The Socialization of Losses

Joseph Stiglitz is one of the most renowned economists of our time. He once criticized the current economic system after the great recession of 2008. He said that the current system is skewed in favor of the rich. This economic system is no longer capitalism. It is a strange combination of capitalism and socialism wherein profits are distributed amongst private individuals whereas losses have to be borne by taxpayers. At that time, it seemed like a one-off incident. However, since then, there have been several cases wherein losses generated by private companies had to be borne by taxpayers. This has created a situation wherein moral hazard is now the norm. In this article, we will have a closer look at the socialization of losses.

The Typical Story

The typical story involves a company which is a part of the sunshine industry of that nation. For instance, the United States is famous for having some of the best financial institutions in the world. On the other hand, India is famous for having some of the best information technology services companies.

One of the companies in these industries grows too big by taking reckless risks. For a long time, these risks pay off. Also, there is no internal mechanism of control since many of these companies are no longer run by founders. Instead, they are run by managers who are rewarded according to the profit they make. This prompts them to take even more risks. As long as the going is good, the managers make a lot of money in the form of bonuses. However, as soon problems begin to appear, the managers are the first ones to jump ship. They have better information than everyone else since they are inside the system. Also, once they are out of the company, they aren’t really responsible for the results.

Hence, by the time, the bad news becomes public, these managers are already out of the company after encashing their stock options and bonuses. This is when the market goes into a frenzy. The stocks of these companies are hammered by the market. The end result is that shareholders stand to lose a lot of wealth. Ideally, shareholders should be allowed to lose money since they are the ones responsible. However, shareholders start lobbying the government stating that if their company falls, they will not be the only one going down. Since these firms are huge in size, a lot of other banks and firms have exposure to them. Hence, the fear of a contagion runs wild in the market, and this brings stock prices to crashing lows.

In the end, the government is forced to intervene to stop the bloodshed under the guise of “protecting the small investor”. The government provides loans or equity money to these firms at a time when nobody else will. In a capitalist system, firms that make a mistake must fall and be replaced by better firms. However, in this strange hybrid system, firms which make mistakes are allowed to thrive using public money.

Examples of Socialization of Losses

  • The most obvious example of socialization of losses is the Troubled Assets Relief Program (TARP) which was launched by the United States government in the aftermath of the subprime mortgage crisis. The toxic assets were purchased by the government using taxpayer money at a time when nobody else was willing to invest.
  • During 2001, a famous Indian software company Satyam was at the center of a major stock market fraud. The valuation of the company plummeted by 83% overnight. The founder of the company was the person responsible for orchestrating the entire fraud. He had created fake revenues, fake employees and even fake fixed deposits to prop up the books. He pledged a lot of his shares at inflated prices in order to liquidate money which was then used in other businesses. In a way, he booked his profits. However, when the market came crashing down, the Indian taxpayer had to bail out Satyam. It is true that the company is self-sufficient and solvent today. However, why should the taxpayers have to bail out any company at all? If they are reckless, they should pay the price. Isn’t that the founding principle of capitalism?
  • Similarly, in 2018, the government of India is now bailing out IL&FS. IL&FS is an infrastructure company which has financial claims on many key infrastructure projects in India. However, the company has been reckless with its finances. This is the reason why it has missed coupon payments on its outstanding debt. The government of India has admitted that the board members acted recklessly to increase profits. They were also able to reap the fruits of their reckless actions. However, when the shares started dropping, the Indian government became worried that its banks have huge exposure to IL&FS. If IL&FS is allowed to fail, banks will have to write down huge amounts of loans. This will aggravate the already deteriorating situation of the Indian banking sector. Hence, to prevent contagion, the Indian government is bailing out IL&FS.

The bottom line is that the same story is playing out over and over again in different parts of the world. It is high time that the governments decided to abandon this “too big to fail” narrative. Capitalism is the best economic system known to man. However, if the rules of the game are not followed correctly, the results can be disastrous.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to and the content page url.

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