Creative destruction in the financial sector

October 12, 2008

Failure is part of the natural cycle of business. Companies are born, companies die, capitalism moves forward.

Fortune magazine

I have not failed. I’ve just found 10,000 ways that won’t work. Thomas Alva Edison

It’s not enough to succeed. Others must fail. Gore Vidal



Failure is all around us. Herbert Spencer coined the phrase survival of the fittest but nature seems to be more about death than surviving. 99.99% of all biological species which have ever existed have become extinct.  And just as species fail—and die out—so do companies. Failure in nature is measured over hundreds of millions of years. In Business the timescale is much shorter. We all know about Pan Am, WorldCom, Enron, and Lehman Brothers but they are merely the tip of the iceberg – ten per cent of all the companies in America disappear each year Is this a damning indictment of capitalism? Maybe but there is another way to look at things.

            When we look at the capitalist system it is not difficult to appreciate what an incredible wealth-creating machine it is. However many people become distinctly uneasy about the failures that are also endemic to it. We are not comfortable with the fact that individual citizens, groups or regions are not doing so well or may actually be worse off. This is when we get the calls for governments to do something. These calls for action are understandable but we should apply some scepticism to them. The left’s schadenfreude about the current financial metdown is reflected in this satirical piece from the Daily Mash:

With more economic bad news on the way, Britain is this week bracing itself for a fresh wave of bullshit newspaper articles about the nature of capitalism. Senior editors at the Guardian and Independent are expected to work through lunch to maintain a steady supply of pieces about hubris, deregulation and why Marx was right all along…… At the Guardian, Jonathan Freedland and Polly Toynbee have been ordered to invent 50 brand new excuses for why socialism failed the first time and 50 exciting reasons for why it cannot fail the next time.

What we need to realise though is that sometimes success and failure are intertwined. As economist Thomas Sowell has pointed out it is no coincidence that Smith Corona was losing millions of dollars on its typewriters while Dell Was making millions on its computers or that the number of pay telephones declined as more people acquired their own mobile phones. In a system like that of the Soviet Union you didn’t get this degree  of failures that the US has. The problem was that if something didn’t work very well it would continue on its way taking up valuable resource.

The concept of creative destruction comes to mind. It sounds like an oxymoron but it is a powerful tool for explaining progress in a capitalist system. It is associated with the Austrian economist Joseph Schumpeter. He employed it to describe the transformation wrought by radical innovation. For Schumpeter the key to long-term growth was the constant entry of innovative entrepreneurs into markets. Companies are always subject to the “gales of creative destruction. We look at established firms now and they seem all-powerful but over time these monopolies are undermined by newer more dynamic companies: we often lack this historical perspective. Schumpeter believed this destruction was important:

“This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted.”

All this talk of creative destruction brings me back to current banking crisis. It can be useful to analyse it from an evolutionary perspective. There are though some areas where the parallels between evolution and the banking sector just do not apply.  Evolution is a blind, random process; there is no intelligent design. There are no governments, regulators or supervisors in the natural world. Can you imagine what it would be like if there were?:

Oh my God! The dinosaurs are becoming extinct!  We have to organise a massive bailout with public funds.

In banking there is at least some kind of design in the system. They may not be omnipotent but there are some deities and they do have a lot of powers. Let’s take a look at regulators. They do have their own perspective and if there is one thing they don’t like, it is destruction. Former Fed chairman Paul Volcker expressed it like this:

“I can remember very clearly sitting in my office then, as President of the Federal Reserve Bank of New York, thinking that what this country needs is a first-class bank failure to teach us all a lesson – but please God not in my district. When I went to Washington, I had the same feeling – we need a clear lesson from market discipline, but please dear God, not in my country. Then if I read correctly the 1990s and what happened when the Mexican crisis came along, Bob Rubin and Alan Greenspan thought what we need is a good country failure to teach everybody a lesson but please not in a large country in my hemisphere.

Regulators find it impossible to avoid protecting the banking system. It’s in their DNA. We are all familiar with the argument too big to fail. Japan shows us the danger of trying to keep hopelessly unadapted banks alive artificially. Extinction may sometimes be necessary and we avoid it at our peril.


Further reading

The great dying: a memo to market dinosaurs Niall Ferguson



Classic cock-ups

October 12, 2008

Saltillo Prison in Northern Mexico was the scene of a gloriously unsuccessful prison escape in 1976. In November of the previous year 75 convicts had begun digging a tunnel designed to bring them up on the other side of the prison wall. Five months later, the escapees finally saw the light at the end of the tunnel but they ended up in a nearby courtroom, the one where they had originally been sentenced. The surprised Judges returned all 75 to Jail.

