Modern capitalists take as gospel truth that capital losses serve as a signal to exit a market. Ideas or businesses that fail to compete in the market are abandoned in favor of those that can compete. In this way, not only is capital preserved, but also capitalism.
This line of thinking is so familiar to market economics that it is easy to forget that it, like any idea, has to first be imagined, and then communicated, implemented, tested, and diligently supported in order to survive the test of time.
The capitalist belief in the necessity of losses is then especially interesting to consider in the context of the most egregious violations of this cornerstone tenet: the modern taxpayer-funded banking system bailout.
Banking system bailouts represent a gigantic socialization of losses and include massive rescues, such as Turkey’s in 2000–2001 (which is estimated to have cost around 62% of its GDP) or the United States’ in 2008–2009 (estimated at around 11.5% of its GDP).
It all boils down to this central question: Can capitalism survive without the important signal of losses? Or, put another way, can capitalism survive if governments continue to bailout their banking systems? Before answering this question let’s first examine some economics history that demonstrates that capitalists throughout time have valued losses as a signal of risk.
Written nearly 300 years ago in 1730 and considered the seed that flowered into Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Richard Cantillon’s Essay on the Nature of Trade in General captured the essence of capitalism and markets:
Entrepreneurs can never know how great will be the demand in their City, nor how long their customers will buy of them since their rivals will try all sorts of means to attract customers from them. All this causes so much uncertainty among these Entrepreneurs that every day one sees some of them become bankrupt.
It is important to note that Cantillon invented the term “entrepreneur,” which, in French, means “undertaker.” Thus, when Cantillon used the term entrepreneur he did not mean our more modern understanding of the word. He simply meant someone who risks capital loss in search of capital returns.
Cantillon is clearly describing that capitalists operate in an environment of uncertainty and competition that may lead them to become bankrupt.
What encourages and maintains these Entrepreneurs in a State is that the Consumers who are their Customers prefer paying a little more to get what they want . . .
Here it is clear that Cantillon understands that profits are the reward for risk taking.
All these Entrepreneurs become consumers and customers, one in regard to the other, the Draper of the Wine Merchant and vice versa. They proportion themselves in a State to the Customers or the number of people who buy hats there, some who are least patronized must become bankrupt: if they be too few it will be a profitable Undertaking which will encourage new Hatters to open shops there and so it is that the Entrepreneurs of all kinds adjust themselves to risks in a state.
Cantillon seems to imply, in the text above, that the loss of capital leads to the exit of a market participant who has made a poor decision. (Ironically, an alternate definition for undertaker in English is “one whose business is to prepare the dead for burial and to arrange and manage funerals.” Entrepreneur, therefore, literally means one who looks after that which has died — profits or otherwise.)
It is interesting that Cantillon titled his masterwork Essay on the Nature of Trade in General [emphasis mine]. He seems to take the precepts of trade as being self-evident and as a part of the universal order — something to be described, not argued.
Indeed, Cantillon was describing market phenomena well before the modern profession of economics had even been imagined. That is, the markets he is writing about were operating in the way they were without the potential influence of an exogenous philosophy. Yet, despite this, the markets of Cantillon’s time were behaving in a way that any modern, dyed-in-the-wool capitalist would recognize.
So from the very beginnings of formal writings on capitalism, the importance of profits — or, if you will, unprofits/losses — is present.
Yet Cantillon is not alone in expressing a need for market participants to experience losses in order to facilitate the efficient allocation of capital. In fact we can go even further back than 1730.
Guân Zhòng (720–645 BCE), a politician and advisor to Duke Huan of Qi, wrote about “balancing the light and heavy” in his book Guanzi. Balancing the light and heavy meant that when a good was abundant its price became “light,” and its price would fall. Furthermore, when the good was “locked away,” it became “heavy,” and its price would rise. Goods were expected to move in or out of markets based on their lightness or heaviness. In other words, if prices fall then goods should exit the market.
Regarding capitalists — a term invented more than 2,000 years later, Guân Zhòng said: “Indeed, it is the nature of men that whenever they see profit, they cannot help chasing after it, and whenever they see harm, they cannot help running away.” Zhòng clearly understood that when there are economic losses market participants should exit the harmful economic activity.
Indeed the list of economic thinkers that wrote about the importance of losses to the proper functioning of markets is a long one, an ancient one, is cross-cultural, and includes such luminary thinkers as: Chanakya (370–283 BCE) in Arthashastra; Ibn Khaldūn (1332–1406 CE) in Muqaddimah; Adam Smith (1723–1790 CE) in An Inquiry into the Nature and Causes of the Wealth of Nations; and Joseph Schumpeter (1883–1950 CE) in Capitalism, Socialism and Democracy.
So the idea that losses are important for preserving the integrity of markets is an ancient one; though, unfortunately, not one that is perennially appreciated. Standing in stark contrast to the importance of losses in capitalism are the consistent and ever more gigantic bailouts of banking systems worldwide.
Thus, in part two, the history of the modern bank bailout will be contrasted with the bedrock capitalist tenet of the importance of losses.
Dr. Ralph T. Byrns, Department of Economics, University of North Carolina contributed to this piece.