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March 1, 2010

BAILOUTS AND INNOVATION: AN INVERSE RELATIONSHIP

BAILOUTS AND INNOVATION: AN INVERSE RELATIONSHIP

I've been reading a good book, "Economics Does Not Lie: A Defense of the Free Market in a Time of Crisis" by Guy Sorman and a discussion in the book prompted me to think about bailouts and innovation.

INNOVATION
Innovation, the ability to create something new and better out of something old (or nothing at all) has been the back-bone of America's growth over the past 200+ years. America wasn't first to industrialize, but thanks to the free market and the innovative spirit that pursued, America became an industrial powerhouse before the Civil War. Today, innovation drives people to create new and exciting things from practically nothing. Whether it was the birth of Harley Davidson, Fubu, YouTube, or Google, the idea that you have the freedom to take your idea to the next step has distinctly defined us.

So what can hurt innovation?

I think it is apparent that socialism and communism do not help innovation. When's the last time some great invention came out of China? High taxes are another barrier. These costs create prohibitive restrictions that make people think twice before launching that new idea. Entrepreneurs want to keep their profits for themselves or re-invest them in their company, not hand it off to another entity.

I believe we can all agree on the above, but do bailouts encourage innovation?

Economists have increasingly thrown around the word "creative destruction" over the past century. Creative destruction is the idea that innovation feeds off the failure of old and ineffective ideas/industries. These industries could consist of massively inefficient companies that are consuming massive amounts of resources in order to operate. They could also be competing directly with the entrepreneur.

Examples of creative destruction can be found throughout our history. Creative destruction occurred from the death of the Pony Express to the telegraph, to the telephone, cell phones, and the evolution from the typewriter to the PC to the iPad.

So, would the telegraph have had an easy time if the federal government had bailed out the Pony Express? What benefits to society would have the propping up of Smith Corona had the government stepped in to bail it out from bankruptcy in 1995? (Note: Smith Corona was the last traditional typewriter company, and still produces electronic typewriters).

So what benefits have the General Motors bankruptcy brought? Sure, in the short term jobs have been saved, but what do we think would have happened to GM if the company had liquidated? Do we really believe everyone would have been laid off and all facilities shuddered? We can learn from other Chapter 7 bankruptcies that this is almost never true.

Let’s start with Circuit City. While the bricks and mortar of the former electronics giant is gone, the real estate is there for the taking for any vying entrepreneur. Also, if you go to circuitcity.com, you will see that another company has bought the Circuit City name in bankruptcy to provide electronics online at good prices. Some may question the reliability of buying off this website. My response to that would be to recall the reliability of the old Circuit City.

Restaurant chain Bennigan’s declared Chapter 7 bankruptcy in 2008, but about six months ago, I had dinner with friends at a Bennigan’s in Peoria, Illinois. While the Bennigan’s chain went under, the branches that were profitable and not part of the greater conglomerate’s inefficiencies were sold to other entities.

To believe that General Motors would disappear is to believe that the Chevrolet, GMC, Buick, and Cadillac are totally worthless, which is not true. Had a liquidation occurred, the remaining global auto manufacturers would have come in and purchased all of the positive assets that General Motors held. We can see that in the purchase of Saab, Hummer, and the near purchase of Saturn, despite all of these being considered “failed” brands.

Some say that foreign companies would move production out of the country and all of the jobs would be permanently lost. My counter-argument would be to look at the new Suzuki facility in Indiana, or the Honda facility in Ohio, the Kia facility in Georgia, the Toyota facilities in Alabama, Kentucky, Indiana, and Georgia, and Nissan in Tennessee and Mississippi.

On a personal note, I believe that a new industry could have emerged from the financial crisis. Companies could have made profit buying homes on the verge of foreclosure and either renting or selling them back to their tenants. The high payments that distressed owners faced due to poor credit or adjusted mortgage could be replaced by lower fixed payments from the company. The company of course would make a profit, but the distressed homeowner would save money and get to keep their home (in some way). This could not be done, however, because the government came in and froze foreclosures, thus eliminating the initiative to start such an industry. No industry means no jobs.

The bottom line is that bailouts stifle innovation. Innovation is the engine that keeps the American dream going, keeps our society in a state of constant improvement, and creates jobs. We should have let the automotive giants, which did not carry systemic risk fail. Those who stepped in and bailed out these lumbering, inefficient giants, clearly cannot believe in the free markets.

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