Cascading Failure

As I watch our country slip deeper and deeper into economic depression (yes – this is a depression, like it or not), I often wonder how bad it’s going to get, how things will look on the other side, what will finally get us to the other side, and what this all means in the long run.

Short answer: Like everyone else, I have no idea.

Longer answer: Keep reading.

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What To Do About Detroit?

Car Fire - Vehicle engulfed in flames uploaded by 7mary3 on January 1, 2007

Update on Nov 18 @ 9:30am: Jonathan Cohn at The New Republic makes a good case for an auto bailout with conditions. Without one, Chapter 7 (liquidation) might be Detroit’s only other option.

I’m deeply torn about what our government should do about GM, Ford, and Chrysler – a fact that doesn’t sit well with my Conservative sensibilities. I’m a big believer in creative destruction and Darwinian-style survival of the fittest when it comes to business, and it does seem that the American automakers simply cannot compete with Japanese (and now Korean) car makers. Still, I foresee VERY BAD THINGS if these companies are allowed to fail.

Point: U.S. Automakers Have Been Dying for Decades. End the Misery Now.

Spending billions on Big Auto now will only delay their inevitable bankruptcy. Let them fail and then restructure under Chapter 11 to rid itself of the monkeys on its back.

Ford, GM, and the privately held Chrysler are stuck in a very bad place. They are victims of brainless management who couldn’t innovate their way out of a box. At the same time, these companies are tied down by union labor costs and obscene legacy obligations (pensions and retiree health care) that put it at a severe handicap compared to foreign automakers. This, in turn, forced them into decisions which have further lead to their decline, as Megan McArdle so excellently put it:

Management has made a lot of mistakes. But making big cars wasn’t one of them. That’s because they couldn’t profitably make small cars in the United States. And the reason they couldn’t is that their labor costs were too high. All in, Detroit was paying about $30 more an hour than other companies to make cars. At that kind of differential, you have to concentrate on large cars with big profit margins, not economy cars where consumers fight to save $15 on the headlight bezels.

So, to sum up this argument: Let Detroit implode. They’ll restructure and continue to make cars, and someday they’ll be stronger and more competitive than ever.

Counterpoint: Letting the Big Three Die Would Devastate an Already Bad Economy.

The rust belt states already have some of the highest unemployment rates in the country. The three American automakers directly employee over a million people. Factor in part suppliers, car dealers, and other related jobs, and something in the neighborhood of three to seven million jobs. Given, not all of those jobs are in Michigan, Ohio, and Indiana, but the bulk of them are, and a sudden loss would accelerate the death spiral in those states.

Also, a bankrupt automaker would find itself facing a very skeptical market. Unless there are some very explicit guarantees put in place, customers are going to think long and hard about buying a $20k+ vehicle when there’s a good chance its maker won’t be around to honor the warranty and provide parts and service. From a New York Times article today (emphasis is mine):

A study of 6,000 consumers last summer by CNW Marketing found that 80 percent of them said they would switch companies if G.M. or Ford filed for bankruptcy protection in the United States, suggesting that only G.M. loyalists would stand by the automaker.

Practical Solutions?

If our economy weren’t already in crisis, I’d be inclined to let the Detroit automakers declare bankruptcy, rid itself of its baggage, and come back leaner and more competitive. But given that this is not our reality, I think some sort of infusion of bailout money is necessary. I believe it would be a huge mistake to give them a blank check without any oversight or restrictions (see also, the Wall Street bailout).

This week Thomas Friedman proposed what I think is a responsible and pragmatic model for a Detroit rescue plan. From Paul Ingrassia, he takes the following suggestions:

In return for any direct government aid, the board and the management should go. Shareholders should lose their paltry remaining equity. And a government-appointed receiver — someone hard-nosed and nonpolitical — should have broad power to revamp GM with a viable business plan and return it to a private operation as soon as possible. That will mean tearing up existing contracts with unions, dealers and suppliers, closing some operations and selling others, and downsizing the company. After all that, the company can float new shares, with taxpayers getting some of the benefits. The same basic rules should apply to Ford and Chrysler.

Friedman also adds one other qualification:

Any car company that gets taxpayer money must demonstrate a plan for transforming every vehicle in its fleet to a hybrid-electric engine with flex-fuel capability, so its entire fleet can also run on next generation cellulosic ethanol.

Separately, former CEO and Vermont Transportation Secretary Tom Evslin made a novel suggestion that makes so much sense there’s no way it would ever be implemented:

The US government should order a complete replacement for its vehicle fleet to be delivered over the next four years. The new vehicles must be either plugin electric hybrid, pure electric, or possibly natural gas. Obviously retooling both at the manufacturers and suppliers is required to deliver this order so the government should be willing to prepay a significant part of it as it does for new weapons systems. That gets money into the system fast and creates/saves jobs almost immediately. It lets the suppliers retool as well as the final assemblers.

