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The Importance of Failure

Mises Daily: Tuesday, February 10, 2009 by

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There is much discussion these days about bailouts. Are they needed? Are they just? I say no on both counts. Yet many economists, politicians, and businessmen tell us that bailouts are needed to prevent catastrophic economic collapse. Without commenting on the justice of bailouts, they warn that we are facing massive economic pain if we stand aside and let markets run their course. Bailouts can staunch this pain, they claim, and restore order and calm to the economy.

I don't buy the probailout folks' predictions of impending economic chaos. But what if they're right? What if the short-run pain in store is just too terrible to endure if we don't start bailing out key industries? After all, we're talking massive unemployment, a new wave of foreclosures, a shrinking economy — in a word, recession. If the dire forecasts of the bailouters are correct, we'd be stupid not to do it; we'd be like a beaver caught in a trap: slowly dying, yet too timid to chew off his own foot to escape.

Capitalism depends on three highly complementary, yet distinct, institutions: prices, property, and "profit and loss." Classical-liberal economists have demonstrated the essential role of these pillars of prosperity for centuries. These fundamental institutions of the market economy are like legs of a stool. If we gradually weaken one leg, we will eventually bring the stool toppling down — economic collapse.

In this light, the implications of bailout are clear. Bailouts are designed to insulate people from the effects of bad decisions. When market prices change dramatically, exposing yesterday's poor investment choices, bailouts come "to the rescue," promising those left holding the bag that they won't have to endure the full cost of their errors.

But we should realize, as the fine print always says, that prices are subject to change. Change is a defining feature of markets. Entrepreneurs make money by casting about for "wrong" prices and making bets on what direction particular prices will move in the future. Successful entrepreneurs, who correctly anticipate price changes, are rewarded with profits. Erroneous entrepreneurs, who do a poor job of estimating price movements, are penalized with losses. This is the essence of the market process.

Bailouts, then, attempt to erase the effects of losses, or economic failure. But such efforts inevitably undermine the loss aspect of "profit and loss." Profit and loss go together — like up and down, left and right, good and bad. If we try to do away with losses, we'll wind up diluting the meaning of profits. After all, why strive for profits if Uncle Sam will cover your losses with a bailout? Why bust your butt to compete and succeed if you can just clamor for a handout instead? Bailouts destroy the profit motive — and all the benefits of a competitive economy.

There's a great irony in bailouts, too. The only reason we can afford to even talk about bailouts is because of the accumulated wealth brought about by centuries of capitalism.

"If we try to do away with losses, we'll wind up diluting the meaning of profits."

Long ago, bailouts were unheard of; failure meant starvation, perhaps death. Consider the caveman: Ug's tribal chief couldn't afford to say, "It OK Ug no kill deer this week. It not Ug's fault. Tribe will bail out Ug."

If he wants his tribe to stick around, the chief must say, "Ug no kill deer: Ug family starve."

But modern man lives in a world of comparative abundance. If Doug is laid off because of recession, he'll have to find a new job and maybe tighten his belt. But Doug doesn't face starvation in our economy, and there are ample opportunities for him to adjust to economic changes. Yes, Doug will suffer somewhat during the transition, but the short-term pain of economic failure will guide him toward more productive, successful choices.

Failure is no fun, but it does teach essential lessons. We shouldn't miss out on those lessons simply because we think we can afford to bail people out. Instead of trying to abolish failure via bailouts, we should let markets work, let failure run its course, and be so much the wiser for it.