One of the reasons for the insolvency of the Detroit automakers (General Motors, Chrysler--and Ford, which appears to be insolvent too, despite its denials) is that their workers are paid higher wages, and receive much more generous benefits paid for by their employer, than the workers employed at the automobile plants, mainly in the South, owned by Toyota, Honda, and other foreign manufacturers. The total wage and benefit bill for the Detroit automakers is about $55 per hour, compared to $45 for workers in the foreign-owned plants, and the difference is plausibly ascribed to the fact that the Detroit automakers are unionized and the "foreign transplants" not. (The comparison excludes retiree benefits, a very large cost of the Detroit companies, but not an hourly labor cost.) This difference may seem small, considering that labor is only about 10 percent of the cost of making a car, but many of the workers at the companies that supply parts to the automakers (and the parts represent about 60 percent of the total cost of manufacturing the vehicle) are also represented by the United Auto Workers. Anyway, since the foreign transplants have other competitive advantages over the Detroit automakers, the latter can hardly afford to have even slightly higher labor costs.
When the auto bailout bill was being debated in Congress in November (ultimately it was voted down), Senator Corker said that he would support the bill if it conditioned the bailout on the Detroit automakers' reducing their workers' wages and benefits (to which the union would have to agree) to the level at the foreign-owned plants, as well as conform work rules to the work rules in those plants. The significance of the work rules must not be underestimated. As is common in unionized firms, the United Auto Workers has successfully negotiated not only for wages and benefits for the workers they represent but also for rules governing what tasks the workers can and cannot perform, how many workers must be assigned to a particular task, the order in which workers are to be laid off (usually it is in reverse order of seniority, because older workers tend to be stronger supporters of unionization than younger ones because the latter have better alternative employment prospects and so don't worry as much about job security) in the event of a reduction in demand for the firm's products, methods of discipline, and so forth. These work rules, collectively "featherbedding," make it difficult for a firm to optimize its use of labor, and, like the higher wages and benefits that unions obtain, add to the firm's labor costs relative to those of its nonunion competitors. A December 16 blog by Rand Simberg, http://pajamasmedia.com/blog/detroits-downturn-its-the-productivity-stupid/, presents a shocking picture of how work rules impair productivity at automobile plants at which the workers are represented by the United Auto Workers.
The goal of unions is to redistribute wealth from the owners and managers of firms, and from workers willing to work for very low wages, to the unionized workers and the union's officers. Unions do this by organizing (or threatening) strikes that impose costs on employers. For employers are rationally willing to avoid those costs at a cost (provided it is smaller) of higher wages and benefits and restrictive work rules. Because the added cost to the employer of a unionized work force is a marginal cost (a cost that varies with the output of the firm), unionization results in reduced output by the unionized firm and, in consequence, benefits nonunionized competitors. Unless those competitors are too few or too small to be able to expand output at a cost no higher than the cost to the unionized firms, unionization will gradually drive the unionized firms out of business.
Unions, in other words, are worker cartels. Workers threaten to withhold their labor unless paid more than a competitive wage (including benefits and work rules), but unless their union is able to organize all the major competitors in a market, the cartel will be eroded by the entry of nonunionized firms, which by virtue of not being unionized will have lower labor costs. The parallel to producer cartels is exact--workers are producers.
We are seeing this process of erosion of labor monopolies at work in the automobile industry. The market share of the Detroit automakers has shrunk steadily relative to that of the foreign "transplants" and with it the number of unionized auto workers--they are fewer by a third or more than they were in 1970. If the Detroit automakers will be forced to liquidate unless they can bring their labor costs down to the level of the foreign transplants, the UAW will be out of business either because the Detroit automakers liquidate or because, as a result of union concessions, the workers will no longer be getting anything in exchange for the dues they pay the union.
I don't think there's much to be said on behalf of unions, at least under current economic conditions. The redistribution of wealth that they bring about is not only fragile, for the reason just suggested, but also capricious, as it is an accident whether conditions in a particular industry are favorable or unfavorable to unionization. By driving up employers' costs, unions cause prices to increase, which harms consumers, who are not on average any better off than unionized workers are. Unions push hard for minimum wage laws and for tariffs, both being devices for reducing competition from workers, here or abroad, willing to work for lower wages. Current union hostility to immigrant workers is of a piece with the unions' former hostility to blacks and women--which is to say, to workers willing to work for a wage below the union wage. And by raising labor costs, unions accelerate the substitution of capital for labor, further depressing the demand for labor and hence average wages. Union workers, in effect, exploit nonunion workers, as well as reducing the overall efficiency of the economy. The United Auto Workers has done its part to place the Detroit auto industry on the road to ruin.
There is also a long history of union corruption (though not in the UAW). And some union activity (though again not that of the UAW) is extortionate: the union and the employer tacitly agree that as long as the employer gives the workers a wage increase slightly above the union dues, the union will leave the employer alone.
There may be, I grant, cases in which unionization reduces an employer's labor costs. If there is deep mutual antipathy between workers and employers, perhaps breaking out in violence--with strikebreakers beating up strikers and strikers beating up scabs and sit-down strikers destroying company property--there may be benefits from interposing an organization independent of the employer between employer and workers, and from creating (as the National Labor Relations Act has done) a civilized mode of resolving labor disputes. But in cases in which union organization is mutually beneficial, the employer will invite the union to organize its workers. I am sure the Detroit automakers would very much like to disinvite the United Auto Workers.
