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Michael Burt
Associate Director
Industrial Outlook, Trade & Investment |
There is certainly one business activity that has been spurred as a result of the global financial crisis and resultant decline in economic activity; looking to governments for help. As the queue is now extending past financial institutions to include industrial firms and others, one can’t help but notice the girth of the firms in line. No mom and pop retail stores or manufacturing firms with only 10 employees here. Only those who are “Too Big to Fail” need apply.
Business failures are a part of everyday life; in fact they are the norm. According to Statistics Canada data only about one in five businesses last ten years, with tens of thousands of businesses being born and dying every year. During times of economic weakness, death rates increase and birth rates slowdown and the end result is a net decline in job creation and business activity. This is the process that we refer to as “creative destruction”, whereby labour and capital are continually being reapplied to new ideas in the never-ending quest to provide goods and services with increasing productivity and at a lower price.
So what makes the firms that are seeking assistance so special? The common mantra is that they are too big to fail, but what exactly does that mean? The two most likely answers are the number of people they employ and their market share in their line of business, or some combination of the two. If you employ a million people, or are the dominant provider of a particular product it is much easier to get the attention of policymakers. The first argument is the one that automakers are currently employing, while the second is the key reason why Fannie Mae, Freddie Mac and AIG are all now essentially owned by the U.S. government.
These arguments are debatable, since a firm that declares bankruptcy does not necessarily disappear, and demand for their products definitely does not. In general, consumers of those products will simply choose a different vendor. However, if we accept that it is possible for a firm to be too big to fail under certain circumstances, is it desirable for these firms to exist? The short answer is no. Under the current system, large organizations are free to take risks and reap any rewards, while passing on the risk of business-ending activities to taxpayers. This mismatch between risk and reward encourages organizations to take unnecessary risks and may lead to poor business decisions.
Better regulation is the key to resolving this market failure. One possible means to prevent firms from becoming too big to fail is through anti-trust laws. As firms become dominant in their market, they often become subject to anti-trust scrutiny. However, the focus on anti-trust rules at present is the protection of competition in general and consumers in particular. There is no consideration as to what implications the larger firm would have for the economy. As such, this would require countries to consider additional criteria when undertaking anti-trust studies.
While a new focus for anti-trust laws would help to prevent the creation of new firms that are too big to fail through mergers and acquisitions, it would not address firms that are already too big or grow to become too big organically. As such, other regulatory measures would likely need to be established once an organization reached certain triggers. In this event, if limiting the size or market share of a firm is not desirable or possible, than restrictions on the risks that it is able to undertake must be put into place. This is why we have capital requirements for banks.
While in general it is optimal to keep regulatory intrusion to a minimum, it is also important to note that the costs of failure of large institutions can be catastrophic. Smaller countries are particularly vulnerable given their inability to cover the liabilities of their large businesses. As in the case of Iceland, national bankruptcy can be the result. As such, if businesses are truly “too big to fail”, then the state has a responsibility to essentially take out an insurance policy against catastrophic failure through increased regulatory oversight.