Profits and Losses

The terms ‘profits’ and ‘losses’ are common parts of the business vernacular.  However, many people don’t fully understand their role in a market economy.  This has become even more pronounced after the recent financial crisis.  To date, the government has attempted to perpetuate a system of profits without losses.  The problem with trying to build a market economy without both profits and losses is that it will inevitably lead to one of two extremely undesirable results.

Re-Distribution

One sentiment that was popular in the middle of the 20th century was the notion that private profits are fundamentally immoral.  According to this philosophy, production should be socialized.  This is the fundamental tenant of socialism and communism, and ultimately results in a stifling of risk-taking.  This happens when the rewards for entrepreneurship become non-existent.  In this environment, the resources available for redistribution don’t grow, and the costs of government control place a tremendous burden on national output as access to wealth becomes a function of political connections instead of skill or productivity.

Socialized Losses

Another sentiment is the notion of socializing losses from private activities through creditor bailouts.  In this model.  profits are privatized to politically connected businesses and losses are socialized on the backs of taxpayers.  Some people refer to this as “crony capitalism.”  However, the term is an oxymoron since capitalism is a system where market conditions are allowed to prevail.  In this situation, political officials are unable to provide special benefits to their “cronies” through the power of government.

Flawed Models

There is a  fundamental characteristic that both of these flawed models share.  Namely that they distribute wealth based on political influence instead of ideas and productivity.  In both cases, the government wields tremendous power and entrepreneurship is suppressed.  This happens by either an absence of profits from success or from companies with government backing that crush competition.  The danger that is posed by this model is that the “profits” it generates look the same as earnings from legitimate business activities.  However, the former provides nothing of net value to the marketplace, and the latter is the fundamental foundation of every market-based economy.

Real Capitalism

In a ‘real’ capitalist economy, profits are generated by success in the marketplace and failure results in losses for both equity and debt investors.  The current brand of “crony capitalism” has architected bailout after bailout of creditors who financed excessively risky business operations.  The importance of this comes from the fact that creditors have historically been the primary guardian of prudence in business activities.

Consider that a creditor receives no premium if a business is successful like a stockholder . . . all that they get is their regular interest payment.  Because of this, creditors in a ‘normal’ environment will demand a higher interest rate from risky businesses.  These higher interest rates will temper risk taking by entrepreneurs since the increased financial obligations will reduce their probability of success.

Subsidized Losses

However, if the government guarantees the debtors of a particular company, then they have no reason at all to encourage prudence . . . they are going to get their money back from the government if things go upside down.  This creates perverse incentives where risk taking becomes more and more intense while the cost of borrowing stays low because of a government guarantee.  When big profits roll in, management gets big bonuses.  If a collapse occurs, the government bails out the creditors and the taxpayers get stuck with the bill.

Even in cases where government guarantees have been “successful” for companies that did not require an explicit bailout, they have contributed to insane risk taking that eventually culminated in the financial crisis of 2008.  Further, these ‘successful’ bailouts are fomenting an even larger collapse, since the fundamental incentives have not changed.  Thus, the system of government guarantees results in an ever increasing avalanche of risks that are concealed from the public through clever accounting tricks until they eventually explode into a massive market collapse.

What it all Means

In the end, both profits and losses are necessary for true capitalism.  Unfortunately, true capitalism has not been present in the developed world for nearly 100 years.  In an environment of increasing manipulation and government control, the strategy for success is to gain control of income producing assets that can be financed with fixed-rate debt.  This will allow you to realize financial gains when the day of financial reckoning arrives and the US government falls back on creating inflation by printing money to finance its bailouts and entitlement promises.

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