Creative Destruction and the Social Contract

We are rightly proud of the economic achievements capitalism and hard work has brought to the US, but free market capitalism is not a flawless mechanism. I have posted elsewhere about income inequality. Here I want to focus on a flaw in creative destruction.

Creative Destruction is the essential fact about capitalism. - Joseph A. Schumpeter

Creative Destruction quote

 

Here’s the definition from MIT economics.

Creative destruction refers to the incessant product and process innovation mechanism by which new production units replace outdated ones. This restructuring process permeates major aspects of macroeconomic performance, not only long-run growth but also economic fluctuations, structural adjustment and the functioning of factor markets. Over the long run, the process of creative destruction accounts for over 50 per cent of productivity growth.

Below are two significant forces that lead to creative construction.

Technology

Two super-imposed graphs covering 2001-2012. Newspaper ads down sloping; the other Google up sloping. The Total Ad spend nearly steady

Ad revenue shift from newspapers to Google

Technology changes are unavoidable these days and in general lead to greater wealth, although some industries and their employees are hurt by the change. Let’s consider the rise of the internet and one particular area with winners and losers.

The shift from reading news in physical papers which had very fixed schedules to getting information on items of interest from an electronic device, which could also display the latest stories was a technology-driven revolution.

At first both avenues grew. Newspaper ad revenue grew (2001-2006) while the Google ad stream also grew in that time frame. Then, the ad money shifted from newspapers to Google (2007-2012) and probably continuing. The rapidity of the change to online ads is astounding. Newspapers have not died, as evidenced by their $19.5B ads in 2012 along with their online presence drawing an additional $3.4B. From a business perspective, it is imperative to realize that the newspaper cost structure (salaries and fixed expenses) quickly became too large for their diminished ad revenues.

The newer, more flexible, and cheaper-to-the-end-user web-based method is a positive example of creative destruction, although to those in the newspaper business it is a bitter reality.

However the justification of creative destruction is also invoked in cases where it shouldn’t be. Take a look at the definition again.creative destruction comes from product and process innovations.

Financial

Companies can change dramatically under different financial scenarios. In some cases, government programs encourage destruction with harm to the employees of the companies.

Consider this situation. US airlines were under extreme financial pressure earlier in the decade. A number of factors are involved, but a fundamental problem is that older, more established airlines have to fund retirement funds at a level which forces their ticket prices to be uncompetitive. Just look at the large sloughing of United’s pension liability over to the PBGC (Pension Benefit Guarantee Corp), which limits the pension benefits of many of United’s retirees. The Airline industry consolidation chart shows the concentration occurring. American Airlines tried to push its pension liabilities to PBGC, which resisted that, resulting in

Airline consolidation is not creative destruction. It is the transfer of assets without pension responsibility

Consolidation is not creative destruction. It is the transfer of assets without pension responsibility

older companies declare bankruptcy, repudiating their debts. Sometimes being saved from the scrap heap by merging with another firm in their industries, other times established companies or newly formed companies buy up the unencumbered remains. These companies start with a clean slate, no pension liabilities., enabling them to charge less although providing the same service.

A large segment of free market commentary, that this is creative destruction at work, getting rid of non-competitive companies. That’s nonsense. Here the victims are people, middle-class retirees of the vanished company, not the company. They no longer have the pensions they were promised. Unfortunately, financial engineered creative destruction is permitted but it is done on the backs of the working men and women, most clearly on those who have already retired. The shifting of pension liabilities to the public PGB should not be allowed in mergers or in purchases of entire companies which have declared bankruptcy.

Many established industrial and service companies (like GM, Ford, GE, BofA, the coal industry) face a same funding calculus. Capitalism, as we practice it in the US, has an inherent, unchecked tendency to favor the bankruptcy of existing companies, even in profitable sectors.

Societal Cost

Financial engineering is not a natural, free market process. It can result in breaking the social contract. The social contract (follow the law and you can earn a good life style) is broken.

Can society expect citizens hurt by creative destruction to follow their responsibly to the law when their reward from honoring the social contract has been invalidated.

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