General Motors and the pending car industry bail-out

The icon of US industry , General Motors, is on its death bed. After decades of mismanagement the company has finally arrived at the point where most of its cash resources seem close to exhaustion. Its bonds trade at vast discounts to their face value, and credit default swap spreads on its debt have soared. Its stock trades at levels last seen over 60 years ago, in the early 1940's, leaving the company with a minuscule $1,5 billion market capitalization (approximately). Clearly, in the financial market's estimation , the firm is only one small step away from bankruptcy.



GM 1970 - 2008 - click on chart for bigger image.

As GM itself informs us in a little propaganda brief on its web site, allowing this behemoth to fail – i.e. letting the failure that would surely be its fate in a capitalistic free market economy happen - would have the most dire economic consequences.

Breathlessly we are informed that '5,5 million jobs would be lost – 3 million in the first year, and 2,5 million in the following year'. Furthermore, 'personal income would drop by $150, 7 billion in the first year' , the 'total cost to states and municipalities would add up to $156 billion over three years' (in lost tax income, and unemployment and health care assistance).
Lastly the horror show concludes with 'domestic automobile production will more than likely fall to zero , even for international producers, due to supplier bankruptcies'.

This gathering of vast economic threats is ironically entitled 'GM Facts and Fiction, GM tells it like it is'. The above of course is meant to convey the facts, but rest assured, it is actually fiction (more on that below). GM helpfully provides links for readers of this apocalyptic tale that enable them to let 'US senators and representatives know' how important it is to throw a wagon load of tax payer money into GM's voracious maw ('let's throw good money after bad, we have no other choice').

Presumably this should be done so that GM's clearly incompetent managers can continue to merrily mismanage the company and make further losses over and above those already incurred. This is in fact what GM itself is admitting – even if it gets more funding from hapless tax cows, it will keep making losses for the foreseeable future.

So you're worried about your tax dollars being abused to keep this monstrous case of malinvested capital on artificial life support? Don't fret – 'get out the word to your friends and family and tell them how they can be a part of history too' (via badgering the politicos for hand-outs to GM). They will basically steal your hard-earned dough, but what's that compared to becoming a 'part of history'?

Unfortunately for all of us, it isn't even necessary for citizens to badger anyone. The lobbyists for the car makers, including the powerful United Autoworkers Union (which incidentally bears a great deal of responsibility for the firm's distress , as it has had a considerable hand in saddling it with the legacy costs that have contributed to its downfall) , have already seen to it that the government-in-waiting sees the light.

As Bloomberg informed us last week:

'President-elect Barack Obama is pushing Congress this year to approve as much as $50 billion to save cash-starved U.S. automakers and appoint a czar or board to oversee the companies '

So the state is supposed to not only hand the car-makers $50 billion, it is also supposed to appoint a 'czar or committee' (Bloomberg), to 'oversee the company's restructuring'. Yes, that's right, a committee of government bureaucrats is apparently just what GM needs to be better managed – though one must of course admit that doing worse than the current crew would be quite difficult, but then again we have seen what has happened at Fannie Mae and Freddie Mac since they have become wards of the state – their losses have promptly ballooned to fresh record highs.
And let's not forget, the UAW's shadow hovers over the proceedings – as Bloomberg notes: 'If the plan were to offer no strong guarantees against layoffs it would likely draw fire from unions.'

Nancy Pelosi, the democratic House Speaker, appears to have heard of GM's dire list of threats as well: 'House Speaker Nancy Pelosi called for congressional action, saying failure by one or more of the big U.S. automakers would have a ``devastating impact'' on the U.S. economy.'

GM itself meanwhile demonstrates generosity: ``We've not being prescriptive in what would be acceptable in terms of the loans,'' said GM spokesman Tony Cervone, who said he's not aware of the government's plans.
Well , let's all be relieved that the beggar isn't planning on being 'prescriptive' about the hand-out coming his way. I'm not sure we can believe it when Mr. Cervone adds he's not aware of the government's plans, since it all seems to follow a by now well-worn script.

What has suddenly induced this bout of auto industry bail-out restlessness in the Obama team? Bloomberg has the answer: ``The auto industry is too big to fail,'' said Nariman Behravesh, chief economist at IHS Global Insight Inc. in Lexington, Massachusetts. ``While the Obama administration can wait until Jan. 20 to address other matters, on this one they need to move quickly.''

and : 'A GM bankruptcy could send the U.S. jobless rate as high as 9.5 percent, up from a 14-year high of 6.5 percent in October, and produce a recession comparable in length to that of 1980-82, according to Behravesh. '
``If it does collapse, it could make the recession deeper and longer,'' he said.

In short, everyone has swallowed the GM line, as presented in its scary 'fact or fiction' pamphlet.

Now, i won't argue with the idea that the US jobless rate could go as high as 9,5%. In fact, i too expect it to do that and it's conceivable that it could go even higher. Regarding the likely length and depth of the recession, it seems likely to me that the bust of 1980-82 will look mild by comparison. The biggest credit and asset bubble of all time has burst. We must expect the fall-out to be dramatic in every respect – as it already is.

However, none of this indicates that there is a dire need to bail out ailing industries. The Behravesh conclusion that ``If it does collapse, it could make the recession deeper and longer,'' has it exactly the wrong way around – the opposite is true. Putting GM on artificial life support is what could – and probably will – make the recession deeper and longer. It simply makes no sense to support malinvested capital.

