job growth will come, as it always has in the past. The economy, meanwhile, is as busy as ever in shifting labor from one use to another to make the country richer and more productive.”

  REAL WORLD LESSON

  Job destruction, as well as job creation, is critical to economic growth in democratic capitalism.

  Q DOESN’T GOOGLE’S GROWTH AND POWER ON THE INTERNET DEMONSTRATE HOW BIG COMPANIES CAN GAIN AN UNFAIR ADVANTAGE?

  A NO. SOONER OR LATER IN THE REAL WORLD, SMALLER, INNOVATIVE COMPETITORS EVENTUALLY OUTSTRIP BIG PLAYERS.

  What doesn’t Google dominate? In just ten years, the company, which grossed almost $17 billion in 2007, has become a power in Internet search, online advertising, and media. It has helped to remake the news business through virtually inventing the concept of content aggregation, providing readers with the best offerings of a wide range of new media on a single page. Along with selling its own ads, the company in 2008 expanded its reach with its $3.1 billion acquisition of DoubleClick, the largest online ad agency that brokers advertising across the Internet. Google has entered the hardware business with a touch-screen handheld to compete with the iPhone. It is also making deals with computer makers such as Toshiba to provide its desktop search software.

  Little wonder that software makers, telecommunications firms, advertisers, book publishers, and others have expressed fears of this growing power. Indeed, Google seems to swallow everything in its path. Doesn’t its domination of the Internet attest to the brutality of free markets, where big companies crush their competitors and keep getting bigger?

  This thinking lay at the heart of antitrust legal actions that are the price of success for many of the nation’s biggest companies, which each year spend millions of dollars diverting—indeed, wasting—valuable intellectual resources on defending themselves and sometimes paying penalties, in federal, state, and private antitrust cases.

  We discuss in our chapter on regulation that antitrust actions usually have less to do with issues of corporate power and more to do with retaliation by other competitors. As for the notion that big companies like Google and others can gain “too much market power,” it may be true that some companies can for a time dominate their markets. But in the competitive Real World economy this dominance never lasts.

  Freemarket opponents and antitrust supporters fail to appreciate an essential principle of Real World economics: so-called monopolies are almost always temporary. Sooner or later, smaller, more nimble competitors enter the market and supplant established players. This competition can come not just from within an industry, but from competitors with previously unforeseen new technologies.

  The Forbes 500 list of best big companies is a powerful illustration of the vulnerability of big players to market forces: of the top 500 companies in 1983, only 202 were on the list twenty years later. The rest were outgrown or, in some cases, put out of business by competitors.

  In the early 1960s, General Motors was so powerful that it decided to scale back production of its cars and trucks to avoid a federal antitrust suit. Once the world’s most powerful company, the automaker by 2008 was a hobbled giant that had to plead for a bailout from a hostile Congress, only to later be forced into government-orchestrated bankruptcy. At one time, no one could have possibly imagined that the initials of the great GM would years later stand for “Got Money?”

  In his classic analysis The Innovator’s Dilemma, Harvard professor Clayton Christensen explains that in the Real World economy, “seemingly unaccountable failures,” like those of GM and others, take place all the time. In fact, they’re inevitable.11 Why? Christensen makes the seemingly counterintuitive point that great companies almost always fail not because they did something wrong but because they do everything right. They focus so heavily on serving their customers that they become myopic, failing to perceive competitive threats.

  Christensen cites the classic case of Sears. The retail chain at one time accounted for 2 percent of all retail sales in the United States. The chain was a vibrant innovator, in many respects the WalMart of its day: “It pioneered several innovations critical to the success of today’s more admired retailers: …supply chain management, store brands, catalogue retailing, and credit card sales.”12

  Sears was doing a great job serving its market. The problem was that it did not see a new threat emerging from a new type of retailer—discounters. “Sears received its accolades at exactly the time—in the mid-1960s—when it was ignoring the rise of discount retailing and home centers, the lower-cost formats for marketing name-brand hard goods that ultimately stripped Sears of its core franchise.” The company was also losing its lead in the use of credit cards in retailing to two emerging players—Visa and MasterCard.

  The computer industry is rife with similar cases of huge players being usurped by smaller newcomers. Few people today have heard of Digital Equipment, Commodore, Tandy, and other big names that were prominent in the 1970s and ’80s but have since lost out to subsequent waves of innovation.

