Crawl Across the Ocean

Tuesday, December 16, 2008

Bailouts

Here's a question: Under what circumstances should government provide financial assistance to firms that are facing bankruptcy and/or liquidation?

Some upsides to providing financial assistance to firms in trouble:

1) May save the government money if investments in troubled firms have greater value at a later date when the firm recovers
2) Can prevent or minimize the human toll (job loss, pension loss, etc.) from economic events outside their control
3) Prevents the loss of economic capacity caused by breaking up firms
4) May prevent wider damage, chain reactions ('too big to fail')
5) Can promote more entrepreneurial behaviour by firms that believe they may be bailed out if their gambles do not pay off

Some downsides to providing financial assistance to firms in trouble:

1) May cost the government money
2) Unfair to other market participants
3) Promotes reckless behaviour on the part of other market participants who will expect a similar rescue.
4) Allows a poorly run business to continue instead of being replaced by a better run business
5) Prevents reduction of overcapacity or over-competition in an industry

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It seems to me that the government certainly has a role to play when a large industry faces serious problems. The question, in my mind, is in deciding whether there are structural problems of such a magnitude that the best that can be done is simply to cushion the shock and inevitable decline or whether there is action that can be taken such that a government ownership stake taken as part of a financial assistance plan could be reasonably expected to turn a profit at some point within a reasonable (say 5-10 years) timeframe - in which case financial assistance that could keep the form/industry operating as a going concern would be more justifiable.

Consider the problems in the beef industry when the mad cow crisis occurred. Government could simply have ignored farmers pleas for help, but given the likely temporary nature of the situation, and the reasonable expectation that the problems in the food supply chain could be solved and that demand for Canadian beef would eventually be restored, it was only logical to provide assistance so that a temporary crisis didn't cause unnecessary human suffering and liquidate economic organizations that would likely return to viability once the crisis had passed.

Government doesn't generally take ownership stakes in farms, but they could have done so and made a profit in this case had they been so inclined.

As a second example, take the problems with GM and Chrysler. These are very large employers and a sudden, disorderly collapse of one or both these organizations could easily lead to a chain reaction collapse of other market participants such as the other auto manufacturers, parts suppliers, local governments, local service industries, and so on. Furthermore, with the threat currently posed by deflation, the demise of such large organizations could greatly accelerate the economic downturn, possibly pushing it past a tipping point from recession to depression.

Given the situation, it would be highly irresponsible for government not to at least provide enough short term funding to these firms to ensure they do not collapse while a deal is being worked on. And the government definitely needs to at least take action to minimize the potential fallout if one or both of the firms goes into bankruptcy and faces liquidation.

The trickier question, in my mind, is whether it is possible to construct a deal which meets the test I outlined above, i.e. one where the government would take an ownership stake in Chrysler and GM and could be expected to make a profit on this investment within the next 5 to 10 years.

If one believes that the only problem the automakers face is the current economic downturn, then it might be enough to simply providing enough funding so that these firms can survive this sharp downturn, and resume activity once the downturn has passed.

However, this interpretation is belied by the need for government assistance for these firms in earlier years prior to the current downturn, their weak performance relative to other automakers and the fact that capacity for auto production in North America is well above most estimates of likely demand over the foreseeable future.

This means that providing financial assistance to these firms in a manner that might see a return on that assistance likely requires a deal that eliminates some of the structural problems faced by Chrysler and GM such as high debt levels, higher cost structures, and industry overcapacity. Can such a deal be made? I'm not really sure, but I think that is the right question to ask.

Anyway, I don't envy politicians dealing with the problems in the auto industry (or any of the other industries currently struggling) - not many easy answers in this situation.

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5 Comments:

  • Declan,

    This post was entirely too thoughtful and balanced for my liking. Next time, please pick a side of the fence: either the side with blood thirsty crocodiles or the side with liquid hot magma.

    By Anonymous olaf, at 8:12 AM  

  • The biggest problem here is that the auto industry is a luxury - people will buy cars, yes; but there are many suppliers to choose from. The only angle the Big Three have been able to play, with very few exceptions, is the jingoistic route. That just hasn't been enough to convince people to buy a basic work vehicle for $50,000.

    Seriously, there's NO reason for a truck to cost more than a car, any yet...

    I think the best approach would be a series of short-term loans combined with limited financial aid: the objective being to keep people employed at skilled labour until stability, that coming from the original owners or otherwise. If private industry wants to take over the manufacturing locations and dealerships, let them. The people working in the factories will find Toyota a perfectly fine company to work for.

    By Blogger Thursday, at 12:29 PM  

  • Not to worry, we'll be back to partisan mudslinging around here before you know it.

    Thursday - Personally I think we're going to need some sort of government brokered bankruptcy deal - wouldn't be surprised if it involved selling off assets to other auto companies, but there's a lot of overcapacity so its likely some parts of the industry will simply need to be shut down.

    By Blogger Declan, at 8:36 PM  

  • Agreed. Purchasers are only going to want the best pieces, naturally enough; some of that is only going to be information, and not the physical structures themselves. Not really expecting a whole bunch of new car sales for in the next couple of years...

    Even so, if the government wishes to act as a broker for these deals, then a bone could be tossed to workers as part of the purchasing price - severance packages or contract buyouts perhaps. Either of those will help, and hopefully provide a limited safety net for some of the newly unemployed.

    Who knows? This might provide the impetus for universal medical care and stronger social structures in the States. Those things HAVE to be pushed for by businesses for them to happen, and this may get the idea through to a still-reluctant public.

    One hopes, any ways.

    By Blogger Thursday, at 1:32 PM  

  • Declan, this was nominated the Superest Post of 2008. You might want to have your readers vote in the A.S.S.P.O.T.Y. Awards.

    By Anonymous Saskboy, at 9:49 AM  

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