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Bailing out the car industry repeats Britain's mistake

A major reason for any kind of historical writing is to provide guidance for the present. As we read an account of the past, we may see similarities to the present and (we may hope) avoid repeating the same kinds of mistakes. In this sense historiography forms part of the collective memory of a society (which is one reason why history can be a very controversial subject). Sadly, many people lack this kind of perspective, while others who know about the past seem incapable of learning from it. Consequently, the same type of error gets repeated, often at great cost. It seems the U.S. political class, as represented by Congress and much of the commentariat, has done just that by trying to “save” the Big Three auto manufacturers. In doing this they will repeat a catastrophic series of mistakes made by British governments 30 years ago. It is worth recounting this sorry tale.

At one time British-owned auto manufacturers were world leaders. In 1952 the merger of Austin and Morris to form the British Motor Corporation (BMC) created the world’s fourth-largest producer of cars. By the 1960s, however, the British auto industry faced growing problems. The main firms had lost an increasing share of the market to foreign-owned competition both at home and abroad. The profitability of many firms was steadily declining. This reflected a number of problems, such as old-fashioned or low-quality products or those, like the iconic Mini, that were triumphs of design but whose production costs made them unprofitable. Also, the management of many firms was both incompetent and hindered by chaotic organization of production and sales. Most seriously, the industry was plagued by bad labor relations, with frequent strikes and disputes and rigid enforcement of job demarcation.

Faced with this, British governments intervened to encourage mergers and the takeover of the failing firms by the remaining successful ones. This led ultimately to almost all the remaining British-owned firms being brought into one firm in 1968 with the creation of British Leyland (BL) via a state-sponsored merger of BMC and Leyland Motor Company. The underlying problems were not addressed, however, and the labor relations and chaotic management in particular became even worse. In the early 1970s the Heath administration gave financial assistance despite having opposed aid to failing firms during the 1970 election. By 1975 British Leyland was insolvent and on the verge of going out of business.

To Nationalize or Not to Nationalize

At this point the British government had a choice. It could allow BL to go bankrupt, with many of its 40 plants closing and the remainder being sold off, or it could act to prevent this. The government decided to take the firm into public ownership. The idea was to invest several billion pounds in the firm, and several hundred million pounds were indeed put in. The taxpayers also took on most of the outstanding debt. This did not stop the losses, however. The firm (with various name changes) continued to decline while soaking up a steady stream of government money. Several parts of the business were sold off, and eventually the core (the old BMC) was sold by the government in 1988. It never made money and finally closed in 2005—during a general election. In other words, the British government (or rather the taxpayers) spent 23 years and a fortune trying to preserve an enterprise that went out of business anyway.

This was a classic case of trying to prevent the inevitable. The parts of the original firm that survived would almost certainly have done so in any event, as they were always profitable and would have found purchasers had BL been allowed to go bankrupt in 1975. Some might argue that at least jobs were preserved—for up to 30 years in some places. This is wrong for two reasons. First, the number of jobs actually preserved was quite small because there was a steady loss from 1975 onward as a succession of managements made desperate efforts to keep the ship afloat. Even more serious were the hidden costs of this bailout. All the money put into BL and its successors was capital that could have been employed profitably, creating work somewhere else. Instead it was simply wasted. The British-owned auto industry was essentially doomed by the mid-1970s. Trying to resist this did nobody any favors and simply prolonged the agony of re-adjustment to a painful and disruptive change.

Ominous Parallels

The parallels with the current position of the Big Three are not exact, but they are disturbingly close. The firms in question are also run down by a generation or more of bad management decisions, bad investments, and crippling wage, healthcare, and pension costs. It is not that auto manufacturing in America is unviable. Honda, Toyota, and others manufacture very profitably in the United States, just as Nissan does in the UK. There is nothing to suggest that giving the Big Three the massive amounts of money they want will do anything other than delay their demise and create a slow and lingering death rather than a swift one. In fact, so dire is the position of General Motors and Chrysler that even with assistance they are unlikely to survive as long as parts of British Leyland did. Meanwhile, all the money given to these firms will be money that could have been used to more effect elsewhere in the economy.

