What People Are Forgetting About Bailouts

Jerry Remmers recently had a guest post on TMV that summarized what is at stake in the Big Three Bailout. I think he did an excellent job of summarizing the situation, and would just say that the comments add in the important piece that bankruptcy might work in an unexpected way.

Still, I am quite conflicted about whether I personally support the bailout. I wish to take this particular opportunity to describe the key macroeconomic points that we should keep in mind but are not being talked about widely. This will kind of provide an overview of how to think about future bailouts — of which there will be many. I have a feeling that most people that read this will be absolutely shocked at what has been going on the last few months.

There are two huge pairs of business characteristics that are the fundamental drivers of the economy, and we are in historical times on each. The first pair of ideas is credit availability and solvency. I don’t think I have to waste many words describing how we are a credit driven economy, as that’s obvious. What is of more importance is that nearly all traditional approaches to downturns involve increasing the availability of credit. This is precisely what the Fed has done by lowering interest rates, and the bailout of AIG and the financial system were technically to spur credit availability. In fact, the White House and Congress are angry at banks for not increasing the amount of credit they are offering.

The problem is that we have too much debt already, and it must be paid back. Now in “normal” times (i.e. since the end of WWII) the growth of the economy has been directly tied to credit availability. The monetary policy was merely to ensure that credit did not become too cheap, as that would create too much inflation, nor too expensive as that created recessions. This is the mindset that policy makers held until recently and most of public discourse still assumes.

I would argue that at this moment of time, this is the incorrect mindset. I detailed in three long posts why I believe the amount of debt that has accumulated is so gigantic that the emphasis is not on credit availability, but solvency. Our country has become so indebted – with a lot of the debt poured into asset bubbles – that increasing the amount of credit is not working, for we can’t even be expected to pay off what we have accumulated so far.

The treasury/Fed finally accepted this within the last couple months and are now in pure panic mode. They are literally feeding hundreds of billions into the system long term (in public through the bailout bill) and over one trillion dollars through short term Fed mechanisms (much of it will continue to be rolled over so in effect they are long term). It hasn’t been discussed much in public, but the Fed is now lending at nearly a 0% interest rate (effective rate is 0.35% currently) and accepting nearly anything as collateral from the banks. I read a quip that according to statues there is nothing that prevents the Fed from taking a dead dog as collateral, and we’re almost there.

In essence, there is a transfer of hundreds of billions of dollars of bad loans directly into newly printed cash. This amazing chart demonstrates the enormity of what has recently occurred, pretty much in the dark.

While on paper the collateral is merely for loans that will be paid back, in reality it is guaranteed that the collateral is highly overvalued, but the Fed has refused FOIA requests to release what it is doing. It is uncertain whether the values they are taking are 10% less than market value or 10% of market value. Since there is no way that banks can make all that money back, they will eventually have to either default or get a reworking of terms and all that money will be directly on the taxpayer bill.

It is the reason why some people are scared that there will be hyperinflation, where inflation will reach an annual rate of 20% or more, the dollar will collapse, and effective interest rates will shoot up to 15% or more. However, in order for there to be hyperinflation it takes two to tango and that gets to my second pair of crucial concepts.

The other huge mechanism that drives the economy is consumption and how that compares to savings. I think most everyone has heard that we have had a near zero savings rate the past couple of years, the first time that has happened since the Great Depression. What has gotten less attention is that as the economy has gotten worse, consumer behavior has changed massively and at rates far faster than anyone predicted. As this chart shows there has been a huge spike in personal savings and so it’s no wonder that consumer expenditures have collapsed. [Note: the last three months seem very low and not at all what I’ve read elsewhere, or squaring with inflation/sales numbers coming out. I would assume that like most government data it is subject to wild revisions over a full year, with the greatest revision normally occurring after the next quarter. I’ve read from multiple places that said the savings rate seemed to be around 6%, so in January it will be curious to see if the last three months change].

