The "Too big to fail" mantra

In recent months as the global financial crisis unfolded it became clear western, democratic governments do not fully subscribe to market economic principles when it really mattered. Perhaps the political costs at the time were too high, or market participants expected government intervention to stabilise chaotic market conditions, but do not be surprised if the eventual economic costs are going to be much higher!

John Kay, columnist for the Financial Times, wrote the following thought provoking piece:

Neither a democratic society nor a market economy can accept the notion that a private business is “too big to fail”. Liberal democracies of the modern world based on lightly regulated capitalism acknowledge two mechanisms of accountability – the marketplace and the ballot box. In the marketplace, organisations that do not meet, or respond to, the needs of society are ground between the twin pressures of their customers and their investors. At the ballot box, politicians that do not meet, or respond to, the needs of society suffer popular rejection.

Commercial success and democratic election are the only sources of legitimate authority in a society that no longer relies on spiritual leadership nor respects hereditary titles. An organisation exempt from either of these disciplines represents an unaccountable concentration of power.

If “too big to fail” is incompatible with democracy, it also destroys the dynamism that is the central achievement of the market economy. In principle, there is no reason why disruptive innovations and radically new business models should not come from large, established, dominant companies. In practice, the bureaucratic culture of these organisations is such that this rarely happens. Revolutions in business generally come from new entrants. That is why so many of today’s market leaders – Microsoft, Google, Vodafone and Easyjet – are companies that did not exist a generation ago. These companies could not have succeeded if governments had been committed to the continued leadership of IBM and AOL, AT&T and British Airways.

Any form of selective government support distorts competition. To win such subsidy today, the companies concerned must, like General Motors and Citigroup, be both large and unsuccessful. It is difficult to imagine a policy more damaging to innovation and progress.

The assertion that in future we will supervise the activities of large banks so that their businesses do not fail represents a refusal to address the issue. Even if that assertion were credible – and it is not – the outcome would not deal with either the political problem or the economic problem. Such regulation fails to call managers effectively to account, while supervision that ruled out even the possibility of organisational failure would kill all enterprise.

“Too big to fail” – whether the claimant is a bank or an auto company – is not a status we can live with. It is both better politics and better economics to deal with the problem by facilitating failure than by subsidising it.