Why We Shouldn’t Fear the Failure of Some Firms

The Smart Money article is an excellent view of how our fears about “a big crash” are sometimes unjustified.

Few have questioned the basic premise — the notion that many of our financial institutions are truly too big to fail. The underlying theory is not, of course, that the world cannot live without Bear Stearns, but rather that if Bear failed, it could pull under other financial players to whom, through a complex array of trades and credit obligations, it is linked.

For more SmartMoney Magazine features, turn to the October issue.

Exponents of this view often employ the metaphor of a house of cards. Remove one card and the rest collapse. I have never — not when I wrote a book about LTCM, and not now — thought the metaphor was quite right.

Is the economy really so fragile, and is finance really a house of cards? A single firm certainly may implode. When Enron’s books were exposed as a sham, no one would lend to it, and the company did collapse.

But the economy is composed of thousands of firms. They do not all fail at once. David Ranson, an economist at H.C. Wainwright Economics, thinks we are unduly alarmist. A better metaphor, he suggests, is a beehive.

Picture thousands of bees furiously building — and when necessary, rebuilding — the hive. When one bee falls, another takes its place. The bees work in association with each other, but not in a pyramid. If a section of the hive crumbles, the rest of it continues to function. Meanwhile, nature compels the remaining bees to repair the damage. With bees, the motivation seems to be collective. With capitalist human beings, the motivation is individual — but the result is not dissimilar.

Of course, when a house of cards collapses, the entire structure is leveled; the restoration must start from scratch. But that isn’t what happens in the U.S. economy. No sooner does an enterprise fail than others swoop in to snare either the fallen firm’s assets or market share or both. This is how humans repair the hive.

See the entire article here: http://www.smartmoney.com/smartmoney-magazine/index.cfm?story=october2008-financial-firm&split=0