We once again have to consider that in order to support GM and other failing companies, capital must be taken away from somewhere else in the economy. There is no getting around economic truths and economic laws. Just as Obama, in spite of his youthful 'can do' aura can not suspend the law of gravity, he can not suspend the laws of economics.

When he says 'we must approve $50 billion' it does not mean that he can just shake a mythical money tree and $50 billion in capital will fall out.
He appears to have discovered the modern-day equivalent of said mythical money tree though, since Bloomberg also informs us that: 'The president-elect also wants the Federal Reserve to extend emergency loans to General Motors, Ford Motor Co. and Chrysler LLC, according to Obama aides who spoke on condition of anonymity.'

However, neither the Fed , nor the government have a hidden pool of capital somewhere. All they can do is redirect existing resources from where they are now employed to where they think they should be employed.
This is the very definition of a command economy. Instead of the free market deciding on allocation of resources and the employment of scarce capital, bureaucrats are now making these decisions. If this were the proper and most efficient way to allocate resources, we should do away with the 'capitalism' charade altogether and install a communistic system. And yet, even Messrs. Behravesh and Obama and all his advisors would probably agree that this would not be a good idea. They only seem to believe we need to have a 'little bit' of socialism, as opposed to the whole hog version.

If you want to know why, in practical terms, a GM bankruptcy would likely boost the economy rather than harm it, read the following article by John Tamny: 'Pulling Plug On GM Would Help Both Auto Industry And Michigan' (highly recommended).
Mr. Tamny correctly argues that the ineptitude of GM's management has likely harmed Michigan's economy , as capital flees the state as a result.
Meanwhile the dire predictions made by GM and others are simply untrue, as GM's assets would not disappear if the firm were to go bankrupt. On the contrary,since it is to be expected that said assets would be taken over by more capable competitors, this would finally, after decades of ineptness and mismanagement, create an opportunity to see these assets managed in a profitable and responsible manner. There would at last be a light at the end of the tunnel for Michigan's economy.

Not every car maker is running to government demanding hand-outs; this is the exclusive province of those who have mismanaged their assets in both good and bad times.
Nevertheless, all auto makers are now experiencing varying degrees of trouble. Without a doubt the sector's capacities are too large for both present and future consumer demand, and the industry is now forced to 'rightsize' both its production facilities and its car models (sales of gas-guzzlers are for instance unlikely to flourish).
It makes absolutely no sense to attempt to interfere with this process, as it is economically necessary.

For many years, an artificial credit expansion has misled car manufacturers about the expected state of consumer demand – future demand was, so to speak, pulled into the present, as too low administered interest rates sparked a credit and asset bubble, which created what the late Dr. Richebächer has so aptly dubbed 'phantom wealth'.

Nowhere has the 'phantom wealth' concept been more decisively demonstrated than in the just collapsed real estate/housing bubble. When the same houses suddenly cost 15 or 20% more nationwide within a year's time (which is to say, no special reasons for a localized increase in house values could be detected; for instance, if your neighbor were to suddenly strike oil in his garden, your house and land may conceivably become worth more for a good reason) , it does not mean that we all have become 20% richer without effort. It means a credit bubble is afoot, and we are subject to a collective inflationary illusion.

As a little aside, many supply-side economists fell prey to this illusion while it played out. For instance, the prominent supply-side spokesman Larry Kudlow often argued that the huge debt incurred by consumers and their extremely low savings rate were nothing to worry about - after all, so he held, 'wealth had increased even more', due to rising house and share prices. 'Family net wealth, the nation’s true savings rate, advanced 8 percent in 2005 to a record level of $52 trillion.' he averred as recently as 2006 in this article ( which inter alia is marred by the contradiction of his professed belief in a 'capitalist free market economy' combined with the apparently equally deeply held belief that the supply of money and credit should be centrally planned by the Federal Reserve).
Unfortunately, much of it was Richebächerian 'phantom wealth'. When asset prices increase due to monetary inflation, society as a whole does not gain in wealth – it actually loses real wealth, due to a misdirection of resources.

The auto industry is now forced to adapt to reality – as opposed to the previous illusion of prosperity. Hopefully we can all agree that if consumers for instance now demand 12 million new cars per year, it would not make much sense to produce 16 million cars. As an extension to this thought, if consumers prefer cars mad by Nissan and VW over those made by GM, we have to live with that fact as well. This makes the demands of the UAW wholly unrealistic. A decline in employment in the auto sector is unavoidable, whether or not GM and Ford get bailed out by tax payer money. The only question at hand is whether we should allow the market to decide who is best able to deploy the auto industry's capital, or whether this decision should be made by government fiat.
Keeping bad stewards of scarce capital in their jobs only makes life more difficult for those who have been prudent. By bailing out ailing firms like GM, additional damage is inflicted on all its competitors, and once again, avoiding short term pain will likely lead to far greater pain the long term.

PS: the reasons officially given for the pending GM/Ford bail-out omit an important facet to this story: GM is the by far largest issuer of junk rated debt, and the notional value of CDS written on its debt reportedly exceeds the size of the debt by a factor of 10. Even if one were to make very conservative assumptions about the net amount of cash needing to change hands should GM go bankrupt, one arrives at rather scary numbers. The Lehman and the Icelandic bank CDS auctions would look puny by comparison. The specter of cascading cross-defaults is always looming on such occasions, since not all parties to these transactions may hold sufficient reserves against them. This could therefore potentially turn into yet another financial system nightmare. Without a doubt, this is on the minds of policy makers too and an important motivating factor in the bail-out efforts. A tangled web has been weaved by nearly four decades of unfettered inflation of money and credit, and there seems to be no good way of disentangling it.