To Die and Let Live

American civilization has become much more civilized during the last hundred years. In the process, ironically, it has become much more savage toward capitalism and free enterprise.

One hundred years ago, most folks accepted adversity as an unavoidable facet of life. Childbirth was a high-risk endeavor. “Old folks” died at 50. Dysentery claimed more lives than heart attacks. Businesses failed. Governments defaulted. Currencies crumbled.

But not anymore. We are more civilized. Childbirth has become a low-risk endeavor and old folks live long enough to have a heart attack in their 80s.

American civilization has achieved a stunning number of medical breakthroughs during the last century — adding about 28 years to the average lifespan in the process. Unfortunately, American civilization has also devised a stunning number of mechanisms to extend the lifespans of ailing financial institutions and brain-dead corporate entities.

As our civilization has aged, it has become obsessed with erecting economic guardrails, stringing safety nets, straightening curves and legislating Bubble Wrap around almost every conceivable mishap. As a result, the financial system is so thoroughly insulated with regulations and “protections” that it is suffocating.

As a nation, we have become intolerant of any economic adversity…even when that adversity serves an essential economic purpose. We want our summers without any winters. We want our victors without any vanquished. We want our successes without any failures.

That’s not good news for free enterprise. Defaults and bankruptcies are staples of economies that flourish over the long term. “Capitalism is not just about success — that’s the easy part,” observes James Grant, editor of Grant’s Interest Rate Observer. “It’s also about failure — recognizing it, dealing with it, liquidating it, properly pricing it.”

Schöpferische Zerstörung means “creative destruction” in German. In America, we have forgotten what it means. Thanks to the Federal Reserve and other destructive creations of government, the process of creative destruction rarely takes root in American soil anymore.

“At its most basic,” Wikipedia explains, “‘creative destruction’ describes the way in which capitalist economic development arises out of the destruction of some prior economic order…From the 1950s onward, the term ‘creative destruction,’ sometimes known as ‘Schumpeter’s gale,’ has become more readily identified with the Austrian-American economist Joseph Schumpeter, who adapted and popularized it as a theory of economic innovation in Capitalism, Socialism and Democracy (1942).”

The destructive portion of “creative destruction” plays a vital, therapeutic role. But the financial leaders of the US and the eurozone have zero appetite for creative destruction. Instead, creative denial is the order of the day. They pump trillions of dollars of fresh credit into insolvent banks like embalming fluid into a corpse. But the fresh credit rarely revives these financial corpses. It simply enables them to keep hanging around and stinking up the place.

The Federal Reserve should ditch its embalming fluid and buy cement instead. If the Federal Reserve were genuinely serious about reviving long-term economic growth, it would be fitting America’s big insolvent banks with “cement galoshes” and tossing them into the Hudson.

That’s because creative destruction is not just about destruction; it is primarily about creating the investment opportunities that result. When ventures fail, a new generation of capitalists can enter the fray to make the next generation of fortunes.

That’s how the world works…or at least how it should work. The recent history of sovereign defaults and currency devaluations illustrates this phenomenon very clearly.

Within a few years of a default or devaluation, most countries embark on a robust new growth phase. The process is not easy or painless, but it is extremely effective in clearing away the rot so that new ventures can flourish.

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The Russian government defaulted in 1998. An investor who allowed the dust to settle a bit but then purchased stocks exactly one year after the default would have doubled his money in just one year. After three years, the gain would have been more than 200%. After five years, more than 400%.

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This hypothetical example is not an exception: It’s the rule. An investor who purchased stocks one year after the 1997 Thai baht devaluation, 1997 Indonesian rupiah devaluation or 2002 Argentine peso devaluation would have more than doubled his money during the ensuing 12 months in each instance.

The Brazilian default of 1990 was an exception. An investor would have lost money initially. But within a couple of years, that investment would have paid off handsomely as well.

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As the charts show, these five “crisis buys,” on average, would have doubled an investor’s money after two years and tripled it after five years — dramatically outperforming the benchmark international and emerging market indexes over those time frames.

The message is clear: Destruction can be very creative.

Regards,

Addison Wiggin,
for The Daily Reckoning