  IBM, “Big Blue,” was at one time the world’s leading computer innovator. The company dominated the market for big mainframes. But Christensen says that it “missed by years the emergence of minicomputers, which were technologically much simpler than mainframes.”13 IBM became a leader in the market for personal computers. But it was slow to market laptops, fell behind competitors, and eventually sold its PC business to a Chinese company. It was overshadowed by innovations from companies like Apple and Microsoft. Big Blue managed to survive after a brush with insolvency in the early 1990s and today is a large, profitable company. But it is proportionately far less powerful than it was in its heyday.

  The problem with industry leaders like IBM, Christensen says, is that they tend to work on improving their existing products and services, rather than try
ing to anticipate the next big thing. This emphasis is not due to a lack of foresight. To a big industry leader, cutting-edge products can appear less attractive, at least at first: “disruptive products are simpler and cheaper; they generally promise lower margins, not greater profits.” That’s because

  disruptive technologies typically are first commercialized in emerging or insignificant markets… leading firms’ most profitable customers generally don’t want products based on disruptive technologies. By and large, a disruptive technology is initially embraced by the least profitable customers in a market.

  Hence most companies with a practiced discipline of listening to their best customers and identifying new products that promise greater profitability and growth are rarely able to build a case for investing in disruptive technologies until it is too late.14

  A prime example: the failure of Xerox to anticipate the rise of desktop copiers.

  Xerox once dominated the market with its complex, expensive machines. Employees needing photocopies had to wait at the corporate copy center until the operator could get around to the job. But then Ricoh and Canon brought their slow but inexpensive tabletop photocopiers to the market in the early 1980s. Xerox at first ignored these poorly performing machines; they were not good enough to address the needs of the customers who wanted better, faster machines for their high-volume, centralized copy centers. Yet as with minicomputers, the tabletop copiers allowed a larger population of unskilled people to make copies in closets and nearby supply rooms. From those disruptive beginnings, photocopying has become so convenient that easy access to high-quality, feature-rich, and low-cost copying is now viewed as a constitutional right. High-speed photocopying facilities still exist, but they thrive by disrupting conventional printing businesses—enabling low-skilled operators to copy and bind printed matter on demand, which once required the time-consuming skill of professionals.15

  What freemarket opponents fail to grasp is how bigness most often becomes a disadvantage in a marketplace that demands agility to compete. The investment research firm CommScan looked at stocks of the thirty biggest corporate mergers over five years during the late 1990s. On average, they underperformed the Standard & Poor’s 500 index.

  Remember when Internet powerhouse AOL merged with Time Warner in 2000? People feared that the new company would dominate media markets. Instead, AOL–Time Warner is now considered one of the biggest failed mergers in history, a corporate behemoth burdened with debt. The synergies expected between the company’s old and new media divisions failed to materialize and produce any new value for shareholders. The final blow: in spring 2009 Time Warner announced that it was getting rid of AOL.

  All of this is not to imply that small companies are always capable of outstripping bigger ones. Smallness is a disadvantage when a startup tries to do things pretty much the same way big companies do. After World War II, construction magnate Henry Kaiser invested considerable resources into developing a new auto company. But his foray into autos flopped because he offered no real technological breakthroughs. Nor were his models seen as any better than what was already in the marketplace. “Me too”–ism won’t work.

  By contrast, a big company can give another big company a renewed run for its money. Microsoft, having badly trailed in the search-engine business, is making a rejuvenated and innovative run at Google with its new search engine, Bing.com.

  Ironically, companies with the greatest control over their markets are those whose power is enforced by government fiat. Few question the “market power” of their local utility. When government creates a monopoly, no one complains.

  REAL WORLD LESSON

  “Market power” is temporary because of the natural creative destruction of free markets.

  Q IF CREATIVE DESTRUCTION IS ESSENTIAL TO A HEALTHY ECONOMY, WASN’T IT A BAD IDEA FOR THE GOVERNMENT TO BAIL OUT THE FINANCIAL SECTOR IN 2008 AFTER THE SUBPRIME-MORTGAGE COLLAPSE?

  A THE BAILOUT WAS A NECESSARY EVIL TO AVOID THE COLLAPSE OF THE GLOBAL ECONOMY.

  In 2008, many people were incensed when the federal government passed a $700 billion bailout of financial companies on the verge of imploding from the subprime-mortgage collapse. Opposition was voiced not only by those ordinarily hostile to business, but also by many who saw the bailout as a betrayal of Schumpeter’s principles. After all, they insisted, isn’t this supposed to be a freemarket economy? Aren’t companies that make bad decisions—in this case, investing in high-risk mortgage-backed securities and derivatives—supposed to suffer the consequences? Shouldn’t they be allowed to fail?