Pessimism

Sadly, I don’t have any hope that meaningful concessions will be demanded of the American automakers, or that the bailout will be a integral component of a comprehensive national energy/infrastructure project. Instead, it’s probably going to look exactly like the bank bailout and be exactly as effective. Which is to say, it won’t be.

Feeding the Monster (or, The End)

Wall Street Collapse

Update @12:30pm: I also recommend reading The New Trough by Naomi Klein on the Rolling Stone website.

The more time passes, and the more that I learn about America’s crumbling financial system, the more I think maybe we should just let it all burn. You know, start over from scratch.

Last month’s “rescue” plan – which I publicly supported given the dire circumstances – has done little to ease the credit markets because banks still aren’t lending to each other. Instead, the geniuses running these failing companies are using taxpayer money to merge with other troubled banks, give massive bonuses to executives who did nothing to deserve them, and fund hugely expensive executive “junkets” at exclusive resorts. The phrase “pissed off” doesn’t come close to describing how angry this makes me.

Via a Twitter post by Tim Bray, here’s your latest must read: The End of Wall Street’s Boom, by Michael Lewis. Michael, a Wall Street veteran of the excesses of the 1980’s, writes at length about a hedge fund manager named Steve Eisman – one of the few people who saw the anticipated the collapse of subprime mortgages and placed bets that their lenders would go bust.

Eisman’s revelations are both infuriating and depressing. The people running and working at the lenders and ratings agencies were some combination of naive, stupid, and evil. They created financial derivatives so complex (and backed up by almost zero assets) that nobody completely understood how they worked or their potential for disaster. They didn’t know what they were doing, but were so blinded by greed that it didn’t matter. And now everyone has to pay for it.

I believe a lot of people are to blame for our country’s current economic mess – gullible borrowers, greedy housing speculators, complaisant government officials. But none of these groups come anywhere close to Wall Street’s role. Fools or crooks, they are largely responsible.

Staring Into The Economic Abyss

I don’t know about you, but I’ve been riveted to the news the last few weeks as we watch our economy self-destruct. If you’re going solely by anecdotal evidence, or by watching the stock market indexes, things might not seem all that bad. But, if you start digging into the subject in-depth, you begin to realize just how scary our nation’s current economic problems really are.

The United States, and now Europe and other parts of the world, is very close to seeing a total freeze of the credit market. This affected just banks at first, but is now spreading into “main street”, as politicians and the media have taken to calling the rest of economy. Already, some big corporations can’t borrow money to build new factories or to buy equipment. This includes GE and McDonalds – not exactly who you would consider high-risk companies. Without intervention, this is likely to spread even further to small businesses and individuals – even those with perfect credit.

Right now, nobody knows what a given bank’s mortgage-backed assets are worth – even the banks themselves. So, everyone distrusts everyone else and refuses to lend them money in the event they are a cesspool of worthless mortgages This is, fundamentally, what the economic rescue/bailout plan is intended to address. If banks can unload their uncertain assets, trust should be restored, and it’s much more likely other banks will lend to each other. In theory, this prevents the crisis from spreading into the larger economy.

I understand people’s strong opposition to using taxpayer money to buy up bank’s bad assets. It’s not our fault, and it doesn’t seem fair that we should have to pay for their mistakes. There have been many calls to simply let bankruptcy take its course and let let free market forces take care of the problem “naturally”, but as I told one of my friends last week: we are now well past that point. Failing to head-off this credit crisis would be catastrophic. Talk of real economic depression wouldn’t be out of the question. Everyone needs to understand that.

The revised plan that was passed by both chambers of Congress and by the President last Friday is far from perfect, but it’s a start. I have no doubt that it will be revised and adapted as the conditions change. And while there’s no question that $700 billion is an enormous amount of money, it’s far less than what our nation could lose if a financial apocalypse takes place.

If you’re interested in learning more about what are likely the most important events since at least September 11th, 2001, I’ve got a couple of good places to start. First, check out last weekend’s episode of This American Life: Another Frightening Show About the Economy. If you read/listen/watch to only one thing on this crisis, please listen to this. It’s embedded below for those visiting my blog, but you can also listen to it on their site or on your iPod. I also recommend an episode from earlier this year (The Giant Pool of Money), that gives one of the best descriptions of the housing bubble I’ve ever heard.

In addition, the New York Times has a special series on the financial crisis called The Reckoning that explores the causes of the current mess.

Even if business, finance, or economics isn’t your thing, this crisis is too big and too important to ignore.