Tuesday, November 11, 2008

Transportation Whoopee

So we've talked about Obama's desire to provide cash to General Motors, and maybe the other two-thirds of the Big Three. But I wanted to figure out why, exactly, Obama wants to do this and how it might work or fail. I spoke to my friend and resident-Paul Krugman impersonator, Will, on this and got him to write a guest-post as someone with knowledge and work experience in the financial industry. I thank Will for his contribution and hope that this is the first in what will become occasional contributions from guest-bloggers to get some variety of voice, opinion, and background up in this piece.

Here is the question I asked Will:

"So why I am wronge to propose that Obama, when he takes office and assuming GM survives that long, buys stakes in one or all or some combination of the big-three, and makes the 'equity injection' dependant on some set of milestones or goals converting their stupid truck building philosophy into an intelligent super-efficient hybrid car philosophy, then paying the government back and re-acquiring their independence as they recapitalize with new cars that people will, you know, buy. I'm curious of the upside/downside on this, lemme know if you can."

Below is Will's response and a discussion of the perils of recapitalization and getting screwed, again, by stuck-in-the-mud Detroit.

1. Is GM (or any of the US automakers) important enough to save?

In general, free-market conservatives would like to let GM fail, just as they generally wanted the Wall St. firms to fail. Democrats tend to side on preserving these companies and trying to avoid systemic shocks that could send our economy in a dizzyingly unpredictable spiral. The free-market logic, like most Conservative logic, is simple: GM got itself into this position by depending on the high-margin SUV market, not following through with fuel efficient concepts, and getting their collective asses licked by Japanese efficiency and quality.

The world doesn't need GM, and their demise would allow a more nimble, innovative company to rise up (creative destruction). That sounds nice, but I think misses some major points in the macro-economy of the US. One commentator who I think shows some clarity on the issue is Phil Lebeau of CNBC (gasp!), and quick, solid argument can be found here. No matter what you think, there are people on both sides of this issue, and there was a stronger argument to save the banks than there is to save the American auto industry.

2. Is this a good investment?

So let's say that the Auto Industry should be saved. How do we do it? The thing that no one will let us forget is that the Government is playing with OUR tax dollars, which means that we demand a reasonable return on investment. If the government injects capital as equity, and takes part ownership of GM, does anything really change, or does GM just get a whole bunch more money to burn through? This is a serious concern, as GM (and the rest of them) have been burning through cash like a California wildfire this quarter. If the government takes an equity stake, how does it ensure that GM will use that capital to retool factories and designs to make more efficient cars? What if oil keeps going down and SUVs become the rage again, but GM cannot compete with other companies because the Government told them they can't.

This is a really hairy practical problem about the boundaries of government involvement in the private sector. In general you want (or don't want, in the conservative case) governments to set up boundaries and incentives and allow companies to creatively meet those requirements while maximizing profits and growth. A heavy government hand on the Board would be pretty awkward and many would argue hamper the company's ability to compete.

3. The Compensation Problem

This was a bigger deal with the bank bailouts, but it still holds with auto companies. In the markets, someone can decide to invest in GM or not invest in GM. So if GM decides to spend a lot of money on compensation, you can decide to sell the shares because you disagree with the strategy. However, if the government is involved, EVERYONE essentially has shares, and you are basically paying the executives' high salaries.

This problem is much worse politically than economically (the problems are much bigger than cutting some executive salaries), but taxpayers REALLY HATE the idea that their hard-earned money is going into the hands of CEOs who have driven their companies into the ground. Again, the government could negotiate compensation caps as a condition of financing, but it goes back to the problem of government intervention in private business. Why would a top auto executive go to GM, where he or she can only be paid X, when he or she could go to Toyota or BMW and get Paid X,XXX?

Arguably, the one thing that can get these automakers back in good shape is strong, competent leadership, and ironically, government involvement may prevent this from happening. (note: this argument is very free-market, I personally believe that great executives like great challenges and will work for less to basically become a hero and save their country, but i can't prove it . . . )

4. Classic Moral Hazard / Incentive Problem

The one from the econ textbooks is the following problem (which we've heard a lot about lately): "If the government is just going to bail them out every time they get in trouble, then why should the company ever be responsible?" When SUVs were all the rage, GM was making huge margins on them, presumably earning good bonuses, and getting strong returns for shareholders.

In the long-term they should have had a more diversified product line including more fuel efficient cars (the obvious wave of the future) that could sell even with high oil prices. It was irresponsible of management to put so much of their profitability in the SUV basket, but they did what was best for them in the immediate present (sound like the mortgage/credit crisis?). By stepping in, the government is essentially rewarding this behavior, and if the government makes strong demands for a quick turn-around (which would maximize the current value of the investment), GM could easily fall into the same set of behaviors: Find the most profitable thing right now and DO IT A BILLION TIMES. Not smart.

In my eyes, a better option would be essentially "earmarked" financing. GM could turn to the government to provide favorable loans for specific projects that are aimed at diversifying product lines and creating more fuel efficient cars and a production system that mimics Toyota's. This way GM would essentially be forced to come up with socially benevolent solutions, because it cannot survive without government infusion, but the government does not tell them HOW to achieve these goals. However, any plan that goes through (and some plan will go through) will be all about the details. Saving business is a tough business, especially when they are as screwed as the US auto industry. And the government does not have the best track record to be the great savior.

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