The GM bailout: economic arguments for and against government intervention

GM Bailout?

Introduction to the General Motors Bailout

No sooner had Barack Obama been elected President then House Speaker Nancy Pelosi was on NPR claiming that the most important order of business was to arrange a bailout of the Big Three U.S. automakers. This announcement came as something of a shock, given that the issue had not received much press to that point. The Bush administration had floated the industry $25 billion in 2007 and again in September of 2008, but the issue was given a new sense of urgency by Pelosi's public discussion of the issue (Langfitt, 2008). At the time, a bailout of the banking industry had already been orchestrated. This bailout was precipitated by the failure of Lehman Brothers and the last second acquisition of Washington Mutual by JP Morgan Chase. Insurer AIG was essentially nationalized, with the government taking a nearly 80% stake. This occurred because AIG was considered "too big too fail." AIG-backed securities were owned by governments and financial institutions around the world, such that if AIG failed the global financial system was at risk of collapsing (Karnitschnig, 2008).

The U.S. auto industry, however, was not subject to the same pressures. The global transportation industry was not in danger of collapse. With the possible exception of Canada and Mexico, other nations would not suffer substantial damage if the Big Three went under. The two situations seemed very different from one another, and as a result the proposed automaker bailout immediately came under fire. The controversy was exacerbated by the actions of the Big Three CEOs, who famously flew private jets to Washington DC to ask for a handout from the taxpayers (Ross & Rhee, 2008).

The automaker bailout remains a highly controversial idea. Free market advocates point out that the problems at U.S. automakers are of their own making -- poor products, high production costs and overly generous union contracts among the issues. Proponents of the bailout argue that the benefits will outweigh the costs; opponents argue that the costs are unknown because the businesses are not viable. General Motors is at the center of this controversy, with the government recently taking direct involvement in the situation, firing CEO Rick Wagoner and infusing cash as a bridge until a deal can be worked out to save the company in the long run.

This paper will examine the issue of the GM bailout. There are economic and social consequences to both bailing out GM and letting it fail. There is also the third option -- the one the government appears to be leaning towards -- of propping the company up, doing some restructuring and finding a buyer. The economic theories will be outlined and applied to the situation in an attempt to come to a conclusion about the value of bailing out General Motors. The company's situation is unlike that of bailed-out financial firms like AIG. Those companies were profitable enterprises brought down by the actions of one unit. General Motors is more of a systemic basket case. The government took an equity stake in AIG, one that it will likely be able to sell for a profit after the company has been turned around. The government is not taking an equity stake in GM, so there is no profit opportunity. These facts are at the heart of the controversy.

History

General Motors began in 1908 when a manufacturer of horse-drawn vehicles moved into automobile production. Soon Oldsmobile, Cadillac and the future Pontiac were absorbed into Buick, providing the foundation for General Motors. The company was able to grow rapidly and expanded internationally early in its life. The company prospered in the post-war era but by the 1990s competition was beginning to take its toll. For the last couple of decades, General Motors has bled market share in its core U.S. market, dropping from 33% in 1992 to 18% today (Flint, 2009). They have attempted to fill that revenue cap with improved overseas performance, opening plants in China and Brazil (GM.com, 2009).

The problems at General Motors are myriad. Their design has been so poor that they hired an outsider to help redesign their cars (Flint, 2009). They staked their growth plans in the 2000s on products like the Hummer, an anachronism that appealed to a fairly limited subset of consumers. The losses continued to mount. The last time GM turned a profit was in 2004 (MSN Moneycentral, 2009). Since then, GM has lost $80 billion (Flint, 2009). More alarming, the firm's revenues have been decreasing at a rapid pace. Revenues in 2006 were $204 billion; revenues in 2009 were 28% lower at just under $149 billion. Compounding the revenue declines, GM has seen a steady increase in its cost of goods sold over to nearly 98%. In the face of declining sales, the company has been unable to trim the fat, with selling/general/administrative expense not shrinking alongside sales (MSN Moneycentral, 2009).

As a consequence of their terrible operating performance, GM has seen a steady deterioration of its balance sheet. The current ratio, a measure of liquidity, was 1.06 in 2004. By 2008 it was 0.51 (Ibid). By the end of 2008, cash and receivables were insufficient to meet short-term obligations -- General Motors was on the very of bankruptcy.

Opponents

Opposition to the bailout comes from many corners. Taxpayer advocacy groups and libertarians decry government involvement in business on principle. Free marketeers argue that government intervention creates an economic distortion, which will ultimately lead to market failure. At the core of the economic argument is Schumpeter's theory of creative destruction. In his seminal economic work, Capitalism, Socialism and Democracy, Schumpeter (1942) argued that innovation is the process by which economic growth occurs. At times, this means that old, established technologies and companies must be destroyed, but that the net effect will be beneficial. This sentiment runs counter to the theory that the economy would be better off if GM were saved. The economic costs might be high today -- the $150 billion or more figure is not disputed -- but that in the long-run the benefits would outweigh these costs.

In a later elaboration, it was demonstrated that big business turnover specifically resulted in smaller government, stronger rule of law, less bank dependence, stronger shareholder rights and greater transparency (Fogel et al., 2008). Bailing out General Motors therefore harms the economy because it stifles growth and innovation, increases bank dependence (or in this case government dependence) and reduces shareholder rights.