Unions do provide some services that are valuable to employers, such as grievance procedures that check arbitrary actions by supervisory employees; and union-negotiated protection of senior workers can benefit their employer by encouraging them to share their know-how with new workers, without having to fear that by doing so they will be sharing themselves out of a job. But these are measures that an employer who thinks they will reduce his labor costs can take without the presence of a union.
Micky Kaus, another blogger who is an expert on the automobile industry, attributes much of the problem with the UAW to the procedures that govern labor relations in unionized plants. "The problem...is the American adversarial labor-management negotiating system, in which reasonable people doing what the system tells them they should do wind up producing undesirable results. Just as negotiating over work assignments means factories adjust too slowly to generate continuous efficiency improvements (which often involve constantly changing work assignments) negotiating ponderous 3 year contracts (in which Gettelfinger [the UAW's president] must extract every possible concession to please the members who elected him) means contracts adjust too slowly to save the companies from failure if market conditions change...[T[he $14 wage scale for new hires [to which the UAW agreed several years ago] hasn't had an impact because nobody new is being hired by the UAW's employers, who are shrinking, not growing. The obvious alternative to cutting the pay of nonexistent future workers would be to cut the pay of existing current workers--but they are the people the system tells Gettelfinger he needs to please." www.slate.com/blogs/blogs/kausfiles/ (Dec. 26, 2008).
The unions strongly supported the Democrats in the last election and are looking for payback. I do think that there are good economic reasons for keeping the Detroit automakers out of bankruptcy until the current depression hits bottom and a recovery begins--until then the shock to the economy would be too great (see my post of November 16)--and that will keep the UAW alive for a while. But if it resists making substantial concessions to the automakers, hoping that the President and Congress will force the automakers' bondholders to make the necessary concessions or that the taxpayer will be forced to subsidize the automakers indefinitely, the union will be playing a game of chicken that may end in its destruction rather than merely in its continued shrinkage as the industry shrinks. The auto bailout is deeply unpopular with the public and the UAW's stubbornness may reinforce the impression that unions are dinosaurs slouching toward extinction.
Union members constitute a mere 7.5 percent of the private sector American labor force, only one third of its share 25 years ago. This is why the UAW is a dinosaur, a relic of times past when unions were much more important. The UAW 's membership has declined by more than one third since 1970, and its membership is still declining at a fast clip. GM had one quarter of a million UAW workers in 1994, but now has less than 75,000 workers who are members. It is rather easy to explain why in effect, the US has become a non-union private sector economy.
The rapid shift during the past several decades from manufacturing to services has been a significant contributor since the generally smaller service establishments have always been much less unionized than the larger manufacturing establishments, like steel mills and auto plants. Globalization has been crucially important in several dimensions. Increased competition from imports have undercut the higher prices charged by domestic competitors who are forced to pay large benefits to their unionized workers. In addition, if a union tries to raise worker benefits, and hence production costs, by a lot, companies often close these plants, and set up production in other countries where costs are lower. Government provision of unemployment benefits and rules about layoffs- including anti-discrimination legislation- and voluntary provision by non-union companies of health and retirement benefits, and codified rules about the treatment of employees in regards to hiring, layoffs, and discipline have greatly reduced the advantages of unions in providing such benefits.
Border and southern states discovered that they could be attractive to companies if they had more hostile environments to unions than other states. When companies like Toyota and Honda decided to set up auto factories in the US, they generally avoided states where unions were powerful, and instead mainly went to states where unions were not important. Now foreign companies produce more than one third of all cars made in the US. Much of the decline in UAW membership has been offset by the growth of non-union workers in plants owned by foreign companies. In addition, cars made abroad have been out -competing cars made domestically by GM, Ford, and Chrysler. As a result, cars made by foreign companies, whether in the US or elsewhere, now account for more than half the cars sold in this country.
These powerful forces aligned against unions imply that the UAW and other large manufacturing unions are essentially finished, perhaps unless they receive major financial and regulatory support from the federal government. This is why the AFL-CIO and Change to Win went all out to get Senator Obama elected president. Unions are said to have spent over $400 million during the presidential race, and had several hundred thousand volunteers make phone calls and house visits. They claim to have been pivotal in Obama's victories in closely contested states like Ohio and Pennsylvania. According to one poll, about 2/3 of the members of the AFL-CIO unions voted for Obama, and only 1/3 for McCain.
Unions strongly supported Obama not only because Democrats have traditionally been much more pro-union than Republicans, but also because Obama had been explicitly supportive of unions. He and Joe Biden as senators co-sponsored the so-called Employee Free Choice Act. This Act failed to muster enough votes in the present Congress, but unions have placed highest priority on its passing in the new Congress that has a much bigger Democratic majority. Such a bill would give workers the right to join a union as soon as a majority of those employed at an establishment signed cards saying they wanted a union. Under present rules, there must be an election by workers to determine whether they want a union, with votes of individual workers being secret rather than publicly expressed on cards.
