Motor City Meltdown

The financial crisis that began in 2007 has been persistently marked by muddled thinking and haphazard policymaking. Now, the United States Treasury is headed for a mistake of historic and catastrophic proportions by refusing to bail out America’s Big Three automakers.

Make no mistake, if Detroit’s Big Three go bankrupt, the perfect storm really will have arrived with a collapse in both the real economy and the financial sector. This threat means that the financial bailout funds authorized by Congress can legitimately be used to support the automakers. Treasury’s refusal to do so is a monumental blunder that risks a general meltdown, the consequences of which will extend far beyond America’s shores.

Proponents of a bailout for the Big Three have emphasized the enormous job losses associated with a bankruptcy scenario, including not only jobs directly provided by the automakers, but also jobs with parts suppliers, auto dealers, and in the transport and advertising industries.

These job losses will then be multiplied locally and nationally. Lost wages will reduce consumption, causing additional job cuts, while factory closures will reduce investment, hitting employment in capital goods industries. Lost incomes will also drive down tax revenues, resulting in public-sector employment cutbacks.

Moreover, the automakers are essential for closing the trade deficit, and their demise could bring another surge in imports. The automakers are also the backbone of American manufacturing, driving advances in manufacturing technology that will be needed if America is to be a world leader in the coming “green” transportation revolution. Additionally, the Big Three are vital to national security, supplying important military transportation assets. Lastly, bankruptcy will impose massive costs on the government’s Pension Benefit Guaranty Corporation (PBGC), potentially undermining its financial stability.

All of this is true. But missing from this array of arguments is the damage a bankruptcy of the Big Three would do to financial markets. In one fell swoop, the hard-won gains in stabilizing the financial system could be blown away.

The Big Three and their auto finance associates (such as GMAC) are huge debtors whose liabilities are held throughout the financial system. If they go bankrupt, the insurance industry, which is likely a large holder of these debts may quickly enter a spiral of collapse. Pension funds will also be hit, imposing further costs on corporations and households at a time when they are already financially stressed.

But the greatest damage may come from the credit default swaps (CDS) market that brought down AIG. Huge bets have undoubtedly been placed on the bonds of GM, Ford, Chrysler, and GMAC, and bankruptcy will be a CDS triggering event requiring repayment of these bonds. Moreover, a Big Three bankruptcy will bankrupt other companies, risking a cascade of financial damage as their bonds and equities fall in value and further CDS events are triggered. This is the nightmare outcome that risks replicating the Crash of 1929.

Opposition to the bailout is bringing back to the surface the worst of the conservative economic thought that got America and the world into this mess in the first place. The opposition of the Federal Reserve and Treasury to hands-on intervention meant that they were slow to understand that merely ring-fencing the commercial banks could not save the financial system. Now, they are failing to understand the financial significance of the Big Three.

Conservative animus toward trade unions is also once again on display. But it is union weakness that has caused wages to stagnate and forced America to rely on debt and asset price inflation as the engines of growth.

Another conservative accusation is that a bailout would infringe free-trade rules. But it is these rules that have fostered the trade deficits that have destabilized and undermined the American economy. The reality is that world trade would suffer far greater damage from the global economic fallout of a Big Three bankruptcy.

Lastly, conservatives have trotted out the old moral hazard story in order to argue that a bailout would turn American manufacturing into a permanent beggar of government funds. In fact, business has always lobbied Congress for favors and tax breaks, and the Lehman Brothers experience proved the foolishness of confusing parables about moral hazard with crisis management.

There are undoubtedly colossal problems in Detroit, and the bosses of the Big Three automakers could never be convicted of an excess of imagination. Economic policy has also contributed to their current condition as trade agreements and an over-valued dollar promoted auto imports, and incoherent energy and environmental policy stifled innovation.

All of this must be fixed. But sacrificing the Big Three automakers will accomplish nothing while risking a tragic economic depression.

By Thomas I. Palley

Copyright Project Syndicate, November 20, 2008

24 Responses to “Motor City Meltdown”

  1. DTownie Says:

    Amen. I believe the risks to the American economy by far trump the risk of moral hazard. Now isn’t the time to complain that these companies weren’t restructuring rapidly enough to make more fuel-efficient cars. Who needs fuel-efficient cars when the global economy is in depression and nobody is buying gas anyways.

