Capitalism, Finance Theory, Market Risks

Don’t Fear Failure

By, 07/15/2008

Story Highlights:

  • News of IndyMac Bank's failure stirred uncertainty among investors, especially those fearing more failures.
  • Company failures and the subsequent destruction of jobs and market disruptions can be painful to endure.
  • Still, preventing a failing company from actually failing can sometimes cause far more damage than good.
  • Failures make way for new innovations, new companies and new systems—all providing more value and more opportunities at lower costs.

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During the savings and loan crisis, more than 1,600 banks were closed or resolved,* with roughly 830 failures from 1990 to 1992 alone. Eight hundred and thirty is a stunning number—enough to cause a prolonged market and economic downturn, right? Except it didn't. According to the National Bureau of Economic Research (NBER), from 1991 through late 2001, the US experienced its longest period of economic expansion,** an almost uninterrupted period of above-average growth and market returns. So with news of IndyMac Bank, the first major commercial bank failure after 18 months of this cycle, should we fear the failure?

Bank Fears Spread After Seizure of IndyMac
By Robin Sidel, David Enrich and Jonathan Karp, The Wall Street Journal
http://online.wsj.com/article/SB121599581234249669.html?mod=hps_us_pageone

Government Not Expected to Help More Companies
By Joe Bel Bruno and Stephen Bernard, Associated Press
http://news.yahoo.com/s/ap/20080714/ap_on_bi_ge/credit_crisis_new_phase;_ylt=AuxgIFD4Vn3z0lZEbyRpIoCyBhIF

As noted in the first article, we've seen but a handful of US bank and thrift failures since 2007—the start of current credit crunch fears. And far fewer bank failures tied to current credit conditions are expected to occur compared to the early 1990s. So why fear failure so much? Call it the underdog syndrome or perhaps a quirk of being human, but perhaps we fear failure—in ourselves and in those around us. Failure is often accompanied by pain and destruction. When a company fails, we fear the possibility of lost jobs or market disruptions. So we argue for the government to prop up businesses and industries.

But the instinct to prevent failure at all costs is contrary to how free markets work—not letting a failing company actually fail from market forces can cause far more damage. It may seem counterintuitive, but preventing failure inhibits economic innovation and growth. Although company failures may trigger short-term market disruptions, they also bring about what economist Joseph Schumpeter coined "creative destruction"—the creation of new methods, technologies, systems and structures through the destruction of the old. This process of destruction and creation has been the hallmark of human progress. If we stifle failure, we stifle progress.

Even more dangerous is when governments attempt to prevent failures. Often, the government solution creates an ever more rickety infrastructure of government scaffolding to fight natural market forces. History is rife with examples of government "support" prolonging and exacerbating problems. The Japanese experience of the 1990s is a great example, when government regulators allowed hundreds of insolvent "zombie" banks to remain in business when they should have been shut down.

This last comment begs the question, "Should the government, then, bail out Fannie Mae and Freddie Mac?" Here the answer is trickier. These government sponsored agencies have long been presumed by the market to have implicit government backing, and their sheer magnitude separates them from run-of-the-mill commercial banks like IndyMac (which at its height had only a market cap around $5 billion). Even differences aside, the current jeopardy facing Fannie and Freddie is more a function of the accounting fictions of mark-to-market accounting than of true insolvency. In this case, the government would likely be making the right choice of bridging their financing gaps if need be rather than needlessly allowing failures of such critical institutions. (And after all, as Ronald Reagan famously quipped, "The closest thing to immortality on this earth is a federal government program.")

Since man first discovered how to harness fire and shape arrowheads, old methods routinely die, become obsolete, are replaced or are exponentially improved upon. Our standards of living are higher today than ever. This is because failures make way for new innovations, new companies and new systems—all providing more value and more opportunities at lower costs. Those failures may have been painful to endure at the time, but we are inarguably better because of them.

Will more bank and thrift failures be on the way? Probably. But even so, we shouldn't fear failure.

Sources:
* http://www.fdic.gov/bank/historical/history/3_85.pdf
** http://www.nber.org/cycles/

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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