Any substantial shift of federal and state governments toward pro-union regulations would harm the American economy and the position of the typical employee. As Posner indicates, unions want greater monopoly power so that they can raise the wages and other benefits of union members above their competitive levels. Unfortunately, the effects of this are to reduce earnings for non-union workers, shift production outside the US, or toward states with less pro-union laws, and shift production in unionized plants away from labor and toward capital. None of these changes are beneficial to the efficiency and performance of the American economy, especially in a global environment.
Although the union leadership believes the Employee Free Choice Act and related legislation could add several million members, the good news is that they are likely to be wrong. The forces I discussed earlier that contributed to the decline of unions in the US are very powerful, they will continue to operate, and they are extremely difficult to reverse. So while pro-union federal legislation might well slow down the decline of unions in the private sector of the economy, it is highly unlikely to greatly affect the downward trend.
The recently exposed Ponzi scheme by Bernard Madoff is named after Charles Ponzi, an immigrant to the United States, who ran his swindle in 1920, based supposedly on profits from postal reply coupons. He took in a great deal of money for those days that was partly spent on high living. After less than a year he was exposed by a newspaper, and spent many years in jail before being deported back to Italy.
In a Ponzi scheme, investors in a fund typically receive good rates of return on their investments for a while because they are paid with new monies that are invested in the fund. Even when such funds do not make bad investments, or when managers do not spend a lot on themselves and their families, Ponzi funds must attract new investors at a rapid rate in order to pay good returns to prior investors. With wasted spending and bad investments, the required growth rate in new monies is even higher. Since high growth rates of new investments are hard to maintain over time, eventually Ponzi funds collapse. Then comes the day of reckoning as investors are shocked to discover that they have been duped, and have lost most or all of what they invested.
Ponzi-type swindles probably go back to Greek and Roman times Over 50 years ago I had a wealthy uncle who invested with an individual who seemed to be doing remarkably well with a secretive investment strategy: he paid high returns in the form of monthly dividends, and allowed people to withdraw their investments. My uncle not only increased his investment, but advised other family members and friends to do the same (my father was either smart or lucky enough not to do so). After a couple of years the manager vanished, and investors lost all they had given him. It turned out that he was paying these good dividends not from returns on his investments, but from the new funds he was raising- a typical Ponzi scheme. While he did not lose most of his considerable wealth, my uncle went into a year-long depression after he found out he had been "taken".
What was unusual about Madoff's swindle is that it continued for over two decades, and was the largest Ponzi scheme ever uncovered, with perhaps $50 billion lost or missing. It was also the first fully international Ponzi scheme, with investors from Europe, the Middle East, and China, as well as mainly from the US. One hedge fund, the Fairfield Greenwich Group, put over $7 billion into Madoff's fund, and encouraged others to invest in it as well. Bernard Madoff is a 70 year old apparently affable but retiring, person who did not live especially lavishly. He was very active in Jewish circles, so that, many of his investors were wealthy Jews, such as Jeffrey Katzenberg, Steven Spielberg, and Mortimer Zuckerman, and Jewish organizations, including the Eli Weisel Foundation and Yeshiva University.
The enormous scope of Madoff's swindle raises two obvious questions 1) how could this scheme go on for so long without being exposed, and 2) how could so many sophisticated individuals be taken in by a fund that provided almost no information on how it was able to achieve consistent returns of from 8-13 per cent for many years during both good and bad times?
In regard to the first question, various hedge fund managers were puzzled by how Madoff could make such consistently high returns with the information provided about what he did. Apparently, one claim was that he placed both put and call options on say the S&P 100 index. That might make money when stocks are falling rapidly, but the fund should have lost money on average during the mainly good years of the scheme's existence. One former hedge fund manager, Harry Markopolos, reported him for a decade to the SEC and also to state regulatory bodies. The SEC conducted some rather superficial investigations, but nothing much came of them-the SEC is now looking into why the swindle was not discovered much earlier. I believe this is another illustration of what has happened frequently, namely, that regulators too get caught in the hype surrounding an investor, or the economic viability of different banks.
Of course, it is well documented that after a catastrophic event, many "obvious" signs are discovered that if taken seriously could have prevented the event. For example, after 9/11 it was revealed that the FBI did not investigate carefully warnings that some major terrorist act was being planned. This was also the case with the Japanese attack on Pearl Harbor. Roberta Wohlstetter in her outstanding book, Pearl Harbor: Warning and Decision, explains why the Japanese plan to attack Pearl Harbor was not discovered despite the considerable prior intelligence about their plans for an attack.
This is also the case with the Madoff swindle, which makes it more puzzling. Why did many sophisticated individuals, funds, and other organizations entrust so much money to his management, and to management by various intermediaries, without doing any significant amount of due diligence? Part of the answer is that these individuals are not sophisticated in financial matters, and each successive set of investors assumed that previous investors had done some investigation. This led to an example of "information cascades", where private information is revealed sequentially over time to different individuals. Later participants can be badly misled if the information of earlier participants is far from accurate.
