Ev Ehrlich's Everyday Economics

16Jan/12Off

Romney and “Creative Destruction”

Life is the process of finding out about yourself -- as the Buddhist at the cash register said, “I spend my life managing change.” But this week’s new spurt of self-awareness, for me, was shocking and abrupt. Because this week, I found out that I was more committed to the free market system than Newt Gingrich or Rick Perry.

The dust-up over Romney’s career at Bain Capital is now on the record, and it cannot help but leave you with the impression that Gingrich
is an unprincipled opportunist, Perry a sad, empty suit, and Romney one hell of a leveraged buy-out guy. Back to Romney in a moment. More fascinating is the willingness of the first two to say something so witheringly stupid that it risks defining them for the rest of their careers.

Can life really be so sweet, so rich in texture and paradox, that Gingrich actually said: “Is capitalism really about the ability of a handful of rich people to manipulate the lives of thousands of other people and walk off with the money?" The mind reels. Newt, is Christmas really about Santa coming down the chimney and leaving presents for all the good boys and girls? Is an apple pie really about a flaky crust filled with apples, cinnamon, and sugar? It’s only out of respect for you, my reader, that I don’t take twenty of these free shots – I invite you to post your own below.

That’s the very point of capitalism. The world has resources and the resources have to be organized so we can have material (and hopefully psychological and spiritual) comfort. The capitalist system “solves” this problem by defining resources as “capital,” meaning someone is allowed to “own” those resources and decide what to do with them – you can’t define “capitalism” without “ownership” any more than you can define "orthodontist” without “teeth.” The system is designed to let a handful of people make decisions that affect thousands – millions! – of peoples’ lives and then walk off the with the reward. It’s not necessarily a proto-fascists plot, or a scene out of Metropolis – with the right tools of social development (education, respect for human rights, awareness of sustainability, competent regulation), the system can work pretty well, even if it has moments when it seems as scary as Newt described it.. But yes, Newt, that’s capitalism in a nutshell, although the part about “walking off with the money” at the end of the day isn’t guaranteed. That’s what makes it a horse race.

As for Perry, I get the feeling that he was happy to move off of topics he felt uncomfortable discussing – which agencies get closed down, his state’s record on health insurance, his support for criminalizing homosexual conduct, his relatively pragmatic approach to immigration – and move on to a topic he understood – birds in trees. Thus, he described Bain and private equity guys in general thusly: “They're vultures that are sitting out there on the tree limb, waiting for a company to get sick. And then they swoop in, they eat the carcass, they leave with that and they leave the skeleton.”

Let me swoop down from my perch and feast on the carcass of the remark. Let’s start here: what the hell are these guys talking about? The fact that work the work of many private equity firms is sometimes unappealing – administering pain and suffering – doesn’t mean that it’s not socially useful. Otherwise, we wouldn’t have morticians and sewer workers. Sometimes private equity firms build great companies, much as Bain did Staples, and sometimes they put a company up on blocks and strip it for parts, as is deplored in new Gingrich campaign ads. Sure, it’s unattractive close-up, but so are maggots reducing a cadaver to something useful in nature.

When a buy-out firm, or private equity firm, comes in and strips down a company, it’s because the company has by and large failed. There are two reasons why companies fail, broadly writ. The first is that they don’t change quickly enough, wither for lack of wit, faintness of heart, or sclerosis of culture. Look at Kodak, now filing for bankruptcy. http://www.politico.com/blogs/burns-haberman/2012/01/perry-mitts-company-just-vultures-who-eat-the-carcass-110316.html Kodak played a central role in inventing digital technology, and now digital technology has now ripped out Kodak’s beating heart and shown it to them. And the delightful paradox is that, in order to raise enough money to allow the company
to continue in some form, Kodak will sell its patents, the more valuable of which probably relate to digital photography. They simply hadn’t the wit, or heart, or culture, or presence to conclude that somebody was going to compete successfully with their dry-photography business, so it might as well be them. Contrast that to, say, Amazon, which invited tis competitors on to its own site, allowing them to offer comparable, used
merchandise, as opposed to letting a rival emerge that did the same thing. Change or die. The private equity guys are usually doing what the old management didn’t or couldn’t do, but should have done, before it was too late.

