As even Karl Marx once reluctantly admitted, the capitalist system has created more wealth (and more quickly) than any other economic system in history. Yet, despite its obvious success (or, perhaps, because of it), the system is poorly understood and almost never loved. And this ignorance and lack of affection (for self-interest and profit and competition) always makes capitalism vulnerable (especially during recessions) to crack-pot schemes and reforms that strike at the root of its economic performance.

In the current economic downturn, “bailouts” to financial firms (AIG, Citi Bank) and industrial corporations (GM, Chrysler) are the nuttiest of the current crop of government policies and they promise to inflict the most lasting damage on taxpayers, consumers, and on the economy as a whole. Regardless of their intent, they are a serious economic mistake because they cut to the very heart of the capitalist process.

To see why this is so, it must be noted that the search for profit and the avoidance of loss is the essence of the capitalist process. In a market economy, individuals and firms have incentives to discover products and services that consumers want and then produce them at the lowest cost. Profits become a signal of success and a reward for serving consumers efficiently. Contrariwise, when losses appear, they signal failure and inflict a penalty on firms for producing poor products or having bloated costs of production.

Firms that make profits can command additional resources (land, labor, capital) and expand production. Investors who took the risks of production are rewarded. On the other hand, firms that make losses must release resources (land, labor, capital) and ought to curtail production; their investors are penalized. This, then, is the capitalistic process whereby consumers get the products and services they want produced efficiently.

Since market information is never perfect and since production is always future oriented, the capitalistic process is “messy” and is never in any equilibrium; this reality must be accepted. What cannot be accepted is market fraud (especially in accounting for profit and loss) and deceptive practices; these serve to undermine the integrity of the entire process and must be carefully policed. (Think Bernie Madoff.) Nonetheless, the capitalistic process of profit and loss (with fraud protection) just described has worked with more personal freedom and more beneficial results than any other economic system in history.

The recent and on-going government bailouts (begun under President Bush and continued under President Obama) are antithetical to the capitalistic process. First, they weaken both the information and incentives necessary for efficient production. Second, they delay tough decisions by management in a whole variety of areas such as product design, employment, dealer and store closings, future investments, and even bankruptcy. Finally, profitable firms in an industry are put at a competitive disadvantage because of the subsidies to the losers; this is both unfair and inefficient. All of these perverse incentives work to prolong and deepen recessions, not shorten them.

In addition, what governments fund they (naturally) wish to control. So bailouts often come with strings and conditions concerning future business operations (salaries, plant closings, etc.). The assumption here is that the Treasury or the Congress (think Barney Frank) can craft a better plan for any future corporate recovery than can the market or a bankruptcy court. But this assumption is unwarranted and has no support in either theory or empirical evidence.

The huge credit bubble spawned by the Federal Reserve created expectations about future production and consumption that could not be sustained. That it all came crashing down was inevitable. Recessions (actually economic corrections) end when consumers and business finally readjust their respective “balance sheets” to the new price and profit reality. Bailouts delay and distort this adjustment process and thus make the recovery longer and more difficult.

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