Moreover, Madoff had developed an outstanding reputation. He was a respected member of the financial community and exclusive social circles, and a former president of the Nasdaq Stock Market. He helped pioneer electronic trading of stocks, and continued this profitable stock trading business while independently building up his asset management business. He did not let everyone invest with him, so that those who were accepted felt privileged. His activities went on for so long without exposure that newer and older investors alike considered his investments to be legitimate, even if secretive. He bolstered his clients' confidence by quickly refunding investments to anyone who asked.
Stock markets are not fully efficient, and a small number of investors, such as Warren Buffet, can consistently do better than the major indices over very long time periods. However, markets are sufficiently efficient that such a record is extremely difficult to maintain. It takes very many years to establish a good investment track record that is due to skill instead of a good record due to plain luck. The numerous investors not well versed in financial matters have great difficulty appreciating that there are no magical or secretive ways to consistently beat the market. This is why when anyone asks me for advice, I recommend buying a diversified portfolio of stocks and other assets that controls risk while providing decent returns. Some money managers may be able to beat that in the long run, but it is extremely difficult to discover who they are. As a result, most investors looking for exceptional returns are likely to be taken for a ride either by charlatans, or by lucky fund managers whose luck eventually runs out.
I must be cautious in discussing the Madoff scandal because as a judge I am forbidden to make a public comment on pending or impending litigation. Madoff himself of course has been arrested, and already lawsuits have been filed against some of the "funds of funds" that steered investors' money to him. I shall proceed on the assumption that the media are correct in describing Madoff as the author of a Ponzi scheme--indeed he is reputed to have described it that way himself--but I shall treat it strictly as an assumption, a hypothesis, and not as established fact, which is for a court to determine. And I will not comment at all on the suits against the funds of funds.
It is unsurprising that a Ponzi scheme should come to light during a stock market crash. As Warren Buffet is reputed to have said, one doesn't know who is swimming naked until the tide runs out. The stock market crash would have reduced any remaining assets in Madoff's investment account at the same time that liquidity problems caused by the depression would have increased the rate of redemptions.
Madoff's scheme, as described in the media (and remember that I am not taking a position on the truth of any of the allegations that have been made against him), is not a classic Ponzi scheme. The classic scheme is a "con" in the sense of a fraud perpetrated against greedy dopes. A skillful con man uses his gift of salesmanship to inveigle people by such ludicrous pitches that only the least sophisticated, or those most blinded by greed, are conned. A typical Ponzi scheme might offer a 10 percent monthly return on investment--the very improbability that such an offer could be genuine assures that only suckers will invest and they are least likely to discover that they have been conned until the con man has made a bundle. They may never discover that they have been conned--they may be convinced by the con man that they lost their money because of a legitmate business failure. Or they may be embarrassed to complain, or even afraid to complain because they suspect that they've been involved with a criminal enterprise--what but a criminal enterprise could generate a 10 percent monthly return on one's investment? It is possible therefore that many Ponzi schemes are never reported to the authorities and hence never detected.
The strategy that has been attributed to Madoff is the opposite of that of the typical Ponzi schemer: it is to obtain investments from well-off people far more financially sophisticated than the average Ponzi victim, including genuine financial experts such as hedge fund managers and bank officials. And therefore it requires different tactics from that of the ordinary Ponzi scheme, such as offering returns only moderately above average, satisfying redemption requests promptly, turning down some would-be investors (it would be interesting to know whether there was a tendency to turn down investors who might prove nosy or suspicious), and trading on a reputation earned in a legitimate business (Madoff's business of market making). Madoff is alleged to have preyed primarily on his fellow Jews; such "affinity" frauds are common, because people are likely to be more trusting of members of their own ethnic or religious group than of outsiders and because a con man may be abler to identify and exploit the weaknesses of members of his own group than of others.
The most interesting question raised by the scandal is why though it apparently continued for decades it was never detected by the Securities and Exchange Commission, even though beginning eight years ago a money manager named Harry Markopolos began bombarding the Commission with letters accusing Madoff of operating a Ponzi scheme. (The fact that Madoff did not sue Markopolos for libel should have been another warning sign.) There are two hypotheses. One is that regulation is hopelessly inefficient, and that it should be up to investors to protect themselves as best they can against securities frauds. The SEC's budget was increased substantially in 2004 in reaction to its failure to have detected the Enron, World Com, and other financial scandals that erupted in the early years of the new century, yet it still failed to detect Madoff's scheme. The other hypothesis is that under Chairman Christopher Cox (as under the first chairman appointed by President Bush, Harvey Pitt), the SEC has been too trusting of the securities industry, as part of a general philosophy of deregulation, small government, and laissez-faire that has characterized the Bush Administration. The SEC does seem to have been asleep at the switch quite a bit of late. Just days before the collapse of Bear Stearns marked the beginning of the banking crisis, Chairman Cox said that "We have a good deal of comfort about the capital cushions at these firms at the moment." In fact most of the firms about which he was speaking--the investment banks--were teetering at the brink, and in some cases over the brink, of insolvency.
Cox's reaction to the Madoff scandal has been to blame his subordinates in the Commission, rather than to take responsibility himself. That is not an endearing reaction.
