Thursday, Mar. 11, 2010

In Defense of Failure

It sounds like a dubious aspiration, but one of the more pressing priorities for America this decade is to preserve our cherished freedom to fail in this country. This freedom to fail may not have made it into President Franklin D. Roosevelt's famous declaration of the four freedoms that define America — it would have been bad karma on the eve of World War II — but it has long been one of the pillars of this country's exceptionalism. Call it the fifth freedom.

America allows its citizens room to fail — and if they don't succeed, to try, try again. Somewhere between two-thirds and three-quarters of all Americans report that they have considered starting their own business, whereas in Europe that number is only 40%. While the E.U. publishes documents on "overcoming the stigma of business failure," executives in Silicon Valley proudly make their bygone start-ups the centerpieces of their résumés. And when those start-ups shut down, America stands ready with corporate and personal bankruptcy systems that are the most generous in the world.

But after the financial crisis of 2008 and the recession that has followed it, many Americans are no longer feeling so exceptional. At this point, freedom to fail probably ranks right around freedom to remove your own appendix.

That's a pity, because failure is one of the most economically important tools we have. The goal shouldn't be to eliminate failure; it should be to build a system resilient enough to withstand it. Our bankruptcy system's generosity, for instance, has been convincingly linked to higher rates of entrepreneurship. Similarly, the Federal Deposit Insurance Corporation system created during the New Deal has largely put an end to the bank runs that destroyed many sound banks; all it took was simply promising depositors that they can't lose all their money. This is costly, of course. But the bank runs were worse. It's telling that countries with less generous deposit insurance, like Britain, suffered bank runs during the recent crisis and were forced to raise their insurance limits or nationalize banks.

Yet instead of celebrating all our successes in building systems that fail well, we've become wedded to the fantasy of a system that doesn't fail at all. Look at our underwhelming response to the financial crisis. Bubbles and financial crises are natural features of markets, and while there has been some real suffering on the part of millions, the truth is that as these things go, we've gotten off lightly. When financial systems fail badly, you get the Great Depression: 25% unemployment, GDP falling by about a third, life savings wiped out, livelihoods lost. Largely because we studied the failures of that era, our financial policymakers learned that a whole bunch of things didn't work — and avoided a repeat.

We should be searching for the lessons of this crisis, but we can't because we're too busy searching for bad guys. Watch a hearing held before the House Financial Services committee, and you don't see legislators absorbing sound policy advice; you see them mouthing talking points and beating up on bankers. There isn't really much evidence that the "unsafe" financial products vilified by some proponents of financial reform played a large role in the meltdown. While exotic loans certainly helped make the bubble larger, there's no reason to believe that we could have avoided it entirely. But the architects of the proposed Consumer Financial Protection Agency have made it very clear that they think they can tamp down bubbles by nudging people toward "plain vanilla" products. Many financial innovations eventually turn out to be bad ideas. But as with Edison's lightbulb filaments, the failures point the way to our successes.

And so rather than launch a quixotic war on failure, we should be using what we've learned to build a system that fails better: increasing the reserves financial institutions hold against a crisis, improving our tools for modeling system-wide risks, creating better mechanisms for winding down the operations of failed institutions without triggering a market panic, and making better provisions for the people who are hardest hit.

The real secret of our success is that we learn from the past, and then we forget it. Unfortunately, we're dangerously close to forgetting the most important lessons of our own history: how to fail gracefully and how to get back on our feet with equal grace.

McArdle is the business and economics editor at the Atlantic