As part of an inaugural series of blog posts for American Compass, Rob Atkinson makes the case against the “market fundamentalist” view of capture in government support of industry in a provocatively titled post “Government, Not Markets Can Best Pick Winners.”
The claims made in the post are more modest than the title would suggest, and he raises important points. The “common good” brand of conservatism recognizes the potential for a divergence between the social return to economic activity and the private return, and the need for intervention when the former is significantly higher than the latter:
[T]he divergence between public and private returns from investments in innovation means that it is actually government that can best “pick winners.”Consider two technologies: one that provides business with a rate of return (ROR) of 20 percent and no spillovers to society, for a societal ROR of 20 percent; and another that provides business with a 10 percent return and spillovers that generate a societal ROR of 30 percent. Market forces will target capital to the former and business will undervest in the latter, thereby reducing overall growth.
My work focuses on the role that entrenched interests play in using public policy to enrich themselves at the expense of others, and government picking undeserving winners is a front-of-mind issue for me. But picking undeserving winners is more complicated than direct or indirect tax or regulatory preference to the winners, and Atkinson’s view can be buttressed by the way financial regulation encourages lending to the kind of undeserving firms that a competitive market would have weeded out.
Under our current system of low capital requirements, there is a strong incentive for banks leveraged to the hilt to keep lending to unproductive “zombie” firms. This “rolling over” of debt prevents lenders from realizing losses that they can’t afford to suffer.
Noah Smith made this point quite well last year in the context of low interest rates, which have similar effects to undercapitalization in the context of lending to zombies:
[M]anagers who are able to borrow money easily to sustain their companies might become lazy, choosing to live a “quiet life” instead of using recessions as opportunities to restructure their businesses…
[L]ow rates can make banks more vulnerable to failure by compressing the spreads they earn. Such distressed lenders might be reluctant to acknowledge bad loans, preferring instead to keep unproductive borrowers afloat with still more loans — a process sometimes known as “evergreening.” This has been blamed for the proliferation of zombie companies in both Japan and Europe.
Finally, there’s the possibility that even if low rates don’t create zombies, they could create monopolies. Various economists have theorized that excessively easy credit conditions, by keeping inefficient incumbent companies alive, might make it harder for innovative new companies to break into markets.
A natural experiment created by increasing capital requirements in Portugal found that 20 percent of the nation’s productivity decline in 2012 was attributed to rolling over debt to keep zombie firms afloat. Other research found that undercapitalized banks are tightly linked to zombie firms, and that some measures may be necessary to transition away from this dynamic without leading to solvency issues.
It is undoubtedly true that there exist cases where, even if rolling over the debt of laggards is less profitable than investing in higher-growth firms, the most socially desirable investments won’t attract private capital and the government is needed to make up the gap. But it’s worthwhile to scrutinize the policies that attract investment in “losers” so the market can funnel capital to firms with greater potential.
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