The U.S. political class is probably aware of this, even if it does not realize it will simply be repeating on a much larger scale what the British government did 30 years ago. They are motivated by two main concerns. The first is economic nationalism—the fear that if these firms and their suppliers go out of business, the United States will be weakened. The answer to this is straightforward, no matter how unpalatable it may be to nationalists: The aim of production is consumption, not national power and prestige. In the longer term policies that weaken productivity (which any diversion of capital will do) will actually reduce the power of the nation-state (if that is your main concern).

The second concern is for the many who would lose their jobs and the communities that would lose most of their employment. This comes down to an argument about whether concerns of this kind (which are serious and important) should be a matter for government action. Even if you think they should be, however, it does not follow that the right course is for Uncle Sam to support these firms financially. The example of Britain shows that the much more effective policy would be to let the firms be wound up and use the money to try to revitalize the local economy of places like Michigan. As people here in England watched the goings-on in Washington and Detroit, there was an overwhelming urge to shout, “Don’t do it!” Sadly, even if the folks in Congress had heard, I doubt they would have followed the advice of history.

Dit artikel van professor Stephen Davies van Metropolitan University verscheen ook in The Freeman. Vorige week had ik in Oxford het genoegen om van deze libertarische historicus een lezing te kunnen bijwonen bij de "Oxford Libertarian Society" in Christchurch College.

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3 Reacties:

At 17:51 Vincent De Roeck said...

David Henderson van de Monterey Naval Academy en Jeffrey Hummel van San Jose State University keren in dit artikel terug naar de kern van de crisis. Beide professoren stellen vragen bij de gemakkelijkheid waarbij Alan Greenspan als FED-tsaar geld bijdrukte en de economie/politiek met inflatoire maatregelen tegemoet bleef komen.

At 17:53 Vincent De Roeck said...

Professor Michael Heberling van Baker College doorprikt de mythe van "too big to fail" in onderstaand artikel. Heberlings essays verschijnen steeds bij het Mackinac Center in Michigan.

In March 2008 the investment banking firm Bear Sterns failed and the federal government quickly stepped in. The public was inundated with the phrase “too big to fail” (TBTF) by the financial news media. You had to go back to 1998 for the last time it was used so often. In that year the troubled hedge fund Long-Term Capital Management had $4.6 billion in losses. The Federal Reserve stepped in to orchestrate a restructuring deal to avoid bankruptcy. With this government intervention, the precedent was established for future calls for help. In 1999 Kevin Dowd, writing for the Cato Institute, stated: “[T]he intervention implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking...”

An institution is deemed “too big to fail” if its collapse would be expected to create a devastating ripple effect throughout the economy, creating a “systemic risk.” When this occurs the government is expected to provide some form of assistance. This can vary from a guaranteed loan, where management and stockholders get off scot-free (as with Chrysler in 1979), to guaranteeing the assets of a failing bank, to facilitating an outside takeover (Bear Stearns). In the event of an outside takeover thousands of employees could be shown the door and stockholders left with pennies on the dollar. Since the public only notices that it is paying the bill, it has a hard time discerning these subtle differences. As a result, the term “bailout” is used broadly to describe any form of government financial intervention to assist a crashing TBTF company or its creditors.

Too Big to be Free-Market

There are no clear guidelines on who is (or what constitutes) TBTF. As a result the “systemic risk” scare is ad hoc and apparently meant to be taken on faith. Any large company can claim it is vital to the health of the economy because its failure would have a domino effect on suppliers. Other firms can pick up the slack and even acquire the assets of the failed firm, but this is usually ignored.

TBTF is problematic because it indirectly influences how companies are managed. If there is a real, or implied, government safety net should things “head south,” management might be inclined to take on more risk for greater profit. This illustrates the concept of “moral hazard,” an insurance term. If you are insured, you may be less cautious. TBTF is actually a state of mind that afflicts the senior management of our largest corporations. If they think they are TBTF, even if they aren’t, they still behave as if they are. This is the crux of our current financial problem.

