Government’s misguided attempt to end the economic cycle (DATE DE PARUTION 13 NOVEMBRE 2008)

By Robert Presser on June 18, 2009

Late last week, General Motors and Ford announced a combined third quarter loss of $7.2 billion US.  In other years, this would be considered catastrophic as an annual loss figure, but in the current economic context it was expected since new car purchasing in the US has fallen to a 25 year low with no sign of immediate recovery.  GM has put its potential acquisition of Chrysler on hold and now all three major US automakers are appealing to the US government for $25 billion in low interest loans on top of the $25 billion handout they were previously offered for retooling their product lines.  The automakers are burning through their cash at such an accelerated rate that they are projected to be out of money by mid-2009.  Should any of the big three fail, the viability of second and third tier auto parts and subassembly suppliers would be threatened, implying a wider collapse of the auto industry that would affect all auto manufacturers operating in North America.

Yes, the situation is dire – but should be big three be saved?  If support is offered to the domestic auto manufacturers, then why not to Honda, Toyota, Nissan and others who operate North American plants and contribute to the economy as well?  This is the problem with government handouts and bailouts – once one industry or firm(s) within it are offered support, where should the support stop?  The Japanese automakers are right to complain that they are being unfairly treated since they did everything right while the domestic automakers were losing market share to them – the Japanese produced better designed products with higher initial quality ratings that allowed them to gain an ever increasing share of the market.  The US manufacturers had been bleeding cash for years for a variety of reasons, the most important of which is that for a long time they produced inferior products and took their consumers for granted.  A free-market economist would argue that we should allow the US manufacturers to declare bankruptcy, shed unproductive plants and product lines, extract concessions from their workers to make the remaining plants more competitive, and in the case of GM, restructure their massive legacy health care costs.

Unfortunately, the free-market economic case is going to lose to political expediency.  With an incoming US Congress dominated by Democrats, there is no way that the new Obama administration is going to allow a major US automaker to fail in their first year in office.  Even a Chapter 11 style workout for GM will be considered unacceptable, because the stigma of a major automaker declaring bankruptcy would further erode the sagging consumer confidence levels now being recorded.  Ironically, if GM is bailed out with billions in cash without undergoing the painful restructuring that a Chapter 11 filing would allow, then the high legacy costs that got GM in trouble in the first place will all remain intact.

GM has been struggling for decades with high healthcare costs for its tens of thousands of current workers and retirees.  If GM were to go bankrupt at the same time that the Obama administration was to present comprehensive health care reform there would be an opportunity to broker a deal to transfer the future health care liabilities away from a restructured GM and into the hands of a revamped public health care sector.  Instead, saving GM today with a cash infusion will only prolong the demise of this once proud automaker, as well as create lasting distortions in the marketplace between domestic and foreign-controlled firms in the sector.

The grand attempt to thwart the economic cycle

Ever since the dawn of modern capitalist theory under Adam Smith, there has been an economic cycle of expansion and contraction.  In tough times, firms that did not plan properly, were uncompetitive or simply offering obsolete products fell by the wayside, freeing up labour and capital for the healthy firms that remained to grow and prosper under the next period of expansion.  The liberation of the capital trapped in these firms was characterized as “creative destruction” by early 20th century economist Joseph Schumpeter.  Schumpeter argued that if uncompetitive firms are prevented from dying and releasing their intellectual and capital assets into the marketplace then the future growth of the firms destined to replace them will be compromised and the creation of new wealth will be hampered.  Imagine if governments had intervened to save the horse and buggy industry at the dawn of the automotive age – would we have seen the growth of the auto industry in the 20th century, or it have been stunted and its growth retarded, resulting in a history very different than the one we know today?

Schumpeter would be very disappointed in the current behavior of our first world governments.  At the moment, we are saving the auto companies – the auto parts sector has also lined up for cash, notably in Canada where they are asking for $1 billion in loans from the Canadian government.  The question becomes, who’s next?  If our governments buy the argument that the auto sector is strategic and too big to fail, then what about the airline industry, the aircraft manufacturers, the pulp and paper industry, natural resource firms and the drug companies?  The list goes on and on.  In an attempt to thwart the economic cycle and hold off the current period of contraction, governments are going to spend hundreds of billions of dollars that we do not have to save firms that may not warrant saving.  Governments are traditionally very bad at picking winners, and that goes for whole economic sectors as well as individual firms.  It would be heresy to propose that GM be allowed to fail and that its assets should be sold to the Japanese automakers, which stand a chance of managing them to produce better products more competitively.  While this may make good policy, it makes very bad politics and would never happen.

