The Bailout Fallacy

by
David Gordon
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What Went Wrong with Capitalism
by Ruchir Sharma
Simon and Schuster, 2024; 384 pp.

It is always encouraging when a non–Austrian School economist accepts through his own reasoning an essential tenet of Austrian economics. Ruchir Sharma, who is chairman of Rockefeller International, founder and chief investments officer of Breakout Capital, and a well-known economic journalist, is not an Austrian, though he is aware of Friedrich Hayek’s work. He lends strong support to the Austrian position that because competition moves resources to where they best fulfill consumer demand, the government must not interfere with this process by bailing out businesses that fail.

The position just referred to is called consumer sovereignty, and Ludwig von Mises explains it in chapter 15 of Human Action in this way:

“The direction of all economic affairs is in the market society a task of the entrepreneurs. Theirs is the control of production. They are at the helm and steer the ship. A superficial observer would believe that they are supreme. But they are not. They are bound to obey unconditionally the captain’s orders. The captain is the consumer. Neither the entrepreneurs nor the farmers nor the capitalists determine what has to be produced. The consumers do that. If a businessman does not strictly obey the orders of the public as they are conveyed to him by the structure of market prices, he suffers losses, he goes bankrupt and is thus removed from his eminent position at the helm. Other men who did better in satisfying the demand of the consumers replace him.

“The consumers patronize those shops in which they can buy what they want at the cheapest price. Their buying and their abstention from buying decides who should own and run the plants and the farms. They make poor people rich and rich people poor. They determine precisely what should be produced, in what quality, and in what quantities. They are merciless bosses, full of whims and fancies, changeable and unpredictable. For them nothing counts other than their own satisfaction. They do not care a whit for past merit and vested interests. If something is offered to them that they like better or that is cheaper, they desert their old purveyors. In their capacity as buyers and consumers they are hard-hearted and callous, without consideration for other people.

“Only the sellers of goods and services of the first order are in direct contact with the consumers and directly depend on their orders. But they transmit the orders received from the public to all those producing goods and services of the higher orders. For the manufacturers of consumers’ goods, the retailers, the service trades, and the professions are forced to acquire what they need for the conduct of their own business from those purveyors who offer them at the cheapest price. If they were not intent upon buying in the cheapest market and arranging their processing of the factors of production so as to fill the demands of the consumers in the best and cheapest way, they would be forced to go out of business. More efficient men who succeeded better in buying and processing the factors of production would supplant them. The consumer is in a position to give free rein to his caprices and fancies. The entrepreneurs, capitalists, and farmers have their hands tied; they are bound to comply in their operations with the orders of the buying public. Every deviation from the lines prescribed by the demand of the consumers debits their account. The slightest deviation, whether willfully brought about or caused by error, bad judgment, or inefficiency, restricts their profits or makes them disappear. A more serious deviation results in losses and thus impairs or entirely absorbs their wealth.”

Sharma states Mises’s principle in this way: “When capitalism is working, it gives people freedom to vote in the marketplace, by investing in new ideas and growing companies. Their choices determine prices, and those prices reflect the public’s best bet on which ideas and companies are poised to thrive in the future. The collective wisdom of millions of individuals, scrutinizing every deal closely, cannot be matched by the lone mind of the state, trying to steer capital from on high.”

Sharma is thus fully aware of Mises’s argument for consumer sovereignty, though he does not get matters entirely correct from an Austrian perspective. Influenced by Joseph Schumpeter’s concept of creative destruction, he thinks that supporters of capitalism need to accept periodic booms and busts. During the busts, they should not support bailouts but allow failing firms to go under. As Austrians see the matter, booms and busts come about only because of the government’s credit expansion. Absent that, the process by which resources are transferred from failing entrepreneurs to successful ones, though no doubt temporarily painful for the losers, will not cause a general recession or depression.

But aside from this, Sharma gets it right. He says, “When government becomes the dominant buyer and seller in the market—as it has in recent decades—it distorts the price signals that normally guide capital. Money starts to flow down the paths of least resistance, or most government support. Each crisis brings bigger bailouts, leaving capitalism more mired in debt, more dysfunctional and fragile.”

He explains with exemplary clarity what is wrong with bailouts: “‘Socialized risk’ refers to the government safety net, which was originally designed to protect the weakest members of capitalist societies from hard times but now extends under the feet of everyone, poor and rich, all the time. . . . Bailouts are no longer reserved for individual companies or banks, they extend to industries and a commitment to perpetual growth in the economy as whole. . . . What began in the New Deal as a safety net for the poor has become a system of socialized risk for the superrich with government guaranteeing markets that would move only one way—up.”

Sharma pays generous tribute to Hayek’s 1920s insights into the danger of easy money. Austrians should respond with the same generosity to Sharma’s arrival at Austrian insights in his own way.