Creative destruction takes place when inefficient producers are outcompeted by other firms, especially those brandishing new technologies. The concept, originally developed by Joseph Schumpeter in the 1940s, came to be accepted as a hallmark of market dynamics and capitalism. Successful market entrants rise to compete and eventually cripple incumbent producers who’ve grown stale in their offerings, inputs, or methods.

Creative destruction encourages long-term economic growth in several ways. First, it allows unproductive firms to fail, freeing resources to be absorbed by firms having solid growth opportunities. Second, creative destruction enables the diffusion of new technologies. Third, it motivates incumbents to improve their game, adapting to new realities in the marketplace. This is a continuous process. There are always firms that fail to keep pace with their competitors, whether old-line producers or failing risk-takers, but this is especially the case during periods of economic weakness.

Harmful Policy Menu

Attempting to prevent creative destruction via public policy is counter-productive, anti-competitive, and it impedes economic growth. Yet we constantly expend well-meaning energies to short circuit the process by attempting to promote uneconomic technologies, shield established firms from competition, and resuscitate dying firms. These efforts include industrial policies, barriers to foreign trade, excessive regulation of new technologies, selective taxation, certain bankruptcy reorganizations, and outright bailouts.

Creative destruction is a sign of flourishing competition, but it is subverted by industrial policies that subsidize politically-favored firms that otherwise would be uncompetitive. These policies create artificial advantages that waste public resources on what are often just bad ideas (see here and here).

Likewise, protectionism breeds weakness while shielding domestic producers from competition. And selective taxes, such as those on online sales, create an uneven playing field, blunting competitive forces.

Policies that encourage the survival of “zombie firms” also thwart creative destruction. These are companies with chronic losses that manage to hang on, sometimes for many years, with refinanced debt. Companies and their lenders can expend a great deal of internal effort forestalling bankruptcy. However, it’s not uncommon for zombie firms to languish for years but ultimately fail even after bankruptcy reorganizations, especially when the sole focus is on financial restructuring rather than business operations.

Government sometimes steps in to prolong the survival of struggling firms via subsidies, loan guarantees, and protracted efforts to keep interest rates low. Bailouts of various kinds have become all too common. Bailout activity creates perverse incentives with respect to risk. It also wastes resources by propping up inefficient operators, trapping resources in uses that return less to society than their opportunity costs.

Macro Maleficence

Ben Landau-Taylor makes a provocative but sensible claim in an article entitled “Industrial Greatness Requires Economic Depressions”. It’s about an unfortunate side effect of government policies intended to stabilize the economy: business failures occur with greater frequency during economic contractions, and that’s when policymakers are most apt to render aid via expansionary fiscal and monetary actions. No one likes economic downturns and unemployment, so “stimulative” policy is easy to sell politically, despite its all-too-typical failures in terms of timing and efficacy (see here and here). One intent is to support firms whose travails are revealed by a weak economy, including those relying on obsolete technologies. It might buy them survival time, but on the public dime. Ultimately, by forestalling creative destruction, these policies undermine economic growth.

Landau-Taylor emphasizes that creative destruction is not costless. Business failures and job losses are painful. And creative destruction brought on by dramatic advances can actually cause recessions or even depressions. Is that a rationale for delaying the inevitable failure of weak incumbents and impeding the broad adoption of new technologies? Our long-term well-being might dictate that we allow such transitions to take place by shunting aside interventionist temptations.

As a rationale for intervention, it’s sometimes said that we can’t regain the output lost during contractions. An appropriate riposte is that government efforts to counter recessionary forces are almost always futile. Furthermore, the lost output might be a pittance relative to the growth and permanent gains made possible by allowing creative destruction to run its course, liberating resources for better opportunities and growth.

On this point, Landau-Taylor says:

“If we want our descendants in 2125 to surpass our living standards the way we surpass our ancestors from 1925, then we will have to permit economic transformations at the scale that our ancestors did, including bankruptcies, job losses, and the cascading depressions that result. The individual pain of depressions does not have to be quite so severe as it once was. Because we are richer, we can and do spend vastly more on welfare, but this should be directed at individuals rather than at megacorporations. But there will always be some pain.“

Conclusion

Too often public policy creates obstacles to natural and healthy market processes, including creative destruction. This prevents the economy from reaching its true growth potential. Subsidies, bailouts, protectionism, and arguably macroeconomic stimulus, too often give safe harbor to struggling producers who manage to retain control over resources having more valued uses, including firms relying on obsolete and impractical technologies. Recessions typically expose firms with the weakest market prospects, but countercyclical fiscal and monetary policy may give them cover, forestalling their inevitable decline. Thus, we risk throwing good resources after bad, foregoing opportunities for growth and a more prosperous future.