The standard governmental response to a major governmental failure is reorganization. The government wants to prove that it is doing something to prevent a repetition of the failure, and the cheapest yet most visible and dramatic way to show that it has "gotten the message" and is going to "do something" is to reorganize. Hence the creation of the Department of Homeland Security and the Directorate of National Intelligence in the wake of the 9/11 attacks. It is beginning to seem likely that there will be an ambitious reorganization of the financial regulatory system. In the course of that reorganization, the SEC may be abolished. If so, Bernard Madoff and Christopher Cox can share the credit.
We blogged on November 18 about whether the government should provide money to the U.S. auto manufacturers to keep them alive. (I was for; Becker was against.) In the short period since then, there have been important developments bearing on the issue, culminating this past Friday in the blocking by Senate Republicans of the Democrats' modest ($15 billion) auto bailout bill, and the announcement by the Bush Administration that it might, after all, agree to use part of the $700 billion financial-sector bailout to keep the U.S. auto manufacturers going until President-elect Obama takes office. So Becker and I have decided to return to the issue.
The issue has a political and an economic dimension. From a political standpoint, the current position--no bailout legislation, but possible allocation of part of the financial-sector bailout money to the domestic auto manufacturers--represents, unusually, a victory for both political parties. The Republican Senators have stood up for principle--that freedom to fail is basic to capitalism, that wages and benefits should be set by free labor markets rather than by powerful unions, which are worker cartels, that government should not manage businesses, and that government expenditures should be minimized--and for the interests of Toyota and the other foreign manufacturers that have plants in the United States; for those plants are mainly in the South, which is the stronghold of the Republican Party. By opposing an auto bailout the Republican Senators have also distanced themselves from the Bush Administration, which is at once unpopular and believed by many Republicans to have betrayed Republican small-government principles. There is a grave risk that, as I argued in my November 18 posting, a collapse of the domestic auto industry could have serious adverse consequences for the U.S. economy as a whole, which would expose the Republican Senators to criticism. But that risk is buffered by the Administration‚Äôs apparent willingness to bail out the auto industry without new legislation.
The Democrats (including the incoming administration) have scored points among their constituencies by standing up for union workers, for the ‚Äúgreening‚Äù of the automobile industry, for states in which the domestic auto industry is centered that voted Democratic in the November election (Michigan, Ohio, and Indiana), for the principle of active government, and for trying to avert a deepening of the current depression.
The bailout bill was a mess, but a harmless one, if I am right that the domestic producers should not be allowed to collapse at a time of profound and, it appears, worsening economic distress. The bill was a mess because of the conditions that it would have imposed on the industry, conditions that earned the justified ire of the Republican Senators because of its failure to lean hard on the collective bargaining agreements negotiated by the United Auto Workers, because of the divided control of the industry that the bill if enacted would have brought about--divided among the manufacturers, a federal "car czar," and intrusive congressional oversight--and because of the considerable element of fantasy in the idea that Congress plus the President can revitalize the domestic auto industry. Nowhere is it written that the United States, let alone the midwest, where the domestic auto manufacturers are centered, has a comparative advantage over other countries, or other regions of the United States, in manufacturing motor vehicles. Evidently it does not, and Congress and the President cannot change that, as Japan learned from the failure of its "industrial policy" administered by Japan‚Äôs once-admired Ministry of International Trade and Industry.
For the problem of the Detroit manufacturers is not just a matter of higher wages, to be solved by renegotiation of their collective bargaining agreements. The wage difference (actually the benefits difference--the hourly wages of the auto workers employed by the domestic manufacturers are only slightly higher than the wages of the workers employed in the U.S. plants of Toyota and other foreign manufacturers) is an important but not the decisive factor in the decline of the domestic auto industry. The difference in the wage and benefits package between employees of the domestic manufacturers and of the foreign ones in the United States has been exaggerated by treating as a part of that package the annual payments to retired workers divided by the number of hours worked annually by current workers. The money owed the retirees is a fixed cost, like any other debt. Eliminating those payments, like reducing the industry's bond debt, would improve the industry's balance sheet by reducing its fixed costs, but would not reduce the cost of making cars, or increase their quality. Merely wiping out existing debt, the main consequence of reorganization in bankruptcy, does not improve the efficiency or competitive position of the reorganized firm, which is why most reorganizations end in liquidation. What would improve the efficiency of the domestic auto manufacturers, besides reducing wages and current workers‚Äô benefits, would be jettisoning union-imposed work rules; that was part of Republican Senator Corker‚Äôs ingenious proposal (of course rejected by the union) to condition a bailout on the union‚Äôs agreeing to a reduction in the wages and benefits of the Detroit auto makers' workers to the level prevailing in the southern automobile plants of the foreign auto companies. The adoption of his proposal would have been tantamount to putting the United Auto Workers out of business--if unionized workers have the identical wages, benefits, and working conditions as nonunionized ones, why would anyone pay union dues?
I doubt that anyone in Congress or in either the outgoing or the incoming Administration really thinks that a bailout bill will place the domestic industry on the path to salvation. The conditions imposed to achieve the "reform" of the industry are window dressing. All three domestic manufacturers (yes, Ford included) are insolvent, and while they are unlikely to close down and liquidate completely if forced into bankruptcy--Americans will probably buy 10 million motor vehicles in 2009 and they are unlikely all to be made by foreign companies (the foreign share of the U.S. car market, including both imports and cars manufactured in the U.S. plants of foreign companies, is about 50 percent, though they could take up some of the slack created by the collapse of the Detroit manufacturers, since the foreign companies‚Äô sales are down too). Even with an infusion of federal money, there will be many plant closings and layoffs and many bankruptcies and liquidations of auto parts suppliers and auto dealers.