Conservative and progressive economists will tell you that governments should try to run surpluses in good times in order to have the financial strength to invest in the economy in bad times, be that through infrastructure investment or financial incentives to consumers.  The problem with the current economic contraction is that the financial strength of the US and many European economies has already been weakened via the banking bailouts, expected to total in the trillions of dollars worldwide.   If governments go to market to sell more debt to finance multiple industry bailouts, they risk crowding healthy firms out of the market which will end up being unable to raise capital.  The result may be that healthy firms in relatively strong industries will starve for capital and die while troubled firms in weaker industries are saved by governments, all because they were better lobbyists in the corridors of power.  We will all be poorer if this happens, and evidence is that we are already on that path.

Save the consumer first!

It is popular to say that there is only one taxpayer; the corollary to that statement is that there is only one consumer.  Consumer spending represents over two-thirds of all North American economic activity and without renewed spending on their part it is not worth saving the firms that supply them with goods and services.  Another $25 billion for the auto industry is wasted money if demand for cars does not pick up; therefore, something must FIRST be done to restore consumer confidence and spending, which ultimately will lift the economic tide for all industries and begin the next cycle of expansion.

The most important bank for US consumers is not an institution – it is their houses!  The increased housing values over the past 10 years allowed consumers to refinance their credit card debt when they renewed their mortgages and also provided security to finance big-ticket items like cars, appliances, home improvement and even vacations.  John McCain was right when he proposed a plan for a direct intervention in the mortgage market to buy up mortgages in default and begin a work-out and refinancing process.  He repeatedly stated that unless home values stabilized and started to rise again then there was no hope to re-ignite economic growth.  We have seen that the bailout package for the banks allowed them to rebuild their capitalization but that the extra money has not flowed into the lending market fast enough to prevent further deterioration in home prices and consumer sentiment.  What’s worse is that the sub-prime mortgage rate re-sets are not over – there is another round of interest rate hikes coming this winter and into early 2009.   Unless a better program is created to help consumers, then industry specific bailouts will not produce economic traction since buyer’s wallets will remain closed.  If Obama is smart, he will take McCain’s plan and make it part of his economic stimulus package to be presented after he assumes office in January and he will recruit McCain to assist its passage through Congress to produce a truly bipartisan effort.

The great Canadian deficit debate

Canada is in the best shape of the G7 nations, but it is too small to engage in economic engineering to isolate itself from the turmoil in other nations, most importantly in the US.  Canada’s government is probably headed for a small deficit in fiscal 2009 of between 5 to 10 billion dollars, a pittance in relative terms since that would be the equivalent of a maximum $100 million deficit in the US, which is actually looking at a $1 trillion deficit for the same period.  Canada has also been paying down its debt and now has the lowest debt to GDP ratio in the developed world.  Therefore, Canada has the balance sheet to support one or two years of deficits to temper the effects of the international economic storm on our economy.  The question is twofold – first, will the Conservative government have the political will to admit that a deficit is coming, and secondly will they use the deficit spending prudently to protect consumers and industry from the harshest effects of the downturn?

Finance Minister Flaherty repeated that a deficit was a non-starter during the recent election campaign, but has recently softened his discourse and allowed the possibility that a deficit may result, even if it was not planned for.  The government is missing important revenue from its two percent reduction in the GST, and is having difficulty making revenue projections since our resource industry, the star of the last 10 years, is currently in trouble with declining prices.  There is going to be a political strip-tease over the next several months as the debate rages around the cabinet table over which direction to take – either cuts to spending to maintain a zero deficit, or selective initiatives to maintain economic activity.  Readers are invited to purse statements made by the Prime Minister and his Finance Minister very carefully for clues as to which philosophy will win out.  Stay tuned, your pocketbook is in play!



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