  2. Gerald Booth Says:

    Well said!

  3. Anarcho Says:

    This is an interesting article on the UAW’s suggestion for making a small efficient car back in 1949.

    If there is to be a bailout, turn the industry into a co-operative!

    The workers, whose jobs are on the line, have a greater incentive to make the right decisions, not to mention the efficiency gains to be made by workers’ control.

    And it is hard to see how the workers could make a bigger mess than the bosses!

    Why should be funnel public money into the hands of a few capitalists when it can be used to benefit far more people and increase liberty in the workplace?

  4. evildoer Says:

    There is an easy way to convince Paulson to bail out the auto industry. All that is needed is that GMAC apply for a bank license.

  5. bena gyerek Says:

    agree with the sentiment, but pls avoid the pitfall of thinking of cds contracts as being like insurance contracts. cds are margined daily, meaning that the “insurance” payouts under cds contracts referencing the big three are already largely prefunded by margin calls because these contracts are already trading close to default levels.

    having said that, it probably is still the case that bankruptcy would cause turmoil in the cds markets (in the same way lehman’s bankruptcy did), because it would lead to another enormous spike in credit spread volatility, meaning that market participants would start hoarding cash again in anticipation of future margin calls.

  6. Ronnie Horesh Says:

    I disagree. Where do the funds for the bailout come from? Sure there will be massive benefits if all those funds are given to car-makers. But that means taking it away from someone else. There’s a lot of evidence to suggest the big three are hopeless at allocating resources efficiently. Government is supposed to help people, not corporations. If the US Government has that much loose change to throw around, give it to ordinary people…you know, those guys being thrown of jobs, or children living in poverty. Or upgrade schools, or infrastructure.

  7. deepsouthdoug Says:

    evildoer - easy way to convince Paulson is to give him GM stock options - the corrupt bastard would go for it then.

    The question is moot whether the big three are bailed out or not. There are not enough pumps to keep the USS econo-Titanic afloat. A bailout postpones the next crisis that brings on the crash a week, a month………………

  8. Rev Finley Schaef Says:

    Amen to Anarcho! We need more and more worked-owned plants — good for the economy, good for the people.

  9. anonymouse Says:

    All the economic arguments aside, it really bothers me that people keep mentioning the role of the carmarkers in building the future “green economy”, presumably by making “greener cars”. But if we really want to reduce the environmental impact of transportation, the solution is not cars that run on biodiesel or electricity or pixie dust, it’s to build cities that don’t force you to drive everywhere. Cars in any form are a tremendous waste of space, and much more part of the problem than the solution. GM’s former EMD division that made train locomotives: that’s part of the solution.

  10. M. Gaffney Says:

    Wrong. Wrong. Wrong. The bailout of the financials makes sense because for every dollar we give them we put about $7 back into the economy because of they way lending works (if we could only get them to lend the $, which was the point of the $700B). For every $25B we sink into the black hole that is GM/Ford/Chrysler we get… 3 months. And then they will be back for more. You’re entire argument (just like their CEO testimony the other week) is a “too big to fail” argument whereas it should be “here’s how we won’t continue to suck if you bail us out.” The Big 3 are far too big, have far too many similar models, too many dealerships, too much UAW baggage and have been clueless in car design for the last 10 years. Quick. Show of hands. How many of you would have wished an Aztec on your evil mother in law?

    I couldn’t help but notice your screed didn’t give ONE hint as to how the Big 3 would use any bailout money to right things. You chastise those who would blame the union wages, ignoring the fact that all of the competition of the Big 3 are making cars profitably IN THE US while the Big 3 cannot. Why not? The Big 3 are stuck with $74/hr wages vs. Toyota’s $48/hr wages. They are stuck with a ridiculous pension and health care albatross that the UAW hung around their necks while their competition is not. And yet, you somehow blame “union weakness” for the Big 3 debt level? Que? Part of their debt problem is that their companies are so poorly rated that debt has a high cost. They are poorly rated because they have unsustainable pension and health care costs and because of the mad hattery that is the “jobs bank”!