But formal declarations of bankruptcy by the domestic manufacturers would, I believe (as I argued in my November 18 posting), have a substantial added negative effect on the economy. Consumers are markedly reducing their purchases of durable goods because their savings are so depleted that they cannot, as in previous economic downturns, reallocate savings to consumption. Instead they are reallocating income from consumption to savings. The result is a downward spiral: consumers spend less, so output drops, resulting in layoffs that result in further reductions in consumption and in turn in output. The spiral will eventually bottom out, but it will bottom out at a lower level if hundreds of thousands of employees of auto manufacturers, auto parts suppliers, and auto dealers are terminated more or less all at once and consumers planning to buy a car in 2009 are scared off by the uncertainties associated with bankruptcy. (Will warranties be honored? Will parts be available? Will the dealership from which one bought a car survive? Will service standards slip? What about the car‚Äôs resale value? And should one believe the soothing assurances that bankruptcy is no big deal for the customers of the bankrupt firm, as long as it does not liquidate, when all the other soothing assurances by the government have proved unfounded?) Because motor vehicles are highly durable, it is easy to be prudent and defer replacing one‚Äôs existing vehicle until one‚Äôs economic situation clarifies.
Granted, with General Motors having publicly acknowledged hiring a leading bankruptcy lawyer to counsel it and announced that it will be shutting much of its North American operations for a period of months, there is increasing public recognition that the Detroit automobile industry is bankrupt in all but name. But I still fear the psychological effect of a formal declaration of bankruptcy at a time when many--probably most--Americans are anxious about their economic situation. Individually, consumer prudence is wise; collectively, it will exacerbate the depression.
The realistic goal of an auto-industry bailout is not to reform, revitalize, or restructure the domestic industry; it is merely to postpone its bankruptcy for a year or two, until the end of the depression is at least in sight and consumer confidence is restored to the point at which the bankruptcy of the domestic manufacturers can be taken in stride. To attain this goal does not require imposing conditions on the use that the auto manufacturers make of the bailout moneys. The conditions that the bill would have imposed and that any other form of government funding will impose are not an economic but a political necessity because of widespread anger at the incompetence of the industry; a majority of Americans oppose any bailout of the Detroit manufacturers.
At the very least, the Obama administration should be allowed to decide the fate of the companies; that argues for a modest government loan that will keep them out of bankruptcy until, say, February.
Posner gives an excellent and skeptical discussion of the negotiations over terms of the auto bailout. I am in full agreement with him except on one crucial point: I believe, as I stated in my November 18 discussion, that the big three auto companies should be allowed to go bankrupt. This sharp recession is actually a good rather than bad time for them to go bankrupt.
The global auto industry is in a deep depression, and GM, Ford, and Chrysler have been among the hardest hit. GM said that it expects to produce about 30 percent, or 250,000, fewer cars in the first quarter of 2009 than it did in the comparable quarter of 2008. It is temporarily closing about 20 North American factories in order to make these production cuts. Since they cannot sell their cars anyway because of the depression in car demand, especially for their cars, any disruptive effects bankruptcy would have on their production actually helps them adjust their production of cars to the reduced demand for these cars.
GM and the other carmakers have claimed that bankruptcy would have a particularly big effect on sales because consumers would fear that their warranties on the cars they bought could not be honored in the future. Whether this is true or not would depend on whether consumers expect these companies to emerge from bankruptcy in the future as stronger rather than weaker companies compared to a bailout. If they expect bankruptcy to lead to better labor conditions for the company and smaller debts, bankruptcy would give consumers more rather than less confidence that their warranties would be honored in the future. Furthermore, car prices would only have to fall a little to offset any fears about future warranty protection since car buyers are not willing to pay a lot for warranties.
But suppose for this and possibly other reasons, customers did reduce their demand for cars of the bankrupt American car producers. What would that mean? Presumably, they would not stop buying cars, but they would instead shift their demand toward the closest substitutes; namely, American-made cars of Toyota, Honda, Nissan, and other foreign carmakers. Their share of American made cars is over one third and rising, so bankruptcy of the big 3 might speed up this growth in their share. What that mainly means is increased employment of autoworkers in Tennessee and other states where foreign producers congregate relative to employment of autoworkers in Michigan, Ohio, and other Midwestern states where the factories of the American car producers are mainly located.
I understand the political pressures that the bailout is responding to. The UAW was an important supporter of Obama and Congressional Democrats, whereas the workers in foreign-owned plants are mainly nonunion, and tended to vote more for Republican candidates. Still, one should not confuse the politics of the situation with what is the better economic outcome for consumers, and what is the effect of bankruptcy of the big three automakers on overall American employment and unemployment.
