What About the Auto Industry

My friend, James, is a graphic artist and did my book design. He’s also a Socialist, but that doesn’t seem to hinder our friendship. If anything, it makes for exciting conversations. He was asking about deflation, it’s causes, and what we should do about the auto industry. I thought some of you might find our conversation interesting:

Preston: Well, regarding the auto industry, what do you expect the government to do? Bail it out? This is not the first time the auto industry has been bailed out?

James: Yea, I know.

Preston: Is the auto industry somehow of such strategic significance to America that we must defend it?

James: Well it’s manufacturing. Which means high paying jobs for people.

Preston: Well sure. But what exactly can the government do about it? I’m reminded of the comment Bill Bonner made in Financial Reckoning Day: Surviving the Soft Depression of the 21st Century regarding the hopes that America had that Alan Greenspan would be able to bailout the economy in 2002. Bill Bonner described Alan Greenspan and the Fed as being “Like a transvestite. Having all the tools needed to do the job except the essentials.” 

James: *laughs*

Preston: And really, what can the government or the Fed do? When the chips are down, businesses have to make a profit. If the businesses are unprofitable, you can throw all the money in the world at it, and the situation’s not going to change.

James: But is the industry really unprofitable?

Preston: Yes. Even in the last Greenspan inflationary boom of 2003-2007, GM did not show a profit for manufacturing cars. Instead their profit was made in the financing (GMAC) wing, and that’s obviously fallen on hard times now. When the chips are down, the combination of labor, resources, and management have to produce a product profitably on the world market or close shop. 

James: Not necessarily.

Preston: How so?

James: We could put up tariffs. 

Preston: Studies have indicated that the more protectionist societies have lived poorer compared to the societies that engage in free trade.

James: Poorer for who. 

Preston: Well, it was like what Che Guevara and what he did with Cuba. He felt that steel was a strategic industry and that Cuba needed to manufacture it domestically. They erected tariffs making foreign steel expensive and the end result was that the price of steel caused manufacturing in Cuba to suffer. The society was made poorer compared to how it would have been due to protectionist policies. 

James: But Capitalism is always focused on short term consumption. 

Preston: No it isn’t. You’re confusing the society of the last thirty years with Laissez Faire, free market Capitalism. It’s not. In a free market society, savings is a virtue. Companies and individuals save and invest and prosper. Those that borrow and spend fail, which is what we’re seeing with the auto industry. Management tended to take on large amounts of debt and engage in certain manipulation of earnings in an effort to boost short term profit at the expense of long term viability, but that’s not symptomatic of the free market system as a whole. In fact, in a free market society, the firms that allow themselves to be foolishly managed go broke and the virtuous survive. 

James: You live in the 1800s, but the world isn’t like that anymore and it’s not going to go back. 

Preston: Well I’ve studied what the thinkers were thinking back then. It makes sense to me, and it seems that their greatest fears have all been realized in our day and age. I just keep asking we can’t go back to the good ideas that seemed to work so well for us as a country. 

James: But the free market would allow for greenhouse gas emissions to run rampant. 

From there our conversation degenerated into Environmentalism. James is a good man, but he has a deeply held mistrust of the power of corporations. To him, corporations must be regulated else society will become one of the savage rich versus the many destitute and I don’t seem to be able to convince him otherwise.

Bailout Question from Bill

Bill, a relative of mine that recently got in touch with me through the internet, has started reading my blog and emailed me this question:

HELLO Preston,

    I just ordered a copy of your book. Reading your blog, I really like
your writing style so I’m sure I will enjoy the book.

    I really don’t know very much about economics, I wish I did. I took a
course in Agriculture Economics in college but about all we talked about was
the commodity market. I have been reading everything I can find here lately
about credit default swaps and collateralized dept obligations — OH MY GOD,
Did anyone think this <stuff> would really work??

    I don’t know very much but I recognize a Ponzi scheme when I see one.
How in the world did they get away with it for this long??

    I think our government does one thing better than anyone else. They
play “don’t look over there, look over here”. Every time something happens
that they don’t want to explain they use all their powers to get us looking
in a different direction. They are blaming this on sub prime loans but it
looks like we were headed like lemmings to a cliff even if the loans had
been good.

    In the 1980’s Ronald Reagan sent the Marines to Lebanon and many of
them were killed in a bombing. I remember a politician talking about the
Marines going before the bombing. He said “if they are sending them to fight
they are not sending enough, if they are sending them to die, they are
sending too many”. That always stuck with me. I seems to me that if they are
spending 700 billion to pay off bad loans they are spending to much, if
they are trying to cover the hedge funds and derivatives they are not
spending near enough. Is there enough?????? 


Bill asks a good question. Is there enough money to pay for the bailout. As with all things in our modern economy, questions involving money can be a bit confusing. The simple answer is “Yes there is enough money for the bailout” because, as Ben Bernanke has so astutely observed, “the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” So, as our illustrious central banker has pointed out, the government can simply run the printing press to generate the needed cash to pay for the bailout. Problem solved. 

Or maybe not. For one thing, $700 billion is a lot of money to pull from thin air. And since it’s a purchase from banks, it would show up to the banks as “high powered money” or money that they could then loan against. In a fractional reserve banking system, $700 billion in high powered money could be loaned out to borrowers who then deposit it back into the banking system in the form of checkbook money which can then be loaned out again. In this way, the money can be pyramided many times over. Using the reserve requirement of 10% as a guide (which I believe is the correct figure for the United States) an injection of $700 billion in high powered money would result in $7 trillion dollars of new money injected into the economy by the time all that lending was done.  As you can figure, $7 trillion is a huge wall of money to hit the economy, and it doesn’t take a genius to see that we would see runaway inflation. 

Now, were the US government to borrow the needed $700 billion, then it wouldn’t show up as high powered money so the immediate impact wouldn’t be quite so inflationary. The question is, of course, who exactly is going to loan us this money, and that’s the question few people seem to be asking. Currently the other nations of the world seem to be fighting their own problems in this economic downturn, and I’m not sure how readily they are going to want to part with $700 billion dollars of new US Government bond issues. I’m predicting that the interest rates needed to attract this kind of cash are going to be higher than the government would like.  Higher interest rates will show up in higher mortgage rates, which will further exacerbate the housing downturn. 

All of this ignores your other question as to whether the $700 billion price tag is realistic. The true answer to that is, as you already suspect, unknowable. As we say with Japan, bailing out banks that have lots of bad debts on their balance sheets tends to transform an painful collapse into a long slow death. I sincerely doubt that the $700 billion dollar price tag will be the last we see of this, but that’s assuming that we ever get that far. Raising this these funds is going to be the real test of whether our economy is allowed to suffer on a bit longer or whether we start to see an implosion of value as the dollar loses values and interest rates escalate. 

Should be interesting. I’d say that the next few months will provide you with all the education in economics that you’re going to need.