GM, Banks, Bailouts and Incentives

With the GM IPO having succeeded so well this past week, the critics and nay-sayers have had to change tunes.  I don’t know that I really see the government investment in GM’s bankruptcy and restructuring as a “bailout”.  I see more as the kind of strategic government intervention that helps the economy that a good government does.  But, in the interests of brevity I’ll go with the common parlance of the critics and refer to the investment in GM as a “bailout”.  To understand my position better, see my post on the GM Tale.

The critics can no longer claim the GM was a waste of money.  The government has gotten back something near half of it’s original loans and equity money. The publicly traded market has now put a value on the remaining share ownership and  while it isn’t at break even yet, it’s very plausible that within a couple years the government could recoup all and even profit. The critics claimed GM was hopeless. They claimed the UAW was too overpaid and wouldn’t cooperate. Wrong again. A $2billion profit in 3rd quarter 2010 when total auto industry sales are still down 25% from 2007 disproves that charge.  The critics claimed it was socialism.  Judging by the strong investor demand for the IPO, it’s apparently the kind of socialism that capitalists want.

But now the critics claim that the whole GM bailout experience being successful sets up the wrong incentives. They claims that more large companies will seek big government bailouts too.  They’re wrong again. What the critics are suggesting is called “moral hazard” in economics.  It’s the idea that managers or firms, if they know they will be rescued or bailed out when things go bad, will start taking excessive and unjustified risks.  Moral hazard is the kind of situation where the incentives are wrong.  It’s what you intuitively expect to happen if you tell somebody to choose their risks, then tell them that the riskier choices have higher possible payouts, and that if the risk turns out OK the chooser can keep all the profits. But if the risk turns out bad, the chooser won’t suffer at all.  Obviously this is a “heads the chooser wins, tails the chooser sticks the loss to somebody else”.  Just as obviously, it’s not a good scenario.  It leads to wild and excessive risk taking and leaves other people to clean up the mess and take the loss.

The GM “bailout” doesn’t significantly increase moral hazard at all, though.  In contrast, our policies towards the large Wall Street banks has increased moral hazard.  Why does a GM bailout not create moral hazard but bank bailouts do? Simple. Despite legal and Supreme Court claims, corporations are not persons.  They do not make choices.  Managers of corporations make choices.  For a bailout or the prospect of a bailout when things go bad to create a moral hazard situation, the decision-maker, the person making the choice must be the one to get bailed out.  That means the manager(s).  Government bailouts create moral hazard when the managers are kept safe and allowed to profit when bets decisions go well and allowed to skate without consequence when their decisions don’t work.

In GM’s case, this didn’t happen.  Senior management lost their jobs.  Both Richard Waggoner and Fritz Henderson, both long-time GM managers who rose to CEO lost their jobs and were replaced by outsiders.  Further, the shareholders of GM got wiped out entirely.  They got zip, nada, zilch from the bankruptcy and turnaround.  In fact, technically, the “old GM” is being liquidated, it’s life over.  The IPO is in fact a new company.  No rational existing manager of another company wants to go through what Waggoner and Henderson did.  They want to avoid it.  No shareholder in any other corporation is looking at GM and hoping they can do the same – get wiped out. There’s no moral hazard setup here.

Where the moral hazard of bailouts has been created is with the banks.  The big banks, particularly JPMorgan Chase, Goldman Sachs, Citi and BofA, were all saved from disaster in late 2008 by the government investing billions more money than they did in GM.  Yet, not a single senior manager of those banks has suffered negative consequences as a result.  Quite the contrary, Wall Street hit record management bonues in 2009.  They actually learned that losing other peoples’ money and getting bailed out was a good thing for them personally.  Further, no common shareholder of those banks has suffered.  In fact, the government went out of it’s way to make sure the bailout didn’t affect dilute common shareholders when the government choose non-voting preferred stock as the way to make the bailout investment.  The bank bailouts – now that’s how you create moral hazard and keep them coming back for more.


One thought on “GM, Banks, Bailouts and Incentives

  1. Pingback: I’m Back! « EconProph

Comments are closed.