Consent, Competition and Bankruptcy

Suppose a man walked into a body shop one day and told the auto repairman that he was having trouble with his engine overheating. Naturally, he wanted to have it checked and repaired.

"Fine," the repairman says. "I'll have it looked at in two days and then I'll call you to let you know what your options are for repair."

The man with the bad engine agrees to this and leaves his car at the body shop for two days. After two days, he doesn't receive a call from the repairman but decides not to worry. He simply assumes that that the body shop was just a little busier than expected and the mechanic has been pushed back on his schedule a little bit.

However, no call comes on the third day either. On the fourth day, the man begins to worry that something is wrong. At lunchtime on the fifth day, he decides to go to the body shop where he finds the auto repairman and asks him about the phone call.

"Oh yeah, sorry about that. I forgot to call you," says the repairman. "Basically, it's like this: you only had one option. The engine had blown a major gasket here and the transmission was all busted up over there. Also, your steering alignment was a little off and this in turned caused a few more problems, so we just decided to order a new engine and transmission. We just installed them today. Give us another day to set the alignment and your car will be set to go."

By now, the customer is fuming. Not only had the mechanic failed to call as he promised, but he decided to do extra work on the car without asking permission. Now the customer faces huge repair costs for services he might not have wanted. He tells himself that next time he needs a repair job for his car, he will do some research with the intention of finding someone who sticks to his word and only does what he's hired to do. Not only that, he'll tell all of his friends to stay away from this mechanic and advise them to tell their friends to do the same.

After two more years and several more very upset customers, the same auto mechanic that swindled our original customer on the repair job is going out of business. Flabbergasted, he doesn't know why hardly anyone comes to his shop anymore.

Meanwhile, the old customer has found an honest repairman who does good work at a fair price...and most importantly, he asks his customers for permission before he does anything to the car!

This little story illustrates how voluntary consent, competition, and bankruptcy work in a free market. First, the man in our story voluntarily agreed to have the mechanic do a job for him, trusting that he would do it correctly. However, when it turned out that the mechanic was crooked, our main character immediately decided that he would find another person among competing alternatives to handle similar jobs in future. Moreover, because he was so upset with the shady tactics of this auto repairman, he would spread the word about his dishonesty, therefore reducing the cheating mechanic's competitiveness against other honest mechanics. Because he was able to spread the word effectively (and because the auto repairman continued dealing dishonestly), the mechanic quickly lost customers and eventually succumbed to bankruptcy since he no longer generated revenue from his unwanted service.

Why is a simple story like this so important?

Unfortunately, the United States is forgetting the very simplicity and common sense that is found in free market principles like competition, consent, and bankruptcy. In October, the Federal government passed a $700 billion bailout plan for America's banks after it had forced them to involuntarily give out subprime mortgage loans (See The Government Created Mortgage Meltdown by Thomas DiLorenzo). Meanwhile, Congress insulated FreddieMac and FannieMae from both competition against the private sector and the consequences of bankruptcy. (See Freddie, Fannie, and Curses on FDR by Llewellyn Rockwell Jr.) As a result, with government protection, FreddieMac and FannieMae created huge investment vehicles out of worthless subprime mortgage loans. After all, if they completely failed (as they were sure to do), they had the promise of a government handout to keep them going. When the private banks saw Fannie and Freddie getting these special privileges, they naturally wanted in on the fun too.

In other words, because the government ignored the basic principles of free market economics from our mechanic story, they created an artificial atmosphere where success was determined by how much banks earned by investing in subprime mortgage packages! We now know how successful that atmosphere was. As it turns out, government's ignorance of capitalist principles (and not capitalism) fueled our current economic crisis.

Even though the Wall Street Journal has reported that Congress just failed to pass another bailout bill of $15 billion for the Big 3 automakers, it is likely Congress will restart more bailout discussion in January after Obama's inauguration. Even though the failed bailout was more humble in size, the bill would have partially nationalized the car industry under a "car czar" which would have ensured that the car companies stay in business. This would have insulated the car makers from competition and bankruptcy while Americans would have been involuntarily forced to keep these companies in business with our tax dollars. Even though this plan has failed for now, we can only breathe a short sigh of relief until January.

Quite simply, Congress has no good justification for this (or any other government run solution) to our economic problems. At the Ludwig Von Mises Institute, Jeff Tucker detailed the decline of America's former powerhouse industry: pianos. During the late 19th and early 20th century, America stood as the forefront of everything that had to do with pianos. But as Tucker shows, shortly after this time period the industry collapsed and almost all major piano companies went overseas. Yet, today, we are not at a loss for pianos nor did all of the former laborers for the piano industry fail to find new jobs after the piano industry collapsed. Back then, people were not forced to keep alive a dying industry simply because it used to be a big part of America's economy. Competition, voluntary transaction, and bankruptcy ruled the decline of the piano industry and the ensuing rise of the auto industry. There is no reason why these principles shouldn't also oversee the auto industry's decline.

It's time to go back to the common sense understanding that free markets provide. Government issued bailouts ignore the simple principles that you use every time you get upset at bad service and decide to look for competing alternatives. Instead of allowing the bankruptcy of the unnecessary, inefficient, and dishonest, the bailout philosophy argues that we should keep such services in place in order to "fix the economy."

All the while, the true fix lies in simple free market forces like voluntary transactions, competition among businesses for those voluntary transactions, and bankruptcy for those firms that don't compete well.

Supporting Resources:

In Praise of Bankruptcy by Henry Thompson

Ben Bernanke's Pretense of Knowledge by Doug French