My earlier discussion argued that in fact bankruptcy would strengthen rather than weaken the competitive position of the American automakers, especially when combined with government debtor-in-possessor financing. The bankruptcy proceedings would likely break the union contracts and reduce their pay to levels comparable to those received by American employees of foreign car manufacturers. They would also break the contracts for health payments and pension obligations, which have been significant factors in causing their financial distress. Bankruptcy would also help the companies restructure their debt so that interest payments are much lower. I do not know whether even after all this, the big three can compete effectively in the long-run market for cars--almost surely Chrysler cannot--but bankruptcy combined with management changes, especially at GM, would give them their best chance.
This is certainly true compared to the alternative proposed by the Democrats, which includes the preposterous idea to create an auto "czar" who would oversee the industry. Since when does the American approach to market structure include czars and congressional management of an industry? Such an approach is just an encouragement to the development of a chronically sick patient (American auto producers) who never gets better, and continues to rely on taxpayer support.
It is true that the bankruptcy judge has great powers as well to guide the restructuring of bankrupt companies. However, companies either eventually close down as a result of entering bankruptcy, or emerge as generally more viable companies--as happened with United Airlines and other companies in the airline industry. This is an additional reason why bankruptcy is a much better alternative to a bailout that will cost far more than $25 billion, and could continue for a long time.
I am disappointed that President Bush seems willing to use several billion dollars of the $700 billion financial rescue package to aid the auto companies after Congress could not agree on a bailout. Whatever President-elect Obama will do after taking office, the right policy for the president is to follow Congress' lead and allow American car manufacturers to restructure through bankruptcy.
For many years economists and central bankers have congratulated themselves on the remarkable stability of US economy. Since the early 1980s, inflation has been under excellent control, and business cycle fluctuations in real GDP have been modest. For example, in no year since 1955 was US average unemployment as high as 10 percent. The highest annual rate was 9.7 percent in1982 during the recession then, and the next highest was 8.5 percent during the recession related to the first oil price boom. Moreover, many economists attributed the quite high average rate growth rate of American GDP in large part to the low rate of inflation and the stability of the economy.
Stable prices and mild business cycles were in turn explained not only by the underlying strength of the American economy, but also in an important way by policies learned by the Fed and other major central banks. Inflation targeting explicitly guided the European Central Bank, the New Zealand Bank, and a number of other central banks. It was also important to the Fed. Through such targeting, central banks would raise their interest rates and tighten up access to credit when inflation exceeded say 2 per cent. Inflation has been remarkably mild for the past quarter century. Japan experienced deflation, not inflation during its stagnant 1990s.
To control real business cycles, central banks relied on formal or informal versions of generalized inflation targeting to include real output changes. In these Taylor-type rules, central banks responded not only to inflation rates, but also to slowdowns in the growth of GDP relative to what was estimated as their long-term trend values. When the growth rate slowed relative to trend, central banks would loosen up their interest rates and access to credit. They would tighten when growth rates were above trend values. By "leaning against the wind" in this fashion, steps were taken to dampen the magnitude of fluctuations in real output.
In light of the severity of the recession that the world economy is now experiencing, for example in the US, Europe, and the UK, can this widespread confidence in our knowledge of how to tame the business cycle through central bank policy be called "a Grand Illusion"? In answering this question, one does have to recognize that the Fed and other central banks learned major lessons from the Great Depression about the value of loosening its purse strings when times were bad. And no one can deny that the past 25 years was a remarkable, and perhaps unprecedented, good run for the American, British, Chinese, Indian, and the world economy.
Clearly, however, central bankers and we economists were unprepared for the magnitude of the present financial crisis, and even less for its large effects on the real economy through the drying up of credit for mortgages and business investments. This recession is still ongoing, but it appears as if it will be the most severe recession since 1982, when American unemployment peaked in some months at about 10.5 percent. One year into the recession according to the NBER dating, unemployment has reached 6.7 percent, and it is still rising at a fast pace.
Central banks, especially the Fed, did respond rather rapidly to the unfolding of the financial crisis, even before it had a large impact on the economy. The Fed employed all the weapons in its traditional arsenal, such as lowering interest rates and easing access to the discount window. It also innovated beyond traditional approaches by allowing investment banks access to its credit, and by helping to arrange for the takeover or elimination of weak investment banks, such as Bears Stern and Lehman brothers.
In contrast to the Fed, the US Treasury took a series of actions with dubious merit, including bailouts and a fiscal stimulus, that had few consistent principles. The latest as reported in the NY Times and Wall Street Journal is to use Fannie Mae and Freddie Mac to encourage banks to drop mortgages to 4.5 percent in order to raise housing prices and encourage home building. Yet Freddie and Fannie and their government guarantees contributed to the housing mess by encouraging excessive building of residential dwellings. Any effect of this proposed price ceiling on housing prices on mortgage rates would be small, but the damage to adjustments in the housing market would be major. The goal of policy should be to reduce, not increase, the power and distortions caused by these two institutions.
In any case, the Fed and Treasury's actions combined obviously were not sufficient to greatly contain the damage to the real sector. The retreat from risk has been so large that treasury bills and bonds are selling at very low interest rates, other measures of risk are way up, and lenders are reluctant to lend, even when expected rates of return on their investments are high. Not surprisingly, the confidence of central bankers and economists that we have learned how to moderate greatly the real business cycle has been shattered. It is revealing how many leading macroeconomists have been silent during the unfolding of this crisis. Perhaps the prudent approach is to go back to the drawing board before offering an interpretation of what happened, and how to combat it.
