Bailouts affect more than simply the company being rescued. They also have an impact on the economy as a whole, particularly on the sector in which the new zombie lives. What are the macro effects of our new undead friends?
I'm not sure whether the concept is raised elsewhere -- and would appreciate better-read readers informing me here -- but I'm fond of an idea I call financial evolution. I think it lies outside Minsky's work, but I haven't read enough original text to know.
Let's imagine a world where risk is underpriced, and those firms and individuals more willing to assume risk also receive outsized rewards. Over time, as the risk premium adjusts to its normal level, these daredevils will receive just compensation for their gambling proclivities in two crucial forms: higher profits, and a greater propensity to stay employed.
Minsky made the key observation that as the risk premium subsides, more businesses and individuals will be comfortable assuming more and more risk.
Financial evolution is the second order here: the survivors, and particularly the survivors with the most capital, are the units who were most predisposed to risktaking. More profits accruing to risktakers gives them more raw capital to work with, and hence control over a greater portion of the financial system. In tandem, exceedingly cautious individuals risk firing for repeatedly missing profit targets. Together, there's a strong cyclical reinforcement in not just the Minskian risktaking of individuals and firms, but which individuals and firms are strongest.
At the end of a boom, capital will be excessively controlled by people who base jump on the weekend. Conversely, at the end of a bust, those who spend their weekends hovering over 10-Q's and doom-mongering on eschatological financial blogs will command too much of the economy. I believe this forcing function is a strong component of the business cycle.
The Rise of the Zombies
As our present business cycle reverses itself sharply, we would normally expect to see a culling of the excessively bullish and a reassertion of balance. Those who were too optimistic lose all their money, those who were too cynical are wealthy -- but still cynical -- and a lot of firms go under.
Government intervention, ostensibly to save the system, introduces a deus ex machina to our story. This is true to a lesser degree with common interest rate setting, but more evident today.
The unfit are not culled by their own bad decisions in our too-big-to-fail world. Instead, they're given a fresh breath of un-life. These zombies return only as caricatures of their original selves, with the notable institutional aspect of willingness to assume risk at a low cost exacerbated by extraordinarily deep capital pools, an exemption from P&L considerations, and political rules that trump economic rules.
Taxation is another feedback loop. Governments and their undead minions are generally unconcerned with profits, as their revenue comes primarily from seigniorage and direct taxation of profitable concerns. As the ranks of zombies grow, the burden of supporting them on surviving enterprises grows heavier. This parasitic behavior is another feedback loop damaging healthy companies and bolstering the zombies.
We must particularly look at the international ramifications of this strategy. Having healthy, efficient industry is a strong benefit to any nation in good times; competition is good for a country. However, during times of deficient aggregate demand such as a severe recession, the temptation will always exist to devalue and export your way out of the problem. Put another way, in times of excessive competition, a little collaboration will be very appealing.
Governments and corporations have strong mutual interests to collaborate in those times. Countries that are accessible to foreign zombies will generally need to zombify themselves, as they otherwise risk destruction of their domestic competitors by these artificially strong rivals. Eventually, a country that is sufficiently undead is likely to fall, but that can take some time, and take a lot of healthy entities out with it.
Prudent businesses face now not only the lingering competition from careless competitors, but their stronger reincarnate forms. Countries that enforced vigilant regulation now face those competitors too.
AIG has been repeatedly accused of undercutting competitors with offers that are simply not profitable or viable for private sector enterprise. It will be exceptionally difficult for anyone to match a public sector insurer with such deep capital. From the government's perspective, rebuilding AIG into a viable enterprise is key to its offloading, so these Faustian bargains will appear cheap. All insurers who are not state-sponsored will face extraordinary battles to survive.
GM and Chrysler, joining a long parade of global auto bailouts, will reinforce the excess capacity worldwide in car production and exacerbate the un-viability of the entire sector. Fitter competitors not accessories to the groveling, such as Tesla, first protest the unfair advantage, then stoop to their level out of pure economic necessity.
The same issue is strongly present in banking. Competitors without sovereign backing will eventually find it difficult to compete, and many may either fold into the government or fold entirely.
Financial evolution will cause competitors with no access to government funding, or a reluctance to accept it, to gradually fall victim to the zombies or become undead themselves. In the end, the nationalized system will create an entire breed of unfit competitors. This will allowing truly efficient profit-oriented private enterprise to regrow eventually. It will just happen far later and far worse than it ever had to.
The Icelandic economy, and probably that of the UK, are likely to collapse soon, but the zombie US and Eurozone will probably survive a lot longer, with reanimation and collapse both possible outcomes.