Why Bankruptcy Isn't the End of the World

One of the arguments that critics of the automobile bailout have made is that going into bankruptcy is not the end of the world, for the firm, the industry, or the economy.  Bankruptcy simply means that the courts step in to help the firm reorganize, sell off assets to pay of debts, etc..  The key point is that going into bankruptcy does not destroy the firm's capital, both physical and human.  As a result, that capital can become available for a new firm, perhaps even a competitor, to purchase at a discount and use more profitably than the bankrupt firm did.  In the case of the Big Three auto companies, doing things at lower cost and producing a better product would not be hard. 

If they declare bankruptcy and need to liquidate assets to pay off creditors, it's quite likely that other car manufacturers (and let's remember that "The Big Three" are not all of the "US auto industry" as many other firms have plants here) would be interested in buying up their factories and perhaps even rehiring their labor, though certainly with contracts less generous than the UAW's current ones.

If you doubt this scenario, check out this story on CNN.com today.  It involves a commercial bakery in Ashland, OH, that made Archway cookies.  It was closed a little while back by the private equity firm that owned it, leaving 300 workers without jobs or health insurance.  Then:

Lance Inc., a Charlotte, North Carolina-based snack food company, purchased Archway at a bankruptcy auction. And last week 60 workers were asked to return immediately, with perhaps more coming back in the months ahead.

They also provided the returning workers with a $1500 prepaid debit card, which many used for Christmas for their families, as well as immediate health insurance, not to mention coming back at their old wages and seniority.

Yes, it's a very nice holiday story, but it also shows a key economic principle:  allowing some firms to go bankrupt does not destroy physical and human capital, it only reduces their value.  As Israel Kirzner has long pointed out, every mistake made in the market by one entrepreneur represents an opportunity for another.  Bankruptcy is simply an orderly and low transaction costs process by which one firm's mistakes can be translated into opportunities for others. 

Well-functioning markets require that misallocated resources have opportunities to get reallocated to more valuable uses when those mistakes are revealed.  As Pete and Dave point out in their textbook, recessions are not when mistakes are made but when they are corrected - or at least that's what recessions SHOULD BE, if policymakers keep their fingers out of it.  Bankruptcy is one of the "microfoundations" of that correction process, and if we don't allow it to work, we simply perpetuate the mistakes that need correction and set ourselves up for much bigger problems down the road. 

Supporters of the auto bailout could use a refresher course on all of this. 

And happy holidays to 60 families in Ashland, Ohio, where bankruptcy proceedings allowed market correction processes to work, making for more sustainable longer-term jobs and, it would appear, more humane management.

Comments

[libertyfirst]

Yes, I was arguing the same for what concerns bank bankruptcies: the orthodox view is that massive bank failures imply an informational disruption and a large loss of efficiency of financial markets. This is the rationale behind bailouts. However, the informational capital of banks remain intact: hard discs, files, interpersonal relations, human know-how.

There can't be much more than a short term organizational problem behind this argument.

PS The only good point is that banking is the only market that doesn't work without the delusion that these institutions are sound. Everybody knows they are not, but when it comes to realize it it's a social tragedy. That must be some sort of madness.

[dmfdmf]

Based on the media coverage you would think that if GM, et. al. went backrupt they would just vanish with devastating consequences. In fact the net effect of the bankruptcy is that the creditors become the new owners as the current stock holders are wiped out. The new owners (former creditors) get to pick new management that (hopefully) know what they are doing hence the disgracefull beggging for money in front of congress -- the current management is begging for another chance sanctioned by the government.

[xim]

I can see a flaw in your logic. Generally speaking, going bankrupt ensures only a CHANGE of the capital owner, not neccessarily an IMPROVEMENT of them.

A properly managed company with smart personal could nevertheless go bankrupt due to unlucky timing of financial events. And vice versa, a company managed by idiots and weasels could avoid bankrupsy, just because one of their stakeholders happens to be a billionaire and can invest some more private money.

A bailout, when provided under strong additional requirements posed to the management, can be a more predictable and controlled way to learn the lessons.

[marsh]

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