Basically what is happening is that the government is trying to save the economy by giving tons of money to banks and businesses, but none of that is “trickling down” in the form of wages and people are suddenly rushing to save money that they “should” have been saving for the past decade, so they are not able to create the inflation (they don’t want hyperinflation, but that’s just the opinion that they’d overshoot) that they want. As this pair of posts (here and here) points out brilliantly, the market is forecasting deflation and contrary to the popular mythos, we did try to stop the Great Depression and in basically the EXACT same way we are now.

This post talks further about the eerily similar parallels between our response today and back then, and goes on to point out that, “The recapitalization of banks alone was not enough to get them to start lending, however. They didn’t have enough credit-worthy borrowers.” This is precisely the problem: people are in too much personal debt, are forced to cut back on consumption just to service their debt and save for bad times, which leads to huge collapses in demand/layoffs, etc.

In effect, what is happening is that we have been living beyond our means for far too long, and are being forced to change lifestyle whether we like it or not. The key question then becomes: how do we respond and move forward? And that is where the auto bailout and certain bailouts that are already on the horizon come in.

A lot of focus on the auto bailout seems to imply that the two options are to give them money and that will help them limp along and continue to service their benefits and create stuff, or to let them go bankrupt and either they will reorganize or go into liquidation. As discussed in the guest post, letting them go bankrupt would probably lead to massive job losses and a huge number of people put onto government social nets. However, both arguments miss a couple of crucial points.

First of all, auto demand has absolutely fallen off a cliff.

It’s not just the Big Three either, even Toyota and Honda are seeing similar decreases. The entire idea behind a government bailout of any sort is that it will prevent a company from failing that would otherwise be able to create products people would buy. If there is no demand for new autos, then how is giving them $25 billion going to help? A lot of the pro-bailout calculus doesn’t take into account that there is no free lunch, and a proper analysis would look at different scenarios of projected demand and then try to say how much the government would ultimately have to give them in order for them to survive. If the Big Three revenue falls 80% and stays there, then the government is going to have to make up the rest, and that’s money that could be used for far better things.

On the flip side, the anti-bailout people point out that not all of the jobs will be lost, as Toyota (who I believe is actually the #1 employer of US auto jobs now) and other companies will step in to fill the void. But again, these people aren’t thinking about the demand side either. There is a good chance that the other companies have too much capacity as well. I’m not sure that the worst case people are necessarily wrong about how many people’s lives would be ruined. On the other hand, a government bailout of the Big Three would by definition cut into Toyota’s business and they would be forced to cut back extensively as well. Not only would there still be tens of thousands of jobs lost, but it would be from the company that has had much more foresight. That doesn’t sound like something we want.

Now here’s where I have to sound grim for once. Take the auto industry and extend it to pretty much everything. There are nearly no parts of the economy that don’t have extreme excesses in capacity – even energy prices have collapsed as we are driving much less. In fact, some people that have gotten things right so far are saying that there could be 7-10% decrease in consumer demand over the next year. That is entering Great Depression territory folks.

This is why I am tentatively against the auto bailout. We have a gigantic number of cars already in service, and even without the Big Three we would still have plenty of capacity to make more. In the grand scheme of things, we must move beyond “the invisible hand” of the market to fix things, but we must start listening to it more when trying to design targeted interventions and social safety nets. To me that is the conservative way to approach the situation, as it is rooted in the skepticism that we can change what is already naturally in motion, but looks for areas to minimize the damage. I hope I do not come off callously or glibly as I noted seems to be a problem.

We are still talking about each bailout as it is individual and not part of the greater whole. I definitely think it’s important to calmly talk about the peculiarities of each crisis, but without a cohesive strategy we are pretty much doomed. We need to start deciding what massive, country wide steps we want to take, and the economy has a good chance of changing as much and as quickly as it did during WWII for instance. In my next post I will discuss in further detail how falling consumption is the problem to all of this, what the traditional response is and what makes us unique.