The Necessity of ‘Creative Destruction’

Not many years ago, it was fashionable in U.S. political circles to rail against the so-called bond vigilantes--the shadowy traders who drove market interest rates up at the slightest hint that the American economy was growing “too fast.”

We haven’t heard much outcry against the vigilantes in a while, mainly because the bond market has been a relatively placid place over the last two years. As it turned out, the bond vigilantes were fairly reasonable people: They could handle faster-than-expected economic growth, so long as inflation was held firmly in check.

And for all of the ire directed at the bond market’s alleged manic paranoia about the economy’s growth rate and inflation in the 1990s, look at what the United States has enjoyed: an economic expansion that now is nearly seven years old and still going strong, with inflation very much under control and the economy amazingly free of excesses.

One wonders what Southeast Asia might look like today if free and open bond markets had been allowed to develop there, providing financing for businesses and also acting as a watchdog over those economies.

Instead, Southeast Asia’s growth in recent years has been financed in large part by commercial banks, many of which, at the local level, take their cue from central governments.

If a Southeast Asian government wanted a particular industry or real estate project financed for the “national good,” it got done--never mind whether it was truly economically feasible.

Therein lies one of the major causes of Asia’s gigantic financial mess today. Believing in their own magic--the Asian economic miracle, as we in the West saw it--governments from Thailand to Indonesia to South Korea blessed a massive debt-financed spending binge within the private sector in recent years.

But when export growth from the region began to slow last year, in part as China’s avalanche of cheaper exports stole global market share, the ugly reality of leverage came home to roost: Suddenly, the return on investment from all of those debt-financed office buildings and industrial plants declined sharply.

Some of the countries began to run financing deficits with the rest of the world. Some foreign investors began to get nervous and pulled money out. National currencies, the movements of which naturally flow with the health of the underlying economies, began to weaken--and then they crashed, taking stock prices and real estate values with them.

If the Austrian economist Joseph Schumpeter were alive today, he would have a short and sweet explanation for Asia’s troubles: not enough “creative destruction.”

Schumpeter’s views on capitalism have long been championed in Forbes magazine, but the economist’s works--including his book “Capitalism, Socialism and Democracy” (1942)--are little-known to the public at large.

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To Schumpeter, the true wonder of capitalism is its “perennial gale of creative destruction,” as successful businesses arise, then are attacked by new, more innovative competitors. The latter eventually replace many of the older businesses that can’t adjust to the free market’s evolving wants and needs. And in time, these usurpers themselves become targets of new competition from businesses and entrepreneurs with better ideas.

All along, the process drives economic expansion and enrichment, albeit with much turbulence.

“Unlike other economic systems, the capitalist system is geared to incessant change,” Schumpeter said.

That is, if the system is allowed to work, unfettered by heavy government interference.

Imagine if the federal government, reacting to public anger over the extent of corporate restructurings and layoffs in the mid-1990s, had tried to legislate against such restructurings. Could the American economy--as efficient and productive as it is acknowledged worldwide to be--have gotten to this point if major companies hadn’t downsized and refocused on the business lines where they could compete most effectively?

Would the American banking system be better off today if the government still set interest rates on bank deposits, as it did until the early 1980s? Would the U.S. consumer inflation picture be as benign as it is today if the bond vigilantes hadn’t exercised market control over long-term interest rates, raising them when the economy appeared to be accelerating at a rate that might ignite inflation or over-investment?

Obviously, free markets aren’t infallible. In the short run, they can overreact. Imbalances still occur, triggering recessions.

Nonetheless, the American economy’s stunning revitalization in the 1990s--which has produced the lowest unemployment rate in a quarter-century--arguably provides the best evidence that free markets are far better allocators of capital (physical and human) than are most governments.

Schumpeter acknowledged that creative destruction exacts a human toll. The continuing wave of layoffs in the 1990s (in recent weeks, add Eastman Kodak, Citicorp and Levi Strauss to the list) unquestionably creates hardship for the individuals and families involved.

But it’s an occupational hazard for the media that news of 10,000 job cuts inevitably makes headlines while thousands of individual hirings across the country each day go unreported.

Schumpeter believed that capitalism’s success was not a function of perfect competition, but simply of innovation and constant change and renewal at the invisible hand of market forces.

One clear implication is that if it wants to remain the world’s premier capitalist nation, America has little choice but to accept perpetual upheaval in business. Forget the idea, then, that restructurings and downsizings will someday cease. By Schumpeter’s definition, such stability is incompatible with successful capitalism and economic growth.

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It would also seem that if Asia’s economy is to be revitalized, governments there must accept the process of creative destruction, and even sanction it--perhaps just by stepping away from policies that encouraged banks in Japan to pretend their bad loans didn’t exist, Korean conglomerates to invest in industries where world capacity was already excessive, and Thai developers to build office towers for tenants who didn’t exist.

As James Flanigan suggests elsewhere in this section, there are signs that Asia already is embracing deregulation and freer markets; as those governments study their alternatives, it’s tough to imagine how they could rationally come to any other decision. But that should also be a warning for American companies, entrepreneurs and investors: Creative destruction elsewhere in the global economy will demand much more of the same at home.

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Tom Petruno can be reached at tom.petruno@latimes.com