In an ideal free-market environment, entrepreneurs would be willing to take on risk based on an expected return. Since returns are never guaranteed, the entrepreneur’s willingness to take on risk is tempered by the potential downside (a loss), if things don’t pan out. While the rewards for extremely risky investments may be great, so too are the penalties. In severe cases the company could go bankrupt. As a result, this risk/reward/loss relationship in the free market would force rational behavior into the business decision-making process.

TBTF companies are no longer on their own to succeed or fail. With TBTF we now have the government in the game—not so much as another player but as a non-neutral referee ready to step in if the game gets too rough. What’s more, TBTF companies operate under a different set of rules from merely mortal ones. In 2004 Gregory Mankiw, then chairman of the President’s Council of Economic Advisers, said, “Expecting a government bailout if things go wrong creates an incentive for a company to take on risk and enjoy the associated increase in return.”

So if you are (or think that you are) TBTF, there is little or no perceived penalty to counterbalance risky behavior. With a guaranteed—or at least an implied—government safety net, the sky is the limit when it comes to risk-taking. The siren song of big returns (with little or no risk) becomes irresistible—and you no longer operate in a free-market environment. According to Thomas Sowell, “The hybrid public-and-private nature of these activities amounts to ‘privatizing profit and socializing risk’ since taxpayers get stuck with the tab when high-risk finances don’t work out.” In other words, it is a travesty to say or imply that our current crisis stems from market failure.

Mixed Signals

What makes the TBTF phenomenon so difficult to follow (and understand) is that there is no official list of “too big” companies put out by the Treasury Department. The taxpayer only finds out that a company is on the list after the company fails.

The tab to the taxpayer for bailing out Bear Stearns is $29 billion and counting. What remained of Bear Sterns’ assets, along with government guarantees, were transferred to JPMorgan Chase. The next TBTF firm to run into trouble was the investment bank Lehman Brothers Holdings Inc. Although conventional wisdom held that Lehman, with $615 billion in debt, was TBTF, this time the Fed said no.

These mixed signals about what was and what was not TBTF sent the financial markets into a tailspin. Some federal policymakers and many in the financial news media saw this as the beginning of the credit “crunch.” (In fact, while credit standards have tightened, money is still being lent for all kinds of loans.) It was no longer prudent to do business with any “troubled” bank. Since no one knew which banks the government would or would not bail out, inhibition set in.

The next TBTF firm to ask for federal help was the world’s biggest insurance company, American International Group Inc. (AIG). Not wishing to mishandle another TBTF firm, the Fed quickly agreed to lend $85 billion to AIG in September to avert bankruptcy. The following month AIG came back to the Fed asking for an additional $37.8 billion, citing liquidity problems. The Fed’s response: No problem. But are you sure $123 billion will be enough? AIG is intricately involved in America’s money-market funds. In November AIG came back and said: “On second thought, could you make that an even $150 billion?” The government response: Fine, but only on one condition, and you may find this to be exceedingly harsh. We absolutely insist that your top 70 executives not get any bonuses this year. AIG’s response: “You drive a hard bargain, but we have a deal.”

As a result of this action, the government now owns 80 percent of the company’s assets.

In September the federal government took over two more TBTF firms. The quasi-governmental Fannie Mae and Freddie Mac own or guarantee about 40 percent of the nation’s mortgages. This bailout will cost the taxpayer $200 billion. Egged on by influential members of Congress, Freddie and Fannie blatantly abused their government-sponsored-enterprise (GSE) designations, and no two firms better exemplify the “moral hazard” argument. Since they were chartered by Congress, many believed their mortgage-backed securities were guaranteed by the federal government. Then-Fed chairman Alan Greenspan told Congress in 2004: “The Federal Reserve is concerned that Fannie Mae and Freddie Mac were using this implicit reliance on a government bailout in a crisis to take more risks, in order to multiply the profitability of subsidized debt.” When housing prices started to tank we found out that this was exactly what was going on.

Bad Medicine and a Hail Mary

One would think that with all of the government oversight these TBTF events would not keep popping up. Since the government doctor has utterly failed to prevent this disease, why should we think the same government doctor suddenly knows how to cure the disease now that it has metastasized throughout the economy?

