Creative Destruction and the Financial Crisis

I just read an interview with Richard Foster on the McKinsey Quarterly. In his book, Foster argues "that to endure, companies must embrace what economist Joseph Schumpeter called 'creative destruction' and change at the pace and scale of the capital markets, without losing control over current operations". Foster talks in the interview about how the market in general outperforms individual companies because most companies can't evolve as fast while still being able to focus on their operations. The cycle Foster talks about is one where entrepreneurs innovate outside the bounds of regulations (driving unusually high equity premiums), how those equity premiums draw additional people in to create a crash, and then how the government steps in after a crash to create new regulations and institutions. And then the cycle happens again. Entrepreneurs innovate outside those new regulations, etc. etc.

Here's an excerpt about the equity premium cycle:

The granddaddy of cycles in this economy is the equity premium, which is the difference between the longer-term total returns to shareholders and the supposedly risk-free debt rate. It is the premium the equity investor gets for taking the equity risk. Looking back, we can see seven great cycles. During the boom times, when the equity premium goes way too high, everybody hocks everything to get in on the game, and this creates the conditions for a crash. When the crash occurs, the politicians come in and say it was this or that person’s fault. Then they create regulatory institutions, and virtually every one of those institutions—starting with the Federal Reserve, in 1913, as a result of the crash of 1907—has been quite productive for the nation in the longer term. This includes the formation of the Securities and Exchange Commission, in 1934; the Investment Company Act, in 1940; the beginning of the end of fixed commission rates in 1970; and the Sarbanes–Oxley Act, in the early 2000s.

You can see the equity risk premium over the past 40 years in this article on Seeking Alpha and it generally follows the pattern Foster talks about.

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