The Impotence of the Economists, Part II

15 November 2008 at 1:18 pm Peter G. Klein 5 comments

| Peter Klein |

The financial-market bailout is one thing. While most economists, rightly in my view, strongly opposed the Paulson plan, one can at least imagine intelligent arguments for it. The proposed auto-industry bailout is something else entirely. Does any economically literate person support it? Industry bailouts are textbook examples of the fallacy of composition, taught in every Econ 101 class. When I teach it I use exactly this kind of example (bailing out Chrysler in 1980, bailing out the airline and insurance industries after 9/11, etc.). Saving the X industry simply harms the Y and Z industries, while substituting the political process for the market in determining the allocation of resrouces. And yet, here we go.

Along these lines, here are some sentences to ponder from David Yermack, writing in today’s WSJ:

In 1993, the legendary economist Michael Jensen gave his presidential address to the American Finance Association. Mr. Jensen’s presentation included a ranking of which U.S. companies had made the most money-losing investments during the decade of the 1980s. The top two companies on his list were General Motors and Ford, which between them had destroyed $110 billion in capital between 1980 and 1990, according to Mr. Jensen’s calculations.

I was a student in Mr. Jensen’s business-school class around that time, and one day he put those rankings on the board and shouted “J’accuse!” He wanted his students to understand that when a company makes money-losing investments, the cost falls upon all of society. Investment capital represents our limited stock of national savings, and when companies spend it badly, our future well-being is compromised. Mr. Jensen made his presentation more than 15 years ago, and even then it seemed obvious that the right strategy for GM would be to exit the car business, because many other companies made better vehicles at lower cost. . . .

Over the past decade, the capital destruction by GM has been breathtaking, on a greater scale than documented by Mr. Jensen for the 1980s.

5 Comments Add your own

1. brayden | 15 November 2008 at 3:26 pm

I think whether economically-literate people support the auto industry bailout depends on the conditions of the bailout. I certainly wouldn’t be in favor of just handing over money to the industry. That would be like throwing money into a wishing well. But I can imagine a plausible bailout plan that would involve/require restructuring at a massive level. The government would essentially be filling the role of an investment syndicate that is providing the capital for a restructuring and hoping to see a return.

That said, I think the timing of this auto industry bailout is unfortunate. Clearly the industry is using widespread panic as a political opportunity to get money out of the federal government. I’d like to know that officials have done sufficient due diligence before agreeing to take on a project like this.
2. Peter Klein | 15 November 2008 at 3:50 pm

Right, but if the kind of restructuring you’re describing had a decent chance of success, why would we need the government to do it? Doesn’t the fact that no private, profit-seeking investment syndicate — which would be risking its own money, not taxpayers’ money — is willing to do this, suggest that it isn’t worth doing?
3. brayden | 15 November 2008 at 6:31 pm

Perhaps, or it could be a lack of credit availability is making this too risky/expensive for private financing. I don’t know if this is the case, but it makes sense given the larger financial situation. It might also explain why these two bailouts are temporally correlated.
4. David Hoopes | 15 November 2008 at 11:51 pm

Aren’t Democrats always accusing Republicans of being the pawns of industry? I suppose the unions are really leaning on the Democrats for this.

One of the many problems with bailouts is that companies stop attempting their own solutions. Surely one of the big mistakes of the financial bailouts earlier in the year is that they led other companies to expect help too.

Oh well. Insurance, Airlines, Financial Institutions, Auto Industry….

Listened to Reagan’s 1964 speech lately? The guy seems like a prophet now.
5. Andre Sammartino | 16 November 2008 at 9:35 pm

But Brayden, it’s not like the problems of the US car indsutry have only popped up in recent months. If private equity groups (or another car maker) were confident that they could successfully restructure and revitalise these behemoths, they had several years of access to cheap capital in which to make the move… and they didn’t.

I’m sure several syndicates kicked the tyres of GM and Ford and decided what looks like a lemon and smells like a lemon probably is a lemon (to completely butcher Akerlof’s metaphor). And I am guessing that Cerberus wish they hadn’t paid $7.4b for Chrysler that drunken afternoon…