Liquidating reality

Can we get one thing straight? Administration and liquidation do not destroy productive assets or viable jobs. If the assets can be put to profitable use based on any valuation down to a penny, they will be put to that use, unencumbered by the debt that had weighed down on them, as the company emerges from administration or the assets are offered for sale at liquidation. If they are not even worth a penny in that process, then the value had been destroyed before the company went into administration or was liquidated – either because the market changed (i.e. people no longer valued the products to whose production the assets contributed enough to justify the ongoing cost of the asset), or because the managers who invested in the asset made a bad judgment in the first place. Either way, administration and liquidation offer the best way of discovering whether someone with better judgment than the existing management thinks they can make profitable use of them.

Likewise for jobs. If someone believes that they can make a profit out of the use of an insolvent company's assets, they will need employees to operate the assets. If the best use is the original use, the existing employees will be able to carry on as before (although possibly with reduced remuneration that reflects the economic realities). If the best use is a change of use, some employees may be able to retrain, and others will lose their jobs, but still others will gain jobs created by the change of use. If no profitable use can be found, the jobs, like the value of the assets, had been destroyed by the market and the management before the company went into administration.

Subsidising an insolvent company to maintain the existing jobs destroys jobs in the round, it does not conserve them. The subsidised business is continuing to do something unprofitable, requiring taxpayers' money to keep it doing that. It is destroying wealth by continuing to use the assets for a loss-making purpose, when we could be creating wealth (if a profitable alternative could be found by an administrator or purchaser) or at least not destroying more of it, by spending good money after bad (if the best that we can do with the assets is send them to the knacker's yard). The amount of taxpayers' money needed to keep the thing afloat exceeds the value that it adds to the economy (otherwise it could raise the money by other means than relying on the taxpayer). At the margins, those unnecessarily-high taxes are destroying jobs, and because the cost exceeds the benefit, more jobs are being destroyed elsewhere than are being conserved by the subsidy. Unfortunately, politicians, the commentariat, and the public can see the direct effect of the jobs being conserved, whereas they cannot easily spot the indirect effect of the jobs being destroyed, though if they stopped to think about the levels of unemployment in the circumstances where governments prop up bad businesses (usually a downturn), it might occur to them that taxes to subsidise bad businesses do not appear to be helping at a wider level.

Ah, but they don't have to tax in order to subsidise, the interventionist says. Governments can borrow or print money instead. In that case, no business is being penalized to keep the unprofitable businesses afloat. We are all winners. There is such a thing as a free lunch. All shall have prizes.

Sadly not.

Government borrowing competes with other borrowers for funds. Directly (for bigger companies) or indirectly (for smaller companies who borrow from financial institutions who need funds to lend), government borrowing makes it harder for otherwise viable businesses to raise funds, or at least increases their costs of raising funds. At the margins, this kills businesses that would otherwise be viable without this intervention. Borrowing to subsidise businesses isn't saving businesses and jobs in the round, it's just changing which jobs and businesses go bust. Without the borrowing, it is the least viable and least well-run businesses that go. With the borrowing, it is those who were a bit better than the worst ones (who receive the subsidy) but not better enough to survive the extra burden of keeping the worst companies alive.

Printing money (or equivalent) doesn't increase wealth, it just reduces the real value (purchasing power) of each unit of money. And it doesn't do this uniformly throughout the economy. Those closest to the source of the new money benefit and those furthest from it do worst. If a government (or its central bank) prints money and the government uses some of that new money to support businesses or industries, those businesses and industries are more than compensated for the reduction in the value of what little money they had to start with by the fact that they have ended up with more money. Other businesses' money is devalued just as much, but they are not immediately compensated. The worst companies are made better off, and better companies are made worse off. Again, at the margins, some companies that would otherwise have been just about viable are driven to the wall, in order that the least viable companies be protected.

This isn't just theory. You can see it playing out across our economy. It happened in the 1930s and the 1970s. And it will carry on happening, because it takes an unusually principled government to resist the attraction of being seen to do something, however harmful it may be in the round, particularly when the “benefit” is so visible and the harm is so diffuse. Ce qu'on voit, et ce qu'on ne voit pas, as Bastiat said.

What is destroyed in the process of administration and liquidation is the illusion that the company retains any value for shareholders and (to a lesser extent) that creditors can expect to be repaid. Again, these processes have not destroyed anything real – shareholder funds have been wiped out and debts owed to creditors devalued through the operation of the business before administration. There is already nothing left (for shareholders) or a loss to be born (for creditors). Administration and liquidation simply force shareholders and creditors to recognize this reality. It punishes most severely those (shareholders) who had ultimate responsibility for electing the board of management that ran the company into the ground. And, if some or all of the company is still viable without the weight of debt that the business had built up through bad management, it replaces these incompetent or careless shareholders (and usually the managers they chose) with people who have been wise enough in the management of their funds that they have excess to invest in the remnants of the business. In effect, it cuts out the dead wood, and grafts the healthy shoots to more robust root-stock. This, incidentally, is one reason why pre-pack administration is so pernicious - protecting and rewarding exactly those who least deserve protection and reward, preventing better investors and managers from having the opportunity to make better use of the assets and employees.