The Treasury, with the help of Congress, has thrown a $700 billion “Hail Mary” called the Troubled Asset Relief Program (TARP). Whether or not this bailout “restore[s] confidence in our financial system” (Treasury Secretary Henry Paulson) remains to be seen. Judging by the stock market, the early results are not good. Ironically, the first step of the plan was to identify publicly the banks that are really TBTF by buying their preferred stock. Nine TBTF banks, which account for 50 percent of all U.S. deposits, will get half the $250 billion earmarked for banks and thrifts. These include JPMorgan Chase, Wells Fargo, Citigroup, Bank of America (plus Merrill Lynch, which is being acquired by BoA), Goldman Sachs, New York Mellon, Morgan Stanley, and State Street. The bailout bill also includes a provision for the FDIC to offer an unlimited guarantee on bank deposits in business accounts that do not bear interest. For individual depositors, the FDIC insurance limits will increase from $100,000 to $250,000. How do these actions reduce the “moral hazard” problem? The last time the individual deposit insurance limit was raised—from $40,000 to $100,000 in 1980—we had the S&L crisis, which ended up costing the taxpayer $150 billion.

Being on the official TBTF list has its pros and cons. On the positive side, you can’t fail. The government guarantee is no longer implied. It’s real. But being on the official TBTF list has a severe downside: additional regulation. The government will be very close at hand to make sure that our biggest banks become and remain stodgy. In other words: We’re from the government and we’re here to make sure that your risk level remains in the “safe zone.” In October New York Senator Charles Schumer, a member of both the finance and banking committees, wrote Paulson demanding that “banks receiving capital eliminate their dividends, restrict executive pay and stick to safe and sustainable, rather than exotic, financial activities.” Given the makeup of the new Congress and administration, expect even more intrusive micromanaging of our financial institutions—but that is only to be expected if the Treasury becomes a stockholder. From now on innovation will be discouraged, downplayed, or slow-rolled by the government. As a result of these rescue actions, our entire financial system has effectively become nationalized.

A Troubling Cultural Shift

The most troubling aspect of the ever-increasing number of government bailouts is the subtle change overtaking the entire country. The mindset of companies and individuals today is shifting away from self-responsibility. We blame everyone else for our mistakes and look to others (the taxpayer) to come to the rescue.

When it comes to handouts and bailouts the government is no longer simply on the slippery slope—it’s in free-fall. Every bailout makes it harder to say no when the next TBTF request comes forward. Aren’t the Big Three automakers too big to fail as well? In many people’s eyes the answer is yes. At the end of September Congress approved a $25 billion low-cost loan package to help the automakers and their suppliers modernize their facilities so as to be “more green.” But this wasn’t enough. General Motors CEO Rick Wagoner, whose company was hemorrhaging cash, sought another $10 billion in federal assistance the next month to help finance the merger of GM and Chrysler. However, this request was denied. Then in November the Big Three found sympathetic ears from the big two in Congress, House Speaker Nancy Pelosi and Senate Majority Leader Harry Reid, for yet another $25 billion “bridge” loan for the Big Three. The Bush administration ultimately dished out $17.4 billion from the $700 billion TARP fund to assist GM and Chrysler. It also handed the problem of deciding the long-term future of the bailouts to the Obama administration, which had already expressed support for a bailout package. (Notably, the several profitable foreign-owned automakers with facilities in the United States weren’t looking for help.)

It shouldn’t need pointing out that the “too big to fail” doctrine fundamentally changes the nature of a market economy, which when free is a profit-and-loss system. Not only does the doctrine reward error, sloth, and inefficiency, it deprives other, more competent entrepreneurs of the scarce resources they need to serve consumers. Who knows what products and opportunities would arise if the free market, not politicians, determined who had access to capital?

At 16:26 Vincent De Roeck said...

Tip van Vincent De Roeck

Ook "The Economist" is deze week met enkele huisblogs begonnen. Ook online zullen Charlemagne, Butterwood, Lexington en Bagehot voortaan hun commentaren spuien.


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