Monday, September 15, 2008

Creative Destruction

It has been one of the most dramatic weekends in finance that I can remember. The failure of Lehman Brothers and the shotgun marriage of Merill Lynch with Bank of America are seismic shifts in the world of money.

The fall of the House of Lehman ends a 158 year business overnight. Nearly 27,000 people- including several friends of mine- have lost their jobs. The merger of Merill could lead to even larger job cuts as the workforce of some 60,000 is slimmed down. It is hard not to feel sad when venerable institutions disappear.

Yet such is the nature of capitalism. I well remember at the time of the fall of Barings, walking past their offices- lights ablaze as the executives of the bank struggled with the developing crisis. In the end the losses of Barings- about £600 million look pretty minor compared with the scale of losses in the financial markets today. In those days my own office window overlooked the building that was being fitted out as new offices for Barings, and a poster was put up saying "Wanted: £600 million, can YOU help?" A certain gallows humour emerged across the City as it became clear what had actually taken place.

In the end, Barings fell to the control of ING and it continues as a business even today. In fact, the message of the fall of Barings is that markets, while they are intolerant of failure, are also quite resilient. The failure of the Lehman business model will ultimately free up people and capital for the market to apply in better ways. It also provides a warning that "moral hazard" continues to exist in the global market place- that neither the Fed nor the US Treasury can save market practitioners from themselves.

The next few hours, days and weeks will see a financial environment that is likely to be much changed in the light of the events of this weekend. However as it becomes clear that the business models of many financial houses were highly flawed, it also gives the chance for renewal. Businesses will change and adapt to new conditions and ultimately the adjustment should lead to greater efficiency based on a clearer understanding of risk.

The creative destruction of the free market will lead to renewal and change- as it is supposed to do. As I contemplate the loss of employment of so many talented people, and remember when I- at the merger of UBS and Warburgs- found myself in a somewhat similar position I begin to think that there is scope for cautious optimism, even after the titanic changes of the past few hours.


Matt said...

I'm not an economist, but I think the fall of Lehman has less to do with Schumpeter's concept of creative destruction than a pitfall of capitalism - greed. The same thing has occurred many times over the last century: over-investment leads to instability when opportunity and greed reinforce themselves and industry over-reaches. Creative destruction is more like the iPod and iTunes taking over/reinventing the mp3 and digital music market.

Cicero said...

Well, yes you are right, "greed" is a part of the capitalist system, as is "fear". Indeed you could argue that- like the "selfishness" of genes- "greed" or at the least the desire for the highest return is one of the motive forces of the system, though I am slightly nervous about imputing a negative moral atribute to this particular force by naming it like that.

The problem, and in my view the root of the instability of the system is not so much the "greed" as the failure to understand the nature of risk that you are taking to get your desired return.

Nassim Nicholas Taleb is one of those who have begun to explain our "epistemological arrogance" about risk. The most successful investors are never the out and out Bulls, but those who understand the nature of the risks that they are running, and by definition they are the most self critical.

Tom Papworth said...

You are right, of course, but you have missed the ghost in the machine.

There is no moral hazard when Government steps in to bail out investors to the tune of $700bn. And the market does not shake out failure because it is underwritten by the taxpayer.

While some creative destruction will take place, and some resources will be reallocated more efficiently, the sad fact is that Government will undermine that process and make it imperfect at the cost of unbelievable quantities of taxpayers' money.

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