The notion of government dependence is at the heart of this argument. At present the government's steps to bailout General Motors can be viewed as a short-term rational investment. However, the situation with GM is not like the situation with AIG. There is not viable, profitable business. There is only the potential for one. If the government demonstrates that it is willing to bail the company out, there is little incentive for the company to take the steps necessary to improve itself. The government is only partially willing to take those steps. It got rid of Rick Wagoner but replaced him with one of his underlings, when the real change most likely needs to be wholesale and dramatic (Flint, 2009).

Worse, bailing out GM under the rationale that it is necessary for the health of the auto industry as a whole encourages increased government dependence on the part of the entire industry. It creates a situation where an entire industry feels that the government is willing to protect its right to exist, without ever questioning its own practices. This dependence creates, in a sense, an ongoing obligation on the part of government to ensure the viability of the entire industry.

Additionally, proponents note that there is a significant benefit to sending General Motors into bankruptcy. One of the major reasons why General Motors is unprofitable is because the company's cost of labor is substantially higher than that of many competitors. This is a 'legacy' issue in that the firm has an enormous retired workforce dating from the days when automaking was labor intensive. There are more retired GM workers in America than there are active GM workers in America. Competitors such as Toyota, which only began to manufacture in the U.S. In the 1980s, enjoy labor costs as much as $20 less per hour. If GM went into bankruptcy, it could shed the legacy union contracts, giving them significantly reduced fixed costs. For the company, this is clearly the best route. Government intervention, however, indicates that the social and political damage of eliminating the union and pension benefits would be high for elected officials who must deal with the human aspects of such an eventuality.

Lastly, opponents argue that the lack of success at the automakers is of their own making. Other automobile manufacturers are struggling through the downturn, but as more successful firms they have the cash reserves to withstand the downturn. General Motors, with a string of poorly designed and poorly constructed vehicles, lost its market share fair and square. Interference by the government, it is claimed, is pointless. It delays the inevitable, just as happened with the UK auto industry in the 1970s, and as a result represents billions of taxpayers' dollars flushed away. The outcome is inevitable, regardless of government intervention, so the failure should simply be allowed to occur.

The only reason why a company that has made its own bed would receive a bailout is because of its lobbying strength. It has been shown that firms that are well-connected politically are more likely to receive bailouts (Facio et al., 2006). It is also well-known that automakers were the first in line when Obama won the election, meeting with Nancy Pelosi right away to discuss how they could be bailed out (Langfitt, 2008).

Building a Bridge

The third option for GM is to provide bridge financing that would allow the company to restructure, and potentially be sold off. Proponents -- President Obama seemingly one of them -- note that the company still has a decent market share, strong brand equity, and $148 billion in sales. Essentially, despite the heavy losses, there is value in General Motors. The plan for GM, though, is less clear than it is for Chrysler and Ford. The latter has backed away from bailouts for the time being. Chrysler is being positioned by the U.S. government to be taken over by Fiat. The present plan for GM, however, is murky. The government has agreed to provide bridge financing to cover the next 60 days of operations while the company establishes a new business plan (Jackson, 2009).

This option leverages the fact that there is conceivably some value left in General Motors, giving the company time to analyze its options. The benefit is that the catastrophic effects of failure will not be known. The bailout funds provided under this scheme are relatively low, compared with the cost of a full-scale bailout.

There is also the view that the bridge financing will get the company through the roughest time. The economic situation at present is simply not conducive to restoring profitability to an ailing automaker. The financing, however, can buy time for the economy to turn around. Given a management overhaul and some fresh ideas, GM may be able to begin launching better products and better prices within a couple of years.

There is the risk, however, that it will all be for naught. There is little likelihood that an angel investor will come to save General Motors. Most likely, the company will need to succeed on its own. The U.S. operations are weak and market share declining. The future of the company is thought to be in Europe, but that division has been drifting aimlessly for some years (Flint, 2009). Thus, there is little cause for optimism. The company may pull a rabbit out of its hat in the next sixty days (now thirty) but ultimately it will fall.

Conclusion

The fate of General Motors has been tied to the fate of the American automobile industry. This is in part due to the relationships with suppliers. Thus, the cost of not bailing out GM is likely higher than the cost of the bailout. Proponents also cite high social costs. It is not merely a matter of lost tax revenue, it is also a matter of lost industrial capacity, massive unemployment and economic devastation in regions already suffering the decline in industrial strength. National pride is also at stake -- drawing parallels with Britain's ill-fated attempts to keep Leyland Motors alive.

Economic considerations, however, would indicate that the long-run benefits of allowing GM to fail outweigh the short-term costs. The company would be able to rid its 'legacy' cost structure and potentially then build on its successful brands. Even if the company did not emerge from bankruptcy, there are strong economic benefits to such "creative destruction" and the economy would be stronger in the long run as more innovative firms move in and take GM's market share.

From a strictly business point-of-view, GM should fail. The company has performed poorly by just about every conceivable measure. The failure would allow only the viable part of GM -- if one exists -- to carry on. The federal government, however, must deal with the bailout question on many levels. Long-run success is difficult to argue in the face of short-term suffering. The retirees who have lost their pensions will not reap the benefits of creative destruction. It is precisely these social and political consequences that have driven the government towards a third option of providing bridge financing in order to give GM time to establish a recovery plan. This itself is risky, and has generated no shortage of controversy. Whatever the outcome of GM's new business plan, the company is still insolvent and a long way from profitability. The government therefore has at this point merely delayed making a decision. There will come a time, soon, when they must choose whether or not GM will succeed or fail.

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