Creative Destruction

Creative Destruction

One aspect of capitalism that is ugly but necessary is the boom/bust cycle. Why is it necessary? Because the bust cycle has what economists call "creative destruction," as resources get reallocated from less productive to more productive enterprises. What do I mean by "reallocated"?

During the boom phase, businesses invest. If they are manufacturers, they may be investing in tooling to manufacture products. They may be investing money in research & development to figure out what to make next. They may be adding stores to a chain, or adding retail space to an existing store. They may be hiring more workers.

Inevitably, the sum of demand from all the different businesses doing such investments is going to drive up prices. If unemployment is low, and there aren't a lot of workers available, this drives up wages. If machine tool manufacturers are short of capacity, they will jack up the price to take advantage of demand. If office space is in short supply, the costs will go up, as owners or landlords take advantage of the opportunity. Interest rates also rise, as the quantity of money available to lend raises static, while the number of businesses trying to borrow goes up.

Also inevitably, some of those investment decisions aren't so good. A chain overestimates the number of new stores that it needs to add. An existing business discovers that adding 25% to the store didn't increase sales by 25%. A business that was profitable when the average employee cost $14.25 per hour (including payroll taxes and overhead) might not be so profitable when the cost is now $16.50 per hour.

What happens during the bust part of the cycle? Businesses shed workers, equipment, and space. When they do so, it may not be that the business does not make sense anymore. It may be simply that the business does not make sense at the boom phase prices and costs. Imagine if Johnny's Bagels is paying $1900 a month for payments on loans for the bagel making machinery, because they took out that business loan in the mature phase of the boom. They close up one or two or their stores, and sell the bagel making equipment.

Gordon's Bagels comes along, and buys that used bagel making equipment. First, the equipment is now used, and therefore cheaper than it was new. Second, even the new equipment wouldn't be that expensive now, because not so many people are buying bagel making equipment; the manufacturer can't be so greedy, and will likely cost prices. Third, because interest rates typically fall during a bust, Gordon's Bagels may end up paying $1400 a month for the equipment that used to cost Johnny's Bagels $1900 a month. Gordon's Bagels may be able to make a profit where Johnny's Bagels could not.

There are similar issues with labor costs and retail space. I'm making quite a bit less than I did at HP, and I suspect that I am not alone in this experience--even excluding those who are still collecting unemployment.

None of these creative destruction experiences are pleasant when you are going through them. But they are part of why boom/bust cycles take place on a regular basis. Socialism's attempts to "rationalize" this process have not been successful because it seems to replace the individual decisions of tens of millions of consumers and businessmen with the collective decisions of bureaucrats far removed from the needs and desires of those who actually want bagels, cars, and refrigerators.