Why Markets Fail, by Michael Perelman: Markets fail for many reasons. With all the attention to the current financial crisis, the time has come to look at another part of market failure -- the reluctance to invest in long-lived plant and equipment. I'm not merely thinking about the deindustrialization of the US economy, but a more general reluctance. The commitment of funds for fixed capital entails taking a risk. In the words of John Hicks, one of the earliest economists to win a so-called Nobel Prize, pointed to the obvious problem: "an entrepreneur by investing in fixed capital gives hostages to the future" (Hicks 1932, p. 183). Unfortunately, neither Hicks nor virtually any other economist has explored this fear of investment.
The most popular response to this reluctance to invest came from a very conservative Austrian economist, who once served as a socialist minister of finance, before landing at Harvard. Joseph Schumpeter was indeed one of the giants of 20th century economics. Here his reputation to his personal brilliance, as well as a willingness to learn from Karl Marx.
Schumpeter was no Marxist. In fact, he boasted that he was going to turn Marx on his head, just as Marx had done to the German philosopher Hegel. During the dot.com era, Schumpeter may have been the most commonly mentioned economist, not among the living. What won the affection of those who saw the Internet as completely revising the nature of capitalism was a single phrase coined by Schumpeter -- creative destruction.
The idea was that when the economy became sluggish, new innovations would be so profitable that investors would rush in and build up whole new industries. In doing so, they would destroy existing industry, but the net effect was to enliven enliven the entire economy. For Schumpeter, this creative destruction was the lifeblood of capitalism.
Schumpeter liked to use transportation as a dramatic example of creative destruction. In the 19th century, an important German economist, Johann Heinrich von Thuenen loaded a standard wagon with a standard load of grain, hitched up 2 horses, and had 2 farm workers drive the wagon as far as they could go, feeding themselves and the horses on the grain. Theoretically, the wagon could go about 230 miles on a road running through a flat plain before the humans and animals consumed all the grain, which was their only source of energy. In practice, the limit was 20 miles.
Canals slashed the cost of transportation, while setting off an economic boom. Railroads followed with another revolution in transportation, setting off another boom. Finally, the internal combustion engine allowed trucks to haul freight with even more savings, creating still another boom.
But wait! Where are the entrepreneurs? Government, not entrepreneurs, provided the wherewithal for these transportation revolutions. Governments built the canals. Governments finance the railroads with land grants and other subsidies. Governments built the highways that made possible freight hauling by trucks. Schumpeter could not have chosen a more perfect example. Entrepreneurs have good reason not to make such investments. Industries that depend on capital-intensive plant and equipment have difficulty withstanding strong competition, which forces prices down near the cost of production. But, as any introductory economics text explains, previous investments are not part of the cost of production. Unless prices are far in excess of the cost of production, businesses with long-lived capital will be unable to recoup the cost of its investment.
Just as Microsoft would not recover its cost of developing its software code if it sold its software for little more than it costs to embed it on a CD, railroads fold under intensive competition. Indeed, during the 19th century, railroads went bankrupt with some regularity, much like the airlines today. But investment creates jobs that create the demand they keep the rest of the economy going. Spurts of sound investment occur after wars or depressions wipe out large swaths of capital. The period following World War II, known as the Golden Age, was a perfect example. Business can hope to pull in huge profits before the market becomes saturated.
The dot.com boom seemed to be a counter example, but in fact the physical investment for much of that period relatively small. Once the boom was underway, then irrational euphoria brought unprofitable investment online, which ultimately could not be supported.
This reluctance to invest extends to replacement of capital goods. The steel industry near where I grew up was working with factories that were built before World War I. The Great Depression forced more competitive industries to modernize, but, once the crisis passed, they too left their productive capacity age. No wonder deindustrialization swept across the United States, beginning in the 1970s.
Eventually, Schumpeter proposed that capitalism had reached a new stage, where only to large corporations could muster the resources required to develop the new technology, which could drive creative destruction. Yet, Schumpeter's earlier concept of the entrepreneur still has some relevance. New ideas often need new people, outside of the higher echelon of the corporate sector.
For example, Chester Carlsson started Xerox after Kodak rejected his new idea to produce a copy machine, telling him that his copy machine would not earn very much money, and in any case, Kodak was in a different line of business. Steve Wozniak could not interest Hewlett Packard in his idea for a personal computer. Even more ironically, researchers at Xerox developed revolutionary new computer technology, including a graphical interface and a mouse. Yet, the company never showed much interest in the technology. Instead, Stephen Jobs copied the technology for Apple Computer.
In short, the evidence that markets are sufficient to generate investment is lacking -- at least until the business cycle reaches the stage of euphoria. At that point, much of the investment will be irrational.
As business stagnates and profits fall, money will seek higher profits and finance, which will become riskier and riskier. Eventually, the house of cards falls, irrational and outdated investment becomes scrapped, and one of two things will happen. After a painful depression, bankruptcies will wipe out a good deal of debt. New investment opportunities present themselves. Eventually, the economy will be reinvigorated for a while until the cycle begins again. Alternatively, the dislocation of the depression to a different way of organizing production.