At best, bankruptcy has been ex post facto add-on to capitalist theory. And before I get much further, there is more to bankruptcy as in advantages and disadvantages than the economic impact. My scope here is quite specific. There have been some who have taken to arguing that the bankruptcy of Freddie Mac and Fannie Mae would have been good thing and the bankruptcy of Lehman Brothers was a good thing. In the long run the economy, we are told, will be better off for having these things happen.
What people will claim is good is the reallocation of capital based on profits and losses. All things being equal this is correct. In other words, in the normal course of business, that companies decline in size and rise in size based on the potential for profit is not a bad thing. However when we have a situation where a party and a counter party reaches an agreement and one party does not perform, we have an issue. When someone enters into a contract with the intent not to perform, we call this fraud. In other instances, we simply say the contract defaulted. If I were to claim that more fraud would make our economy healthier in the long run, you would think I was being silly. Likewise claiming that more defaults helps our economy in the long run is silly. In short, we have a variation of the broken window fallacy.
Now some will claim that these bankruptcies will make companies more risk averse. These companies therefore won’t make risky loans to ‘sub-prime’ borrowers. (Sub-prime has been used incorrectly used as a synonym for poor people by many analysts. One sub-prime CEO defined his market as those making under $100,000 per year and having assets under $100,000.) And this is indeed correct. That it is better is an unproven assumption. Why not evaluate at another part of the complex chain? If Aunt Matilda dumps her money market account that had invested in Fannie insured MBS and instead hides the money in her basement, has she helped the economy? If she sells her investment bank stocks and instead places the money in her mattress, has she helped the economy? No. That she can give her money to the neighborhood bank and be secure knowing that she will x% for having done so is good for her and the economy. That Joe Business Owner can borrow that cash from the bank for y% to cover costs on a job until he is paid helps Joe Business Owner. This is true as the examples become more complex until we reach the level of complexity we are at today. What allows these transactions to take place is the relative security of all parties that if a default occurs, the defaults will stop there. If Joe Business Owner doesn’t repay his loan to the bank, the bank doesn’t take money from Aunt Matilda. In the larger scheme, what has gone wrong is that the assumption that party A’s default of party B would not cause party B to default of party C has proved false. (Well actually there are about a half dozen more parties there, but you get the idea.) This is a failure of regulation. And implications for the economy are not good but actually quite dire.
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