    As for closing the trade deficit, how many SUVs are they Big 3 exporting and to where? Most of their sedans are too big for Europe and Japan. They’re selling in China but they are building them in China, as they must. Is the Chinese worker getting $74/hr? I think not.

    As for the technology, the Big 3 have plenty of good technology, but they aren’t leaders in putting it into their cars. Ask the average person who has the most technologically advanced cars and they’ll give you a Japanese manufacturer, and they are correct. Who is the big “green” car seller? Toyota! Who invented their technology? Toyota! In Japan! If the Big 3 are the next Green technology leaders, what’s been stopping them as Toyota invented the Green car market here in the US? GM’s hybrids are a a sick joke. The Volt may or may not be good. I’ll believe it when I see it on a cold Michigan day.

    If the Big 3 are “too big to fail” then “Job 1″ should be getting them smaller. Much smaller, and fast.

  11. LJR Says:

    Hogwash!

  12. Danny L. McDaniel Says:

    The Big Three doesn’t need a bailout, which is the financial equal to steroids. What it does need are good policies and regulations and less dealerships, and absolutely no interference by Congress.

    First, GM and Ford could almost overnight move their entire operations off-shore to China and Europe. The have the manufacturing facilities and office space to become a truly global organization outside the borders of the United States. After all, Americans have multi-tv sets in their homes, but not one is manufactured in the States. The same scenario can be said for the GM and Ford if they choose to go this route (Chrsler is a different story). After all, what is the big attraction to Detroit, Michigan that past 40 years.

    Second, being off-shore would allow them to undercut the dreaded Asian imports, and they could do to them what the Japanese have done to the American car market since the mid-1970’s. Ruthlessly lower car prices and take back the market. Congress seems to think that automobile manufacturing is about cooperation, instead of what it realy is: economic competition and brand warfare.

    Third, they should not let Congress get involved in their operations, designs, sales, engineering, management, etc. It would be step back instead of a step forward. Does any one remember the Yugo? Enough said about government intervention.

    Danny L. McDaniel
    Lafayette, Indiana

  13. gilberto dos santos alves Says:

    sinceramente falando? não acredito que as “3 big” tenham que falir, mas que existe a necessidade de uma reformulação muito forte, não temos dúvida. Basta analisar com maior detalhamento a composição do faturamento e do lucro das montadoras, principalmente aqui no Brasil, vem da produtividade, do exercício do livre capitalismo sem as “muletas fiscais” dos governos municipais, estaduais, federal? Será que assim como os pequenas e médias empresas também conseguem utilizar estas “muletas fiscais”? Fica muito desigual a livre competição principalmente em mercados emergentes como os dos BRICs. Será que os dirigentes governamentais esqueceram dos objetivos sublimes da democracia e do livre mercado?

    Google translation of comment (Portuguese to English added by Moderator) Accuracy of translation is not verified.

    frankly speaking? I do not believe that the “big 3″ have to fail, but that there is a need for very strong, we have no doubt. Just look in greater detail the composition of turnover and profit of automakers, especially here in Brazil, comes from productivity, the exercise of free capitalism without the “crutches tax” municipal governments, state, federal? Does as well as small and medium-sized enterprises can also use these “crutches tax”? It is very unfair to free competition particularly in emerging markets such as BRICS. Does the government leaders forgot the lofty goals of democracy and free markets?

  14. Kurt Bayer Says:

    Reading Palley’s argument is the best support for the people opposing a auto bailout: too big to fail is the only argument he has. Of course, this is true and auto bankruptcy would have tremendous knock-on and knock-back effects on the US economy and financial sector.
    One could have hoped that Palley would put a little bit of blame on the automakers themselves. Is he not too lenient to only say that their CEO’s cannot be accused of too much imagination? And what is the basis for his complaint that their demise would endanger US global lead in “green transportation”? US lead..???? Yogi Berra could have argued this way.
    Any automaker bailout would have to be tied to the following conditions: reduction in US capacity, real efforts in developing less environment-damaging cars, strictly no precedence for other industrial sectors, strict implementation of environmental fleet targets, and others more.
    Any unconditional bailout would be a real hazard that - as the past Chrysler bailout history has proven - CEO’s would be encouraged to continue where they left off - and invite the next desaster down the road.