The second (and often related) reason why companies go broke is that they run out of other peoples’ money. Companies don’t go broke when they run out of money – they go broke when other people stop lending to them (much as it turns out for countries like Greece, too). There are probably lenders who think “I’d lend to Blobbo Corp if they got rid of a few plants and product lines and cut 10,000 superfluous workers” and so on and so forth, but making that kind of a plan stick is not the bank’s job – the bank wants to lend money and move on, and if it can’t trust the management team in place to do the right stuff, then it’s not worth the bank’s while. That’s another role for private equity guys – to provide capital for companies that might justify having that capital placed in them if they made radical and dramatic changes, but are incapable of making them. They provide both the capital and the change necessary to make the capital worth providing.

It’s unsurprising that Gingrich and Perry would resort to their depictions of private equity -- as a “values problem” or a flock of “vultures” – as both are more interested in the fabulist version of capitalism than the real workings of the beast. In contrast, Romney obviously knows those
real workings well – Bain was spectacularly successful during his run with it. In fact, Romney has associated that success with Joseph Schumpeter’s theory of “creative destruction,” not for the first time, which brings us to Schumpeter and the pressing issue of “how the
economy works.”

When I was in graduate school, someone quoted Schumpeter to me as having said, “Only two economists have even understood capitalism – me and Marx, and Marx was wrong.” Alas, the Internet makes that quote appear apocryphal. Like Marx, Schumpeter saw capitalism as dangerously unstable, but unlike Marx, who saw a capitalism crashing in an overproduction, Schumpeter saw innovation so pervasive and dramatic that it would create ongoing “gales of creative destruction,” ceaseless innovation and improvement so dramatic that it would be inherently unstable. (Although Marx thought the proletariat would provide the coup de grace, while Schumpeter, like Velblen, thought the revolutionary class was
the engineer/technocrat/intelligentsia.)

But political dynamics were neither Marx nor Schumpeter’s strength. Schumpeter’s broader realization, one that I credit Romney with understanding, is that change and growth are inseparable – that the economy cannot grow unless it changes, giving up old things to do and ways of doing them and replacing them with new and better products and processes.

When I was busy Undersecretarying back in the day, my Chief Economist, Lew Alexander, and I went out to the Census Bureau and discovered an
amazing thing – the Longitudinal Research Database. The Census people took about 50,000 manufacturing plants and tracked them (using the surveys they regularly produced pertaining to employment, output, investment, and the like) over time. In contrast to the statistical “snapshots”
of the economy the statistical system produces, it was the first movie of the economy, and it revealed amazing insights into how the economy worked. One good early summary of that work can be found here.

For example:

  • Even in years in which total employment doesn’t change, it’s reasonable to expect one in five jobs to disappear, and one in five to be created somewhere else;
  • About two-thirds of productivity improvement come from more productive plants and businesses displacing less productive ones – not from “everyone getting better;’
  • Similarly, two-thirds of jobs are lost at places that cut back production by 25 percent or more (or shut down), while two-thirds of jobs are created at start-ups or at places that grow by 25 percent or more.

That’s real “creative destruction” and I think it’s related to the point that Romney (I hope) wants to make – that Bain was involved in that change-and-growth dynamic – it’s “how the economy works.” The problem is not that Romney is wrong, but that understanding that doesn’t tell us what
to do about it.

Knowing that growth and change are inseparable doesn’t mean that managing the economy is simply a matter of letting it rip – it’s not a reason to revert to laissez-faire. On the one hand, it argues for free trade and reducing regulations that limit consumer choice. But it also points out how important a social safety net is, or the importance of designing social protections in a way that doesn’t make the firm the delivery system – health care, for example. And it argues for neutral approaches to such urgent problems as climate change, using broad price signals to change behavior as opposed to a laundry list of directives to firms.

Which takes me back to Romney. I have no doubt that he was a remarkably talented and successful businessperson, and that the way he thinks about business is nuanced and expert. I have no doubt that private equity companies play a positive role in the change-and-growth dynamic that makes the economy work; if they’re stripping a company, it’s usually because the company’s prior management put it on the blocks to be stripped.

But being able to answer those questions doesn’t give you an answer to the question of where to lead the country – how to engineer a fiscal retreat, how to deliver health care, how to redesign the tax system. Those are different matters. And they’re subjects about which free market
types like Mitt and me – even if not Gingrich and Perry – can and will differ.

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