I write quite a bit on distorted markets and misallocated capital so let’s explain how that happens:
Let’s say you have a company that manufactures yellow shoes and you have been manufacturing yellow shoes for a long time. You sell your yellow shoes for $55 a pair.
A new company enters the field, and it makes red shoes. They sell for $48 a pair and people like the red shoes a lot more than the yellow shoes.
The red shoe company takes over the market and the yellow shoe company is in danger of collapse.
The yellow shoe company has been making regular campaign contributions, so they ask their politicians if they can help. Since their Senators and congressman obviously do not want to lose the jobs in their state and district, they listen.
The politicians put in place a plan to subsidize yellow shoes and proclaim they are “saving middle class jobs.” The yellow shoes still cost $55, but the taxpayers now pick up the first thirteen dollars of that; the retail price for yellow shoes is now $42 and it costs the tax payers $13 for every pair of shoes sold. The politicians then tax red shoes at $13 a pair to make things’ fair.’
The red shoe company is none too happy about this and the market starts to even up, but people still prefer red shoes. Eventually, even with the yellow shoe subsidies, the red shoe company starts to pull away simply because people prefer red shoes.
The politicians are now invested in the survival of the yellow shoe company, and when the yellow shoe company reaches out again, the politicians once again proclaim they are “saving middle class jobs” and promises to buy back each pair of old yellow shoes at $30 a pair whenever customers want new yellow shoes. The politicians have effectively put a floor on the resale price of yellow shoes. Effectively, with the subsidy and buy-back promise, a customer only pays $12 for a pair of yellow shoes for which the retail price is $42 and the actual price is $55. For every pair of shoes that now retails for $42 a pair, the taxpayers are on the hook to pay $43.
The red shoe company is really unhappy now, and starts pestering their Senators and congressman and making their own campaign contributions. What’s more, the purple shoe company now enters the market. People like the purple shoes every bit as much and maybe more than the red shoes. Even with all the taxpayer subsidies, the yellow shoe company loses sales and cannot keep everyone employed, so the government decides that in the interest of “saving middle class jobs” the government will now buy millions of pairs of yellow shoes at $55 a pair from the factory and destroy them just to protect the yellow shoe jobs.
The red and purple shoe companies really do not like this and complain. In order to make it “fair,” the government decides to give each shoe company $25billion.
This does not make it “fair,” it just makes the shoe companies wealthier. The government realizes this minutes after they give the money away and decide to continuously inject money into each shoe company so they can all stay in business. As soon as investors realize the government is basically guaranteeing each company will not go out of business, they start buying the shoe companies stock, driving it higher and higher.
The government now realizes that they are simply making the shoe companies wealthier each month and still cannot make it “fair,” however, if they stop giving the shoe companies money every month, the stock price will collapse and the yellow shoe company will probably go out of business, since the original problem that very few people want yellow shoes will still persist.
Something interesting has now happened to the shoe companies: they realize making ever better shoes at an ever lower price is no longer the path to success. The path to success is now in manipulating government regulations, subsidies, and taxes to their advantage. The politicians also now realize something: after they have invested so much of the taxpayers money into the shoe companies to “save middle class jobs,” the shoe companies are no longer beholden to the politicians, but the politicians are now beholden to the shoe companies.
The yellow, red, and purple shoe companies now assist the politicians in constructing a tax, subsidy, and regulatory system where the red, yellow, and purple shoe companies are guaranteed to make money regardless of the quality of their shoes or the demand for their shoes. All of this happens at taxpayer expense, of course. This system also effectively prohibits any new shoe companies from forming in the United States and selling better shoes for less money.
The shoe companies invest less and less time and money into developing new and better shoes, and more and more time and money into government “relationships” and buying back their own skyrocketing stock. This is more lucrative than developing new and better shoes.
The problem they encounter is that no one wants their shoes; people now only buy shoes when they have to, not because they want to. Sales start to drop and the shoe companies tell the government they will “lose middle class jobs.” The government passes a law that everyone must buy one pair of new shoes each year, and they can only buy them from the yellow, red, or purple shoe companies or they will be fined. The government also puts into place a complicated system whereby everyone must report to the IRS if they bought new shoes, when they bought new shoes, and provide proof that they bought the government-approved new shoes on schedule.
Now, something interesting happens: a company in India starts selling silver shoes and they are only $8 a pair. The shoe companies and the government immediately perceive the threat and immediately outlaw silver shoes in the United States, claiming silver shoes are inherently dangerous and that they have a duty to protect Americans from dangerously colored shoes.
The $8 silver shoes are wildly popular all over the world, except in America where they are forbidden. This makes Americans want the red, yellow, and purple shoes even less. People start smuggling silver shoes into the United States. An entire black market develops, which causes the government to create new law enforcement agencies just to combat illegal silver shoes, once again at taxpayer expense, of course.
The tidal wave of worldwide desire for $8 silver shoes means the yellow, red, and purple shoe companies lose all of their remaining overseas sales. They are now only propped up by government regulations, tax dollars, and laws requiring people to buy their product. The shoe companies invest even less money into developing new and better shoes and even more money into politicians.
Now another interesting thing occurs: a group of citizens rise up and proclaim that the entire American shoe business is “insanity.” The politicians, shoe companies, and few remaining shoe company workers and their unions universally deride this group of citizens as “kooks,” “crazies” and “in the pay of foreign shoe companies.”
More tax payer dollars go into propping up the shoe companies while fewer and fewer people are actually employed making shoes, and fewer and fewer shoes are actually purchased. In response, the government puts more regulations in place effectively requiring all of the shoe company employees to work part time. The shoe companies hire twice as many workers, all of whom are working half as much as a full time worker, and also making half as much, but the government proclaims it has doubled the number of workers and so the program is a great success. Everyone pats themselves on the back and compliments each other on the remarkable “recovery” of the shoe companies.
In a nutshell, this is how distorted markets occur. You may think my example is ridiculous, and I agree. Unfortunately, my examples are also true. All of the events in my examples have occurred within the last nine years.
Unless the lessons of history no longer apply and fundamental economic rules no longer hold, this system will collapse in on itself. When the shoe companies in this example go out of business–as they inevitably must–all of the money that has been invested will be lost. This is clearing out misallocated capital.
No model of government or central bank subsidies, taxes, regulations, legislation, or prohibitions is stronger than the collective desire of 320 million Americans or 7 billion people worldwide. Ultimately, what the people want always trumps what the government mandates. This is what causes distorted markets to unwind. When people decide they simply do not want those shoes anymore – or for their tax dollars to play to enrich shoe companies and shoe company shareholders – the delusion will come to an end.