In October 2002, the US investment bank Bear Stearns entered an order to sell $4bn (£2.6bn) worth of Standard & Poor securities in a late trade, 20 minutes before the market closed. In the world of high finance this is not that unusual. The problem was that there had been a “clerical error” and the real sum should have been $4m, 1,000 times less than the order that was actually placed. They were finally able to cancel all but $622m of the order before execution. These kinds of errors do happen from time to time.  In 1998 a Salomon Brothers trader mistakenly sold £850m-worth of French government bonds by leaning on his keyboard.

The Ryugyong Hotel is an unfinished concrete skyscraper in Pyongyang, North Korea. Work initially began in 1987 but ceased in 1992 due to the government’s financial difficulties. It has yet to be opened but after 16 years of inactivity building has finally resumed this year. It has 105 stories and stands 330 m tall with 360,000 m² of floor space, making it by far the largest structure in Kim Jong-il communist paradise. When they first started, they intended it to be world’s tallest hotel. Critics have been less than complimentary about it. It has earned epithets such as the “worst building in the history of mankind”, “one of the most expensive white elephants in history” and the “Hotel of Doom”. The North Korean government has airbrushed the building out of pictures of the capital.

On the bloody Eastern Front during the Second World War the Russian Army came up with the idea of an anti-tank dog. The year was 1942, just a few months after Hitler had launched Operation Barbarossa. It was a brilliantly simple theory; if you always feed a dog underneath a tank, underneath a tank is the first place that they’ll head towards on the battlefield. The starving dogs would carry explosives strapped on their backs with a harness. They were then trained to run under the enemy tanks and in doing so would activate a large wooden trigger that would cause the bomb to detonate. However, there was one slight snag – they were used to the Soviet tanks and in battle they would run often under their own side’s vehicles. They thus became a menace to the Red army, once forcing an entire Russian tank division into retreat.  Although they were credited with the destruction of 300 German tanks, they were then promptly retired from service.

The NASA Mars Climate Orbiter will go down in the annals of incompetence. Lockheed Martin, who were involved in the ill-fated Orbiter project, wrongly assumed that they would be using imperial measurements for the controlling software. Nobody told NASA this and the inevitable result was that the $330 million spacecraft missed its orbit, entering the Martian atmosphere at about 57 km instead of the target of 140–150 km. This was too close and it was never heard of again.

During the 1978 firemen’s strike of 1978 the British Army took over emergency fire fighting duties. On 14 January they were called out by an elderly lady to rescue her cat, which was stuck up a tree. They arrived quickly and soon were able to bring the cat down. The lady was delighted and invited them all in for tea. Once the beverages had been served and they had said goodbye to the lady, they drove off. Unfortunately they then ran over the cat and killed it.

In August 1975 three men were trying to rob the Royal Bank of Scotland at Rothesay, the principal town on the Isle of Bute, off the West coast of Scotland. They found themselves trapped in the bank’s revolving doors. After being freed by some employees, the three men thanked them and left the bank. They probably should have called it a day there and then, but they were nothing if not persistent. A few minutes later they were back and announced that they were going to rob the bank. The staff all thought it was some kind of practical joke and when the men demanded £5,000 the head cashier started laughing.  Furious at the lack of respect they were being shown, one of the men jumped over the counter. But he fell to the floor, clutching his ankle in agony. The other two robbers finally realised the futility of it all and attempted a clean getaway, only to get stuck in revolving doors once again

Millionaire businessman Gerald Ratner managed to wipe off £500 million from the value of Ratners jewellers with one speech in 1991. In the speech he was somewhat unflattering about some of his company’s jewellery products, and by extension all of them.  He said: …We also do cut-glass sherry decanters complete with six glasses on a silver-plated tray that your butler can serve you drinks on, all for £4.95. People say, ‘How can you sell this for such a low price?’ I say, because it’s total crap ……….. We even sell a pair of earrings for under £1, which is cheaper than a prawn sandwich from Marks & Spencer’s. But I have to say the earrings probably won’t last as long ” These comments were picked up by the media and Ratner got the sack. At least he had the satisfaction of having an expression named after him; Doing a Ratner is used for this type of corporate gaffe.

My media week 12/10/08

October 12, 2008

The Andrew Marr programme Start the Week is back on air. It’s a  40-minute conversation about art, history, politics, theatre,  philosophy and just about everything under the sun. It goes out on Monday and the podcast is available for a week.


In this video EconTalk’s Russ Roberts give some keys to understanding the current financial crisis.


John Allen Paulos’s article looks at the same question but from a mathematician’s perspective.


Finally If you haven’t seen this already, I recommend this piece from the BBC Joking about the credit crunch.






My favourite links #18

October 12, 2008

I haven’t had a chance to look at this website in detail but it looks quite interesting. It’s called It contains analysis of Spain, looking at politics, the economy, education and many other areas in Spain. There are some grammatical mistakes but I think it’s a worthy initiative. For example, they have  have an article on the fall of Fannie and Freddie: lessons for Spain.  Go here.