Wednesday, February 22, 2012

Why did Solyndra fail?

This is the response to the above question that I wrote on Quora. The answer is in no shape or form my own original thoughts, although I have thought about these concepts and tried to understand them. The answer is, however, in my own words. It is a little repetitive, but that's because I wanted to make sure I got the mechanism of boom–bust cycle from the Austrian point of view across.

(Also, the reason I keep going on about tulips is because I find the subject interesting.)

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If one studies Austrian Business Cycle Theory (created by such economists as Hayek, Mises, and Murray Rothbard), one learns that boom phases of the business cycle are engendered by too much easy credit provided by cheap sources of money, like Spain robbing South America in the 15-17th centuries, or Ben Bernanke adding a few zeroes on his Excel spreadsheet. As a result of this rapid expansion of monetary supply, interest rates go down, and banks lend money more easily.

Because the interest rates go down, entrepreneurs are encouraged to invest in various long-term projects that suddenly look more profitable (since long-term borrowings are more sensitive to interest rates). The long-term projects usually include "capital-goods" industries, like steel or tractors, but can include any project with a long-term gain, like housing today or tulips in the 17th century Holland (why tulips?.. well, tulips take 7 years to appear from a seed).

This results in a malinvestment in these projects. Why malinvestment? Well, let me back-track.

Under free-market conditions, interest rate matches public's spending time preferences. So, if people want to spend not now, but in the future, they save. The increase in savings accounts leads to the banks holding more money, which they loan out more readily, lowering interest rates. The entrepreneurs, as I mentioned, then invest in long-term projects. Luckily, this matches the public's spending time preference! As the consumers decide to spend in the future, the long-term investments of the entrepreneurs lead to appearance of the future products, for which there is demand in the future.

(In addition, as the customers spend less at the restaurants and movie theaters, the resources, human and material, are freed up to be used by the long-term projects.)

But when the interest rates are lowered artificially by the Fed (or King of Spain whose gold ended up in the Bank of Amsterdam) and there is a lot of easy credit, the investments in the long-term projects are unmatched by the changes in spending preferences! The people never decided to save up now to spend more in the future. So, when the time comes for the long-term investments to reap reward, they don't.

This is why in any bust that follows a boom of malinvestment, there is usually a cluster of long-term project failures. In the 19th century, it was the railroad companies (that failed during every boom-bust cycle created by newly formed Central Banks). In the 21st century, it's housing and solar panels. In the 17th century, it was tulips. From macro-economics perspective, this cluster of failures looks like "recession" and "economy down" and "no growth", but if we realize that these businesses grew as a result of malinvestment, we will see that this recession phase is nothing but a healthy process of capital flowing from wrong targets of investment to the proper ones (as the businesses that have the consumers' custom buy up the equipment and hire the workers from the failing businesses).

In addition, if an investment fad was created (for example, the government pushing for easy housing or green projects, or a fad in tulips), this helps to create the malinvestment bubble — but what makes the bubble possible is the easy credit! (In fact, oftentimes, when the easy credit money runs out, the bubble bursts immediately, such as happened in the case of 17th-century Dutch tulipmania. Sometimes it takes years to realize that the increased supply -- for instance of houses or solar panels -- was unmatched by the demand from the populace.) This is an article by Mises in which he proves that without easy credit, no boom would be sustainable.

So, why did Solyndra fail? For the same reason the housing market failed. The government created (for political reason) new fads: housing and "green" energy. Federal Reserve (first Alan Greenspan, then Ben Bernanke) pumped the banks with the money that it created from the thin air (literally by adding zeroes to their accounts through open market operations after buying back government bonds at a price very profitable for the banks). This lowered interest rates, made the cheap credit of newly created money available for the entrepreneurs, for whom long-term investments in housing, steel... and green energy now looked profitable. But all of these investments were not matched by changing public spending time preferences (people in the early 2000s were not saving up money to spend in the late 2000s on houses and solar panels... at least not enough people to match the investments). Eventually, the bubble burst.

The banks that made bad investments in the housing market were bailed out. Solyndra and a bunch of other businesses went bankrupt.

The thing is: the fact that it failed was a good thing. It was investment of capital (from entrepreneurs and Obama) that was never matched by the customers' demand. That this capital was re-bought by the people (or was it?) who knew how to match the customers' demand is a good thing.

The fact that the banks (or car industry) were not allowed to fail, their assets being bought (and their personnel hired) by more responsible firms, was a bad thing.

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