In the case of shareholders, no tears should be shed. They failed in their responsibilities and demonstrated that they were unfit to choose how their capital should be deployed. Provided that the business was operating in competitive markets where no participant enjoyed a privileged position through anti-competitive behaviour or state-granted privilege, insolvency measures are instances of good economic Darwinism in action. Control of assets (and the jobs that go with them) has passed from those who are unfit to determine how they should best be used to those who have demonstrated their fitness to make decisions about deployment of resources. The investor does not hold some sacred role in the economy that must be protected. Like the accountant or the delivery driver, he needs a particular set of skills, although unlike them, he cannot prove his capability by a piece of paper, but must prove it through the success of his investments. Not everyone will be cut out to be a good investor, any more than everyone will be cut out to be a good salesman. It is in everyone's interests that decisions about utilization of resources be taken by good investors, even if this means that the small proportion of the population that is good at investing ends up controlling a large proportion of the capital. If they do not exercise their judgment wisely, to the benefit of customers and employees, they will swiftly lose their share of the capital, as will they if they decide to consume their capital (which socialists enviously and invertedly assume is what capitalists do). They are an essential part of a functioning economy, and to inhibit the Darwinian movement of capital-control from bad investors to good investors (what Schumpeter described as “creative destruction”) is to damage everyone who benefits from a strong economy – that is all of us.

Unlike shareholders, we may feel sorry for some creditors. Not all of them, but some. Creditors whose business it is to lend money and who failed in their responsibilities to accurately assess credit-risk deserve no more sympathy than failed shareholders. But creditors may also be suppliers, or (in the special case of suppliers of money to financial institutions) savers. These people have less specialist ability and fewer resources to verify the creditworthiness of the people who take their products or money, and yet the economy cannot function without these people exposing themselves to this risk. We have seen that the businesses on whom they rely to provide this specialist service – the credit-rating agencies – may get it spectacularly wrong. We cannot absolve these creditors entirely of responsibility – prudence requires all of us to make our best efforts to know who we are dealing with – but we may feel that they deserve preferential treatment ahead of professional lenders.

The IEA has put forward the idea that savers should be treated as priority creditors of insolvent financial institutions. It is a beautiful idea whose simplicity is sophisticated rather than simplistic. Most insolvent financial institutions will not have no assets to set against their liabilities. On the whole, their liabilities will only marginally exceed their assets (because of the legal requirement not to trade insolvently). If we prioritize savers above professional fund-providers for receipt of the proceeds from insolvency proceedings, it is very likely that all savers will get back all their money. The professionals, on the other hand, will have to take a bigger “haircut” on the money owed to them. This will give them a stronger incentive to be careful about who they provide funds to, and how much. We might usefully adopt the same approach for non-financial businesses, by prioritizing suppliers above funding-providers.

There is always a cost. The cost of this prioritization is that it will make wholesale funding scarcer and more expensive. But this is not a bad thing. By making wholesale funding sources relatively expensive compared to retail funding sources (because the former carries greater risk to the funding-supplier), this should increase financial institutions' desire for retail funding (that is savings) and therefore cause them to offer better rates to savers. And it will act as an automatic break on bubbles, because there is a tight limit on how quickly retail funding can be expanded (unless the government prints loads of money), so to expand beyond that will require the use of more expensive wholesale funding, increasing the costs of borrowing if the economy is expanding faster than its naturally-sustainable rate. The economy may grow slower than it appears to grow when credit can be expanded rapidly and cheaply. But it will be real, sustainable growth. And over time, as people gain the confidence that stems from progress being grounded in reality rather than illusion and creative destruction hands investment decisions to those best equipped to take them, rates of real growth will probably exceed the average rates under the irrational, cyclical, interventionist system that developed over the past century.

What brought this to mind today was the announcement of the resurrection of a “leaner” General Motors. The US government now owns 61%, the Canadian government 12% and the United Auto Workers (whose wage demands are substantially responsible for GM's uncompetitiveness) 17.5%. These groups' investment-prowess makes Bernie Madoff's investors look like Rockefellers. One of the first announcements from the "new GM" was that it was looking at eBay as an alternative route to market, which will really help their remaining, hard-pressed dealers, without whom GM will be in a bigger hole than it is now. But government-backing can cover up a multitude of sins and allow the sickest of beasts to consume or outlast its rivals. How pleased must Ford be that the North American governments have given this wreck the kiss of life, and quite possibly put the numbskulls who run it in a position to devour Ford? Who will benefit if the price of keeping GM alive is to push Ford into greater financial difficulty?

The establishment line that has been repeated ever since various financial institutions were part- or wholly-nationalized was that the action was necessary to prevent them from going into administration, in order to save the financial system from meltdown. That's not just wrong, it is the opposite of the truth. It relies on the misconception described above – that administration destroys wealth and jobs (rather than recognizes the destruction that has already occurred and looks for the best way of utilizing whatever value remains). It's not just that we could have survived the collapse of a couple of institutions (with sensible prioritization of the debt), but that their collapse would have been highly beneficial. The price we pay for standing in the way of this creative destruction is the immodest haste with which many banks have forgotten their shame and returned with renewed vigour and increasingly malign effect to the task of lining their pockets at others' expense.