Posted by
Andrews on Saturday, January 31, 2009 2:06:13 PM
I mentioned before that I had run across my old copy of Hazlitt's
The Inflation Crisis and How to Solve it, Second Edition. I was reading through it today when I ran across something that may be of interest to modern readers.
One thing we always hear as a measure of how bad the economy is doing is the rising number of bankruptcies. However, has anyone ever questioned that number? After all, if rising bankruptcies are bad, doesn't that suggest that the current rate of bankruptcies is optimal? Or do we think that every bankruptcy is bad, so ideally we would have none? Neither is anywhere close to an established fact.
Bankruptcies serve mainly as a means to close down inefficient businesses and allow their assets to be picked up by other, hopefully more efficient, enterprises. To have a zero rate of bankruptcies, you would have to have an absolutely efficient economy, one where existing resources could not possibly be reassigned to more efficient use. So long as the economy is not completely optimal, there will be bankruptcies. The ideal rate of bankruptcies is greater than zero for any imperfect economy.
So, is our current rate of bankruptcies optimal? Is any increase a sign of a weakening economy? That is where Hazlitt comes in, with his description of the German inflation of the early twenties. You see, when the inflation occurred, one of the signs was a decline in the number of bankruptcies:
Inefficient and unproductive firms were no longer eliminated. In 1913 there had been, on the average, 815 bankruptcies a month. They had decreased to 13 in August 1923, to 9 in September, to 15 in October, and to 8 in November. The acelerative depreciation of the paper mark kept wiping out everybody's real debts. (p. 63)
Granted, we have not yet hit the heights of inflation the Germans experienced, but the same could be true of our economy. Between the explicit inflation of the Clinton and Bush administrations and the housing boom, it is likely we too have seen an artificial decline in the number of bankruptcies, and so a rise may be a positive, rather than negative, sign.
Some may ask how the housing boom plays into this. The explanation is simple. Let us suppose a firm bought a factory for $1 million in 1995. Then the housing boom hit. That $1 million dollar factory is now worth (if it is in the DC area), maybe $3 million by 2005. So, if the company runs up $1 million in debts, they could take a $2 million loan against the factory, still have $1 million in equity, and pay off the debts with the paper gain in value. What's more, they have an additional $1 million for expansion. Thanks to the inflationary rise in housing prices (mostly prompted by the monetary inflation and artificially low interest rates, though also helped along by CRA and other bad ideas), they have a $2 million "profit" due to an artificial increase in effective demand, fueled by inflationary pressures. True, real appreciation could have allowed them to do the same, but a 200% gain in 10 years? Only massive inflation can do that. And during an inflationary cycle, such paper gains can easily allow firms to stay in business when they would have gone bust in a more stable economy.
So, when we see people bemoaning rising bankruptcies, it may be a good idea to point out the beneficial purpose bankruptcies serve, and ask whether or not the rise in their number may not be a change in the right, rather than wrong, direction.