All Commentary
Thursday, March 11, 2010

Profits, Losses, and Structural Change

Deeds fail to match words.

A recurring economic theme of President Obama’s election campaign and presidency has been that previous administrations neglected fundamental structural problems that need to be addressed if we are to continue at our accustomed standard of living in the 21st century.  This view was nicely encapsulated in his original budget proposal, which emphasized education, health care, and the environment, especially the “green jobs” concept.

However, his actions have not matched his words. His specific programs for reform, and more crucially his recourse to bailouts and nationalization, all work against meaningful structural change by locking in the mistakes of the past.  In addition, by cutting short the profit-and-loss learning process, these measures deny us the one way we have of knowing whether structural change is needed and what sorts of change it should be.

His proposals for education and health care certainly do not undertake any sort of structural reform.  In fact, one could plausibly argue that in each area, his proposal both fails to address the fundamental problems and actually enhances the very structures that trouble many observers. If rising government subsidies are a key driver of rising college costs, then reconfiguring and expanding student loans to create “access and affordability” only worsens this problem and sounds an awful lot like the housing policies that got us into so much difficulty over the last decade or two.

In health care, until we break the link between employment and insurance by ending the favorable tax treatment of employer-provided coverage, we are not addressing the key structural problem.  Most health care expenditures are outside the direct control of patients, with no mechanism to drive down costs, especially in the absence of interstate competition in insurance.  The current reform proposals in front of Congress would actually aggravate the problem of third-party payment by giving more power to both insurance companies and the federal government.

Worse than all that, however, are the bailouts and nationalizations.  The bailouts were initiated by the Bush administration but continued by Obama, who added the nationalization of several banks and General Motors to the process.  The problems with these policies have been amply documented.  The point I want to make here is that they directly contradict Obama’s claim that the U.S. economy is in need of structural change.  Bailouts and nationalizations are perfect tools if you want to lock in the mistakes of the past. They are awful tools if you think structural change is necessary.

Market Overridden

By definition, a bailout takes a firm that should have disappeared and keeps it alive longer than is justified by profit and loss.  Nationalization simply takes that one step further: Government doesn’t just lend tax dollars to the failing firm; it provides capital through the purchase of ownership shares.  In both cases the judgment of the market is overridden by the political process.

We can look at this another way: The failure of firms reflects the combined judgment of market actors that there is a need for significant, and perhaps structural, change.  Profits and losses are the best signals out there to ensure not just that economies undergo necessary changes, but that they do so in the ways that consumers want.  Overriding the profit-and-loss mechanism through bailouts and nationalizations is a way to prevent structural change from taking place.  The biggest structural changes in economic history, such as the transition from agriculture to industry, were driven largely by the combined effects of profit and loss signals over time.  Those structural changes were successful precisely because the political process mostly did nothing to try to “protect” those who lost out in the short-run transition and allowed market signals to guide the process.

Had we tried to prevent the industrial revolution by “bailing out” dying farms and cottage industries, we would have only made the transition longer and more painful as well as impoverishing consumers and many workers in the process.  The quickest and most accurate way to know what economic changes need to be made and how to make them is to allow the profit and loss mechanism to guide human action.  Bailouts and nationalizations not only lock in the past errors; they also turn economic failures into political battlefields in which the organized beneficiaries, such as unionized workers, fight tooth and nail against real structural change.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.