Despite the seriousness of the present crisis, we should not forget that the past quarter century has been a great period of growth and stability for most of the world. Hundreds of millions of men, women, and children were pulled out of extreme poverty in China, India, and elsewhere by the rapid growth of their economies, due in considerable measure to the steep expansion in world trade, and the stability of the world economy. Even with two years of a rather deep world recession added in, the period since the early 1980s would look good by historical standards.
True, as I argued in prior posts on our blog, additional regulations of financial institutions are desirable, and the Fed has to think deeply about how to expand its arsenal of weapons. Yet it would be a major mistake to seriously hamper a worldwide competitive market engine that has brought so many benefits to the world's population.
Macroeconomic Policy and the Current Depression‚ÄîPosner
I am not a macroeconomist, but given the strange, perhaps embarrassed silence of so many macroeconomists, mentioned by Becker, I feel less daunted by my lack of expertise than I ordinarily would be.
As Becker explains, the focus of central banks, such as the Federal Reserve Board, has been on maintaining price stability by reducing interest rates when economic growth is too sluggish and raising them when it is too fast. The first response encourages economic activity when needed and the second limits inflation. But control of interest rates cannot prevent depressions, including severe depressions. Nor can fiscal policy--government spending and taxing.
There appear to be three types of depression (why that word has been displaced by "recession" eludes me--who is supposed to be fooled by such a euphemism?). In one, the least interesting and usually the least serious, some unanticipated shock, external to the ordinary workings of the market, disrupts the market equilibrium; the oil-price surges of the early and then the late 1970s are illustrative. The second, illustrated by the depression of the early 1980s, in which unemployment exceeded 10 percent for a time during 1982, is the induced depression: the Federal Reserve Board broke what was becoming a chronic high rate of inflation by an unexpectedly steep increase in interest rates, which shocked the economy. In neither type of depression is anyone at fault, and the second was downright beneficial to the economy.
In the third and most interesting type of depression, illustrated by both the depression of the 1930s and the current depression, the cause is the bursting of an investment bubble. There was a stock market bubble in the 1920s fueled by buying stock with money loaned by banks. That was risky lending and as a result the bursting of the stock market bubble in 1929 resulted in bank insolvencies. The severity of the depression may have been due to the Federal Reserve Board's failure to bail out the banks, but the depression itself was due to the stock bubble's bursting and precipitating bank insolvencies. There was a lesser stock market bubble, in stocks of high-tech companies, in the late 1990s, but its bursting had a small effect on the economy as a whole.
The current depression is similarly the consequence, but a very grave one, of the bursting of a bubble. The bubble started in housing, but extended to commercial real estate and other sectors of the economy as well. Very low interest rates, imaginative marketing of houses (and of mortgages on houses) and other goods, and the deregulation of the banking industry spurred highly speculative investing; and the eventual bursting of the bubble, as in 1929, precipitated widespread bank insolvencies and a rapid and steep decline in the stock market, though this time the insolvencies preceded and precipitated the stock decline, rather than vice versa.
An article by Massimo Guidolin and Elizabeth A. La Jeunesse published a year ago in the Review of the St. Louis Federal Reserve Bank noted that the personal savings rate of Americans had actually turned negative, meaning that people were spending more than they were earning. And now such savings as people had, being heavily invested in the stock market, have become depleted by the drop in the stock market. As a result of their inadequate savings, people who lose their jobs or cannot sell the houses they no longer can afford are limited in their ability to reallocate savings to consumption, as they had done in previous, milder depressions. So consumption has fallen steeply, precipitating layoffs that have further reduced consumption (because the unemployed have lower incomes), creating the downward spiral that the economy finds itself in at this writing. And the timing could not be worse: during a presidential transition, with the lame-duck President seeming uninterested in and uninformed about economic matters, with economic officials whose stumbling responses to the gathering financial crisis have undermined their credibility, and with the crisis accelerating during the Christmas shopping system, which normally accounts for as much as 40 percent of annual retail sales. The buying binge financed by the heavy borrowing during the bubble have left consumers awash in consumer durables, so it is easy for them to postpone buying. Moreover, consumer durables are more durable than they used to be, so that replacement can be deferred longer than used to be possible.
If this diagnosis is correct, then the public-works expenditure program that President-elect Obama is proposing, though anathema to economic libertarians, resisted by the Bush Administration, and bound to be wasteful, as all such programs are, may be the most sensible response to the depression and one clearly superior to a tax cut. A tax cut or rebate, like the bank bailout, is unlikely, unless very large or credibly promised to be permanent, to stimulate consumption greatly; most of the money is likely to be used to rebuild savings or, in the case of the banks, to rebuild their equity cushion so that they can make loans, bound to be risky in a depressed economy, without courting bankruptcy. In other words, to stimulate economic activity the government will have to step in and ‚Äúconsume,‚Äù in lieu of reluctant or impoverished consumers by spending money on road repair and other public goods. A critical variable, however, is the length of time it will take for public-works projects actually to be begun. American government tends to be extremely sluggish.