Monday, November 2, 2009

Survival of the Most Fit

I know that it's not an original observation, but Too Big to Fail and similar policies to protect people and businesses who do a poor job are seriously interfering with the basic premise of a market economy.

James Kwak has written a post about how Citigroup CEO Vikram Pandit seems unable to present a meaningful description of his business strategy.

It's not uncommon to witness top business leadership governing on ego or otherwise failing to understand the limits of their firm's competency, and value in the market. One of my favorite examples is Daimler Benz CEO Jurgen Schrempp's famously bad decision to acquire Chrysler. The evidence suggests that Daimler's management team had no workable strategy for how to make use of their purchase or how to integrate it into their organization. No meaningful synergies were ever anticipated, nor did any emerge - as was practically guaranteed by leadership's policy against platform and technology sharing between Chrysler and Mercedes. In the end Schrempp was fired and Daimler paid Cerberus to take Chrysler off its hands.

This story perfectly illustrates how a competitive market is supposed to function, with severe chastening for incompetence. Interference in this process, even for the best reasons, will introduce pernicious effects.

Moral Hazard - Moral Hazard is a technical term that means that the risks of my actions are borne by others, not by myself. Moral Hazard explains why innovations in automobile safety systems, like airbags and seat belts, has resulted in increasing risk to pedestrians. It also explains why beach homes continue to be built in locations that put them at risk in the event of a hurricane (because the government has historically bailed out the wealthy owners of these sometimes non-insurable properties).

Picking Winners - When an incompetently managed firm shrinks or dies, an opportunity opens for the most efficient competitors to take market share. Bailing out large incumbent firms that perform badly interferes with the success of other, better run companies who are then forced to compete without the benefit of government backing. It also tends to strangle small upstarts who are bringing new value and innovation to the market. How do you think the founders of Tesla feel about GM being propped up by the government?

Regime Uncertainty - Perhaps most pernicious of all is the effect of Regime Uncertainty. This is a reluctance on the part of investors to put their money into markets, industries, or countries where the rules are not clear, or could change at any moment. Why has sub-Saharan Africa failed to develop? Well, one reason is because people are reluctant to build businesses in a region that suffers from frequent civil war and political tumult. If I build a factory in Tanzania today, will it be destroyed or seized by government tomorrow? Similarly, how willing am I to try to operate a business in any market where the government is making up the rules of competition and ownership day by day? Consider how the government chose to take money from GM's bond holders and transfer it to the UAW.

Systemic risk is a matter of incentives. Too Big to Fail is magnifying the wrong incentives.


  1. Sobering! Do you find it significant at all that this is a distinctly American problem?

    I suppose you could say that, even though it's deplorable and bad for smaller businesses and the economy at large, TBTF must be effective.

    Not right. But effective.

  2. I find it interesting that the small companies are now getting vocal about Too Big To Fail programs