  15. when he reached one thousand spankings, where wild flowers grow, let them eat cake « inkbluesky Says:

    [...] of Mr. Ford and why he should hardly be a hero to libertarians, let’’s move on to a recent post by economist Thomas Palley, The Big Three and their auto finance associates (such as GMAC) are huge debtors whose liabilities [...]

  16. Why Barack Obama Should Bail Out Detroit « Stephen C. Rose Says:

    [...] Why Barack Obama Should Bail Out Detroit By stephencrose Thomas Palley disabuses us of the notion that not bailing out Detroit is fine and dandy. It isn’t. I assume Barack knows this and that he will be on the side of a serious bailout and rescue of the US auto industry. Make no mistake, if Detroit’s Big Three go bankrupt, the perfect storm really will have arrived with a collapse in both the real economy and the financial sector. This threat means that the financial bailout funds authorized by Congress can legitimately be used to support the automakers. Treasury’s refusal to do so is a monumental blunder that risks a general meltdown, the consequences of which will extend far beyond America’s shores. SOURCE [...]

  17. Stephen Rose Says:

    Thanks. You are right. I linked to this. I am pretty sure Barack agrees.

  18. Saving Motor City « Talking Union Says:

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  19. Ameran Says:

    There are two fundamental errors in your article, even though your view that the Big 3 must be saved is a given. Yes, despite the fact that much of the $25b or whatever they end up getting will be stolen –truthfully, or wasted - PC, in such an emergency they must have it.

    These two fundamental errors are
    1. this is really a pathetically childish game between two political elites, Administration and Congress, who feel that they, and in fact do, own the country to see who blinks first. This is especially true on the part of Congress, which in the course of the past 8 years were treated, and were, less than worms before the Administration, and did every single order, regardless, and worse than any whore ever did. For all we, the people, or the Big 3, are concerned, Congress can today pass a law giving $25b to them.
    Because in this naked robbery Paulson and his gangster buddies are right: they gave these Congress people $150b in bribe to be able to steal this $700b. You musk know the money was $850b and NOT $700b. So Paulson is saying, you already had your cut. So if you want $25b go give from your own cut or pass another bill. Which means, none of these people even have a speck of the thieves’ honor of the past.

    2. The second error is that, why on earth – and this repeated often by so many people who are supposed to be well informed, keep pushing the “bad apple” theory. It was NOT Paulson, it was NOT Bush or Cheney, but the entire ruling class, both its Democratic faction and Republican faction were in all these unrivalled acts of robbery, murder, genocide, law-breaking, torture, spying, you name it together.
    You know where I am going,

    Peace,

  20. Oliver Dreher Says:

    It is easy. Bail the auto makers out with three conditions. One, cap all industry compensation at $250,000, per person. Second, tax all corporate profits at 100%. Third and lastly, when companies make a product that is by some standard green, and meets collectively agreed upon mpg,safety,etc. then the particular division or company or product line team, will be allowed to repeal the first and second conditions.

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    [...] assuming something less than a complete collapse, costs would be devastating. And, as economist Thomas Palley has noted, industry bankruptcies would dramatically worsen the financial [...]

  22. Cornholio Says:

    I wouldn’t let these clowns wash my car let alone build one. These zombies will suck more valuable resources right down the rabbit whole. The US is broke and sooner are latter the treasury market is going to blow a gasket.

  23. M. Gaffney Says:

    Ameran says - “There are two fundamental errors in your article, even though your view that the Big 3 must be saved is a given. ”

    No. POSSIBLY “the big two”, but it is considering letting Chrysler go under an option that’s off the table in an industry that has far too much (US) car capacity? Who says there has to be 3? They sell cars at a LOSS! They need to build less numbers of better cars and make a profit doing it. I have an idea where they can get some money for them, end the ridiculous ethanol subsidy and Brazilian ethanol tariff. Better yet, end ethanol, a policy parsecs beyond stupid.

  24. steve Says:

    No bailout should ever be given because a person or government cannot play financial king. It never works and it won’t work. The more they are to fix the more harm they eventually do.