Monday, January 19, 2009

Democracy in Action (Part II)

"No economic system can depend on the continuing wisdom of its existing leaders. A price-coordinated economy with competition in the marketplace does not have to, because those leaders can be forced to change course--or be replaced--whether because of red ink, irate stockholders, outside investors ready to take over, or because of a bankruptcy court." Thomas Sowell [1]

Unless you're a politician with access to taxpayer money, there's no free lunch--scarce items have a price. In Basic Economics: A Citizen's Guide to the Economy, Thomas Sowell defines a market economy as one coordinated by price--not government decree. Prices are signals that guide business allocation of "scarce resources with alternative uses" to produce goods and services. When the output of a business coincides with the goals of enough consumers to make a profit, the business is successful.

In a free market, if consumers signal a business that its products are too costly and reduce or stop their purchases, the business must change or die. December sales reports for the "Big Three" confirmed the worst year for vehicles sales since 1992 with sales down 31 percent at G.M., 32 percent at Ford, and 53 percent at Chrysler. Foreign automaker sales were down 37 percent at Toyota, 36 percent at BMW, and 35 percent at Honda.

The UAW, Congress, President Bush (R), and President-elect Obama (D) don't want the "Big Three" leaders to suffer the fate Sowell predicts for business leaders on a wrong course. They want you to ignore the fact that not enough people will voluntarily trade money in exchange for "Big Three" cars to keep those companies in business. Instead they've forced us all to "donate" money to the "Big Three" to prevent the corrections a market economy requires:

  • December 19, 2008: President Bush (R) approved up to $17.4 billion in loans for GM and Chrysler on the condition that they seek concessions from their lenders, creditors, and the United Automobile Workers (UAW) union to improve their competitiveness. GM said it would begin talks with its bondholders and the UAW on January 5th.
  • December 24, 2008: The Federal Reserve approved a GMAC petition to become a bank holding company on condition that GMAC bondholders convert 75 percent of its $38 billion in debt into stock and that GMAC raise more money to meet minimum capital reserve requirements. Fed approval also required GM to reduce its stake in the GMAC finance company to less than 10 percent and that GMAC majority owner, Cerberus, cut its stake in GMAC to 33 percent from 51 percent, and reduce its voting stake to less than 15 percent. GMAC was the financing subsidiary of GM and is now owned jointly by GM and Cerberus Capital Management, headed by Stephen Feinberg, which also owns Chrysler. GMAC had suffered huge losses from its mortgage lending subsidiary, Residential Capital.
  • December 29, 2008: The Treasury Department announced it had already injected $5 billion into GMAC, buying $5 billion worth of preferred equity shares in GMAC as part of a deal to meet Fed requirements for GMAC to convert into a bank holding company. So in a way that Joseph Heller would appreciate, GMAC received TARP money so it could be eligible for TARP money (TARP law pdf). As a bank holding company, GMAC can borrow more money at low rates from the Fed.

The Importance of Identifying Failure

Sowell quotes Milton Friedman on the importance of recognizing and terminating failures in a market economy:

"People often refer to an enterprise system as a profit system. This is a mistake. It is a profit and loss system, and the loss part, in my opinion, is more important than the profit part. The crucial difference is not in what ventures are undertaken. The crucial difference is in what ventures are continued and which ones are abandoned...The crucial requirement for maintaining growth and progress is that successful experiments be continued and unsuccessful experiments be terminated."[2]

Friedman says society improves when failed businesses are weeded out. Improvement doesn't come by continuing to do what causes failure. Repeating the same mistakes and expecting improvement is a kind of insanity (or just another example of "democracy" in action).

Free Market Economy

Sowell and Friedman both see price signals as conveyances of the preferences of vast numbers of people as to how they value varying uses of scarce resources. Producers use prices to help decide what to build and how much. Consumers use prices to decide what and how much to buy. In a free market economy, the arrangement is between producers and consumers:

"Prices are important because they convey information in the form of incentives. Producers cannot read consumers' minds, but when automobile manufacturers find it harder to sell station wagons at prices that cover their cost of production and easier to sell sports utility vehicles at cost-covering prices, that is all that the automobile manufacturers need to know in order to decide what to produce."[3]

When politicians get involved in the transaction, they use the force of government to subsidize, tax, or penalize businesses, overriding the goals of individuals and substituting their own. But even politicians, no matter how much they try, can't avoid the reality of prices. As a result, government intervention serves mainly to distort the information content of prices in a price-coordinated economy:

"Anything that prevents prices from expressing freely the conditions of demand or supply interferes with the transmission of accurate information."[4]

Are the problems in the car industry from too little regulation of greedy capitalists?

Friedman describing the status of the free market in India writes (pdf): "In India as in the United States, existing private entrepreneurs are in practice among the most effective enemies of free enterprise." The "Big Three" executives (or the investment bankers) working with the state to receive a bailout with taxpayer money are not capitalists, and government ownership and bailout of businesses isn't capitalism--it's corporatism, euphemistically called "planned capitalism," and also known as fascism.

