Let 'em Die - Why bailout GM?

The rationale behind the $700bn bailout for US Financial Institutions goes something like this: Buying distressed securities at a marked down price on favourable terms. Warren Buffett for example made a deal with Goldman Sachs in very favourable terms - not something which retail investors can make. The idea is, if the US treasury buys distressed securities at current market prices and with the low cost of borrowing that the US Govt can enjoy, and the staying power it has, its going to make money in the long run. The key thing is to buy at market. That these assets will be worth more over time is the main reason why this bailout plan does not punish the tax payers.

This is exactly the problem with a similar idea for GM. Firstly; it is unadulterated nonsense that GM's ills are a ripple effect of the collapsing US economy. Detroit has been declining for a long time now. It is true that tough economic conditions have affected sales, but it has just accelerated GM on the road to bankruptcy which it is already in. In the case of Detroit, the chance that tax payers’ money is squandered away is high. GM made the electric car first in 1996, but ultimately withdrew it. It has always been poorly managed and having this extremely short sighted view of the market. Secondly, it is also not true that the failure of the American auto firms would mean the collapse of the American auto industry. Toyota makes its cars in the US. Nissan, Honda and others have their plants all around. Lastly, there is nothing that makes buying into the big three a sound investment. To quote Ben Graham: "An investment operation is one which upon thorough analysis promises safety of principal and a satisfactory return." If we are to believe that the government is only investing the tax payer money and not squandering it away GM or other companies must satisfy criteria like having good management, sustainable earning power etc.

If it’s not a bail out but only a loan, which I assume is going to be something like that which was made to Chrysler, where do we have somebody like a Lee Iacocca? Iacocca before joining Chrysler had several successes, most notable of them being the Mustang. Are there managers with such a track record today? Look at what Carlos Ghosn has done to Nissan. Ghosn is an icon in Japan. Does the US have an answer? Where are the managers who can face reality and make better cars? Detroit has very consistently demonstrated a lack of leadership. Their answer to the superior Toyota Production System initially was that it had something to do with Japanese culture. Then they lobbied for protectionism. Japan proved them wrong by implementing the TPS right in the US. They even taught GM in the NUMMI plant.

Auto majors have not demonstrated a consistent earning power either. AIG for instance was a sound company before the financial tsunami struck, but Detroit sucked even before the meltdown. The meltdown has in fact helped GM and others hide their stupidity. GM is losing about forty dollars a share which is priced at about three dollars. GM has a minus 110% five year average return on equity. That's underperforming the industry by a 122%. Honda has a return on Equity of 13.7%. Ford has a -22.24% five year average ROE.

So, here is what the Fed is thinking if they do invest in these companies - a company with poor management, myopic vision, no earning power, falling sales, lousy cars, negative ROE etc. promises safety of principal and a satisfactory return to the tax payers' money. Where the hell is capitalism? Why should these companies be saved?

The fact is, the bailout is not going to solve the long term problems. Even an Iacocca and the Federal loan could not help Chrysler from falling now (Actually, Daimler is one of the causes behind Chrysler's ills). Probably a way out could be to do away with myopic managers, put a new management team which is advised by managers like Ghosn, and study how exactly does Detroit plan to get itself out of the mess before committing hard earned money. That they plan to do this by investing in technology, and which is why they need capital sounds a hollow claim. The benefit of new technology is eventually going to go to the customers not to the owners. Technology is necessary but not sufficient. Another way to solve this is by breaking up GM and make a distress sale of the brands like the sale of JLR and forget about American auto companies. That can actually save more jobs, and bring in a new management.

Also read: http://online.wsj.com/article/SB122688631448632421.html

Virtue and Vice Effects in Economics

There is something called as the virtue and vice effect in economics. Modern economists hardly talk of this because it doesn’t lend itself to mathematical analysis. Economists seem to have what Munger calls physics envy – a never ending quest for precision though it may be unattainable and dangerously misleading. Richard Feynman says in a BBC interview “I have approximate answers, and possible beliefs, and different degrees of certainty about different things, but I’m not absolutely sure of anything, and there are many things I don’t know anything about.” It is indeed paradoxical that while physicists can accept to live with saying “I don’t know” economists (who are quite distant from science) pursue a relentless quest for complex mathematics and accuracy and get it precisely wrong many times. They’d better be called wannabe physicists.

Munger talks about the case of a Latin American economy in which people lost their morality and stole everything. Embezzlement was rampant and the economy soon reached a state of chaos. This thing eventually got fixed. If you thought some really good economist were at work, you’re way off the tangent. This case was not even found in the annals of economics, it was in the annals of psychology. A group of clever psychologists went and fixed the problem. The cash register seems to have done much for human morality than any of the religious establishments. What it did was to create a system where stealing was impossible. A system which is hard to defraud is very essential for a good economy.

The role of the cash register was played earlier by religion. Religions instilled guilt in the minds of people. They invented and perfected guilt over the years. It was the main driver which created ethos, and a sense of right and wrong. Economic crises seem to have a close correlation to the breakdown of virtues. The problem is not that rationality takes over religion, that’s actually good. The problem actually is that ethos is essential, and we still to a large extent depend on religion to maintain that. There is a need to develop alternative systems, like the cash register to maintain a system which is tough to defraud.

Let’s perform a thought experiment here on the present economic crisis. Forget economics for a moment, and think religion. So we think of the Seven Deadly sins. First of them is envy. The housing market was booming in the US, and it was so easy to make money by borrowing without collateral, and buying a house and trading it up as the prices rose. You looked stupid when your neighbour made a killing by taking on debt. Envy was a major factor in creating the crisis in the US. Lehman made money on leverage, so AIG looked stupid and so did so many others. The whole of the American economy had so much of leverage, and leverage is unsustainable. “If a thing can’t go on forever, it will eventually stop” is a tautology worth remembering. Envy was the dominating emotion behind leverage. If not for envy, you wouldn’t have cared how much the other guy made. Leverage killed the economy, but it was envy that drove leverage.

Investment bankers were making crazy money during the boom time. There has been so much of talk about unfair compensation for investment bankers. That was a sign of avarice. The dominance of greed is well known. In his book ‘Liar’s Poker’ Michael Lewis talks about gluttony in the trading floor of a well respected trading firm Salomon Brothers. There were even feeding frenzies on Fridays. As the religious economist would expect Jesus willed bad luck to Salomon. There are several examples in history. In a book named ‘Extraordinary Popular Delusions and Madness of Crowds’, Charles Mackay talks about some of these. It is not coincidence that morality and ethos are essential to a healthy economic system.

However visible the vices may be there ought to be rational reasons for proclaiming gloom. The problem is economics is complex enough that, if you believe that things are going to be fine, and the boom will last forever, you can find enough evidence to confirm your belief. Psychologists call this the confirmation bias. We simply reject information that disconfirms our belief. Which means you just cannot find rational reason unless you say ‘I don’t know if the boom is intact, I just want to find out.’ This is very different from saying ‘I hope the boom is on and I want to prove it.’

Morality gives a completely different perspective to economics. If economists had taken the moral triggers seriously, which they evidently didn’t, they would have probably been receptive to the doomsayers. There were people like Nouriel Roubini of the New York Stern University, who in 2006 predicted the crisis affecting the whole world. The economic fraternity though was in such a state of psychological denial that Mr. Roubini was laughed at. People will now say if we had been more receptive to Prof. Roubini, we could have save $700bn, and much more to the world.

Undermining the virtue and vice effects is a problem that economists face. Though it can not give exact answers, it most certainly can provide the impetus to look for evidence in the right direction. Religion seems to be one of the greatest economic inventions of all time.