  Most of the time we’d say yes. But, as we’ve noted, by fall 2008, a series of government errors had put the whole financial system on the verge of collapse. That’s why, in the Real World, the bailout was critical. Very simply: had the government not stepped in, the impact on the worldwide economy, on billions of people, would have been cataclysmic.

  The financial sector is not just another industry. It is the lifeblood of our system. Without banks and other credit providers you don’t have an economy. By September 2008 the U.S.—and global—financial system was on the verge of cardiac arrest. Allowing the financial sector to implode would have unleashed a cascade of calamity: People fearful of losing the money in their checking or money-market account would have withdrawn their cash. Banks would have stopped lending to one another and to solvent borrowers. Merchants wouldn’t have been able to get financing for inventories. Buyers wouldn’t have been able to get credit for their purchases. Entrepreneurs would have been denied capital for startups. There would have been no money available for business expansion. Capital and credit flows would have dried up. Companies everywhere would have liquidated their debts. Unemployment would have soared. Economic activity would have imploded.

  Some of these events did unfold after the crash of 2008. But had Congress allowed AIG and other companies to go under, we would have suffered not just a serious recession but a worldwide depression of untold magnitude. Tens of millions would have seen their jobs destroyed. Countless solvent companies would have gone under. Beyond the devastation of the worldwide economy, the political repercussions would have been uglier than they were in 2009. The resulting government intrusion into the U.S. economy would have vastly exceeded anything the Obama administration will be able to do.

  The repercussions would have been felt outside the United States. In some less stable countries, free markets and democracy itself would have been discredited. Tyrants would have had new opportunities to rise up. Let us not forget that Hitler would never have come to power had it not been for the Great Depression of the 1930s. Before that crisis, the Nazis had carried only 2 percent of the vote in 1928.

  Another reason government had to intervene was that, as we explained in the first question in this chapter, this was not a disaster created by free markets. Companies did not melt down because of “natural causes”—i.e., losing out in the rough-and-tumble competition of the marketplace. This was government-made destruction. There was nothing “creative” about it.

  Low interest rates and a too-abundant money supply, courtesy of the Federal Reserve Bank, stoked an overheated housing market. Government-created Fannie and Freddie helped promote low-interest lending to unqualified borrowers. Federally mandated mark-to-market accounting rules added fuel to the fire, making basically healthy banks and insurers appear in worse shape than they were, encouraging write-downs that set off maniacal short selling of financial stocks.

  The bottom line is that bad government policies distorted the decision making and market behavior of these financial institutions. Thus, government intervention should be seen as an effort to reestablish the normal functioning of the market.

  The cost of restoring bank balance sheets and of other emergency measures pales in comparison to the staggering multitrillion-dollar losses and unemployment that would have resulted if no steps had been taken.

  In 2009 the Obama administration used this TARP money as a tool to micromanage institutions. Ban
ks were forced to do things for political reasons, such as accept a reorganization of Chrysler and GM that harmed their true interests.

  Some opponents of the bailout have characterized this massive intervention as socialism and it has come close. But socialism is permanent government ownership. The bailout was intended as temporary disaster relief. No one fears socialism when the government helps the victims of floods and hurricanes. The markets, in effect, suffered their version of Hurricane Katrina, affecting the lives and livelihoods of millions and threatening the collapse of the freeenterprise system.

  It was not socialism when the government sent the citizens of Louisiana and other states relief after Hurricane Katrina. However, if the government had continued Katrina-level aid indefinitely, not letting people get back on their feet and rebuild businesses—then we would start to worry.

  REAL WORLD LESSON

  The 2008 financial bailout was not corporate welfare but critical disaster relief for a financial-sector “Katrina” that was largely the government’s making.

  Q SHOULD GOVERNMENT HAVE STEPPED IN TO SAVE THE DETROIT AUTOMAKERS?

  A A SHORT-TERM BAILOUT COULD HAVE BEEN JUSTIFIED TO CUSHION THE RAPIDLY DECLINING ECONOMY. BUT THEN WASHINGTON SHOULD HAVE LET GM AND CHRYSLER REORGANIZE UNDER EXISTING BANKRUPTCY LAWS.

  In 2008, temporary assistance to the automakers was justified for two reasons: the number of jobs at stake and the fact that Detroit’s decline is not entirely a case of marketplace creative destruction. Government policies were partly to blame for Detroit’s problems.

  Federal Reserve monetary policies that weakened the dollar were extremely damaging. They sent commodity prices soaring and substantially increased the price of gas. High gasoline prices killed the market for Detroit’s most profitable product, sport utility vehicles (SUVs).