Too Big to Fail?

Is government intervention necessary to save jobs?

As of December, with the taxpayer money handed out, GM was still laying off workers, just as after the Chrysler bailout of 1979, over 60,000 workers were laid off.

In 1979 the federal government intervened to save Chrysler with a $1.2 Billion loan guarantee because, according to a 1979 Time magazine article:

"...the public was demanding smaller, more fuel-efficient cars, but Chrysler, unlike GM and Ford, lacked the money to retool and redesign quickly. With smaller sales than the other two automakers, Chrysler had to spend nearly twice as much per vehicle to meet Government rules."

Frederic Bastiat's 1850 essay, "That Which is Seen and That Which is Unseen," contains a parable of the broken window, illustrating the importance of considering the unintended consequences of an act. James Hickel of the Heritage Foundation identifies consequences of the 1979 Chrysler bailout not considered by politicians at the time:

  • Federal government support helped Chrysler to eventually take market share from Ford and GM after the bailout. Ford and GM would have taken over much of the market of a bankrupt Chrysler and produced cars more efficiently, reducing the cost of domestic automobiles. Instead of two healthy domestic suppliers, there were three not so healthy companies after the bailout.
  • Current and future laid-off Ford and GM workers, whose tax dollars were being used to destroy their own jobs to save jobs at Chrysler.
  • The Chrysler bail-out squeezed $1.2 billion out of the credit market, making it difficult and more costly for small businessmen and private individuals to raise business capital or finance a mortgage on a new house, all of which would have created new jobs.

In a November 2008 NY Times article, an explanation for why the "Big Three" needed taxpayer money is the same as that in Time magazine 29 years earlier:

"...the Energy Department said late Wednesday that the auto companies would be able to apply as soon as next week for $25 billion in low-interest loans to develop more fuel-efficient vehicles."

Because Chrysler didn't solve its problems in 1979 and was not allowed to fail, Chrysler kept doing the wrong things for consumers. Now it's back, looking for taxpayer money again. And this time GM is in trouble, too.

Apparently politicians don't read Bastiat--they're doing the same thing again and we're paying for it.

United Auto Workers and OPEB

One reason the "Big Three" are in worse condition than Toyota and Honda in this economic slowdown is because of decisions made by "Big Three" management over the last 50 years to pay high employee benefits to UAW members. Allan Sloan, in a 2005 article, writes:

"The United Autoworkers placed a high value on these benefits, but the accounting rules of the time placed no cost on GM's risk of providing them. So the UAW and GM made deals that were heavy on benefits, relatively light on wages.

"Lower salaries meant that GM reported higher profits, which translated into higher stock prices -- and higher bonuses for executives. Commitments for pensions and 'other post-employment benefits' -- known as OPEB in the accounting biz -- had little initial impact on GM's profit statement and didn't count as obligations on its balance sheet. So why not keep employees happy with generous benefits?"

Ford and Chrysler were doing the same thing. Sloan continues:

"GM began its slide down the slippery slope in 1950, when it began picking up costs for medical insurance, pensions and retiree benefits. There was huge risk to GM in taking on these obligations -- but that didn't show up as a cost or balance-sheet liability."

What Sloan doesn't mention is the federal law in force in 1950: The Defense Production Act of 1950 froze wages and prices at the start of the Korean war. When prices or wages are kept artificially low, shortages result.[5] Were better benefits the only way automakers could attract the labor necessary to maintain production during the Korean war?

Sloan explains that automakers kept paying high benefits as a way to hide the costs of labor. Sowell also describes the success of unions in the second half of the 20th century as the other side of the problem:

"Here the United Auto Workers union was also very successful in getting higher pay, more job security and more favorable work rules for its members. In the long run, however, all these additional costs raised the price of automobiles and made American cars less competitive with Japanese and other imports, not only in the US, but around the world." [6]

Higher retiree benefits are costs the "Big Three" now have that their competitors do not. With rising medical costs, OPEB costs for the "Big Three" are increasing while car sales are decreasing.

Like a parasite ready to jump to a different host, Ron Gettelfinger, head of the UAW, was alongside the "Big Three" executives as they begged for money at the November/December Congressional bailout hearings. Now that the UAW sees they've squeezed all they can from the "Big Three," they've set their sights on taxpayers.

The 2008 bailout of GM and Chrysler was another shakedown of the American taxpayer. Whose free lunch will we be buying next: the steel industry, the newspaper industry (Pravda anyone), or the porn industry?

[1] Basic Economics A Citizen's Guide to the Economy, Thomas Sowell, Basic Books, New York, N.Y., 2000, p.67.

[2] Ibid. p.73.

[3] Ibid. p. 46.

[4] Free To Choose A Personal Statement, Milton and Rose Friedman, Avon Books, New York, N.Y., 1979, p.8.

[5] Sowell p. 31.

[6] Sowell p.163.

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