I have a short article in this week’s House Magazine (which is not online, sadly) on the Green Investment Bank, arguing that the Bank will fail precisely because it cannot fail. Government support for a firm virtually guarantees that the firm will become a wasteful, inefficient and fail to do what it is supposed to. As a friend emailed:
The idea of un-failable banks reflects idea of un-testable theories. Both are very unlikely to do what they're supposed to do.
This is quite right. I’d go further to say this applies to all market actors. When there is risk-taking in the market, individual failure is the key to overall success.
Economic activity can be thought of as a discovery process: each firm is trying to find out what customers want and how to supply it in the cheapest way possible, to make the most profit for itself. Profit comes when a firm finds a market imperfection and corrects it. Here’s an example. Suppose people in Lambeth are buying watermelons for £5, and you find someone in Battersea selling them for £2 and can transport them over for £1. You have a chance to make a profit by selling them for (say) £4.95. An information asymmetry has been resolved thanks to your self-interest as an entrepreneur. Get it wrong – say, the transport costs are higher than you expect – and you fail.
The strength of capitalism is that it allows these information asymmetries to be resolved by rewarding success and punishing failure through the profit and loss mechanisms. There’s an incentive to try something out (profit) and an incentive to be careful (loss). By weeding out the sustained loss-makers, it emulates natural selection in its tendency towards firms and actors that are suited to the environment in which they live. We live in a confused, chaotic and complex world where information is dispersed. The environment – resources available, consumer tastes, etc – and the information describing that environment is constantly changing. Because of this, markets rarely reach equilibrium, but they tend towards it if allowed to work properly.
So, how do we allow them to work properly? By allowing the feedback mechanisms to transmit information. I see entrepreneurs less as enlightened geniuses (though, of course, some are) and more as risk-takers: they try something new out and, if it works, they flourish. If it fails, they die. This system of natural selection has proved to be considerably better than state planning, the “intelligent design” theory of economics. It's a shame that, with his Green Investment Bank, Vince Cable is rejecting Darwin and Hayek once again and practicing faith-based economics instead.
