Rhetoric Is A Powerful Tool To Advance Moneyed Interests

Money is essential to a successful economy.  But it’s money in circulation that’s useful.  Money that’s locked up in storage in vaults and savings doesn’t help.  The early economists understood this well and often used the analogy of money-is-to-economy as blood-is-to-human-body.  Circulating money, money that is used to buy things is as important to the economy as the blood in your arteries and veins.  The analogy works.  It leads us to realize that money, and more of it, can and usually is a good thing.

The analogy, however, doesn’t work for those economists and policy-makers who want are more interested in enabling the top 1% or so to profit at no risk by earning income on holding money.  Theoretically, the rich, the top 1%, could earn income from their large stores of wealth by investing it in production.  But the profit-by-investment-in-production method requires risk. It’s hard. It requires work to find and exploit good investment opportunities. From the perspective of the really wealthy, it can be more desirable to make money by simply owning money.  To do that, it’s necessary to that there be no inflation. They actually prefer deflation because then their cash wealth gets more valuable without being risked or used productively at all. The other approach to making money without risk by simply owning money is to lend it. Instead of starting, owning, and building a business, investing in equity, you make loans. Ideally you use your wealth and influence to get politicians to guarantee your loans – heads you win and tails somebody else loses. These approaches to making money by simply owning money require that money be scarce and hard to get.  It’s directly counter to the money in circulation paradigm.  A circulatory system deprived of money is good thing those who make money from money instead of labor.

But to persuade the mass of people, the 99%, the ones earning money from labor, it’s necessary to change the metaphor.  That’s been rather effectively in the second half of the 20th century.  It’s been done by extending a different metaphor.  Economists have long used the word liquidity for the idea of how easy it is to convert an asset into cash and therefore spent. For example, real estate (particularly in this market) is very illiquid.  I could own a $1 million house but be unable to buy a Coke from the 7-11 store because I lack any cash.  That’s an extreme example of illiquidity.  In contrast, a liquid asset is one that is either actually cash or easily turned into cash so it can be spent.  There’s a whole range of assets in between with varying degrees of liquidity.

This idea of liquidity and it’s association with cash has been used to push a metaphor that suggests the problem is too much money in the economy.  We’re peppered with phrases like “drowning in debt” or a house mortgage that is “underwater”.  It makes us feel that the liquid stuff is undesirable.  So we get  a central bank that’s reluctant to create and inject money into the economy because critics claim that will create too much liquidity and they falsely claim that it’s inflationary.  When the central bank does increase inject liquidity into the economy, it does it by getting the money to precisely the people who keep it from circulating.  We get a government that refuses to use it’s ability to directly inject money into the economy and get it into circulation.

Government ultimately is the source of all money.  Only government can define and create money.  It has two ways to do it. It can simply create (“print” or “mint” if you will, but it’s not that way anymore) money and spend it.  That puts money immediately into circulation in the circular flow of goods and services.  Or, the government could create money reserves for the banks, a riskier strategy.  The banks then can lend using a fractional reserve logic.  If the banks lend out the reserves, then money is created.  If the borrowers from the banks spend the borrowed money, then it’s in circulation.  If the borrowers use the money to simply buy other financial assets, then it’s not in circulation and is sterile.

In our modern system, the government (in the U.S. and many other nations) has delegated the responsibility for creating money and putting it into circulation to quasi-private central banks such as The Federal Reserve Bank.  In today’s workings of the financial system, these central banks have further delegated the responsibility and decision-making on money-creation to private commercial banks by providing reserves for whatever level of loans they choose.  When those banks choose not to create money or choose not to create and provide money in a way that puts it into circulation, the system suffers. We suffer from too little liquidity.

Daniel Becker at Angry Bear made this point very well in a long post there in June 2011.  He points out that we should really talk about “dehydrating in debt”, not “drowing in debt”.  The dehydration metaphor leads us directly to the solution – more money in circulation.  I from the conclusion to his post:

Got that? Let’s summarize: The share of income to the 99% of people declined from 1976 onward. At the same time the means of making money changed from labor production to money manipulation (producer economy to finanicialized economy) adding to the reduction in share of income. We also changed the ideology to one from relying on the vast population (as represented by the individual and We the People) to relying on a small portion of the population to distribute what money was created. We did this for 33 years. By 1996, people were borrowing as a means to sustain their standard of living (not increase it). If the people are not spending to increase their standard of living, then is the economy really growing? By 2006 people were no longer able to make the payments and consumption was declining.  Then gas hit $4/gal and winter heating was looking like another $4000 to $6000 would be needed.

To date, nothing has been done to address this. Nothing at all. And, by “this” I mean, the income inequality that has resulted in an an economy where a very small group of people (top 1%) are taking money out of the system (that is money that would fuel the engine) faster than the engine can make it which results in an ever faster declining share to the rest of the people. Instead, we have refined new fuel and dumped it right into the top 1%’s hands and wonder why the engine is still sputtering?

One other issue I have with framing and the words used today: Under water.

People are not under water. They are not drowning in debt. On the contrary, people are dehydrating. They are starving for water. Do you know what the symptoms are of dehydration? You get thirsty and then urinate less to conserve water. (debt spending) Then you stop making tears and stop sweating. (can’t borrow) Eventually your muscles cramp, the heart palpitates and you get dizzy. (close to bankruptcy, voting against your interest) Let it go long enough and you get confused, weak and your coping mechanisms fail. (Tea Party, etc) In the end, your systems fail and you die. (recession)

People are dehydrating and Washington is doing nothing about it because they believe it is drowning.  They are throwing out life boats to people in a desert.  That is the chart Ken linked to.

Banks Want to Do To Student Loans What They Did to Mortgages

On the heels of yesterday’s post about student loans and their growth.  I want you to know that Wall Street is hot on the problem.  They’ve made a quiet proposal to the “supercommittee” that’s supposedly addressing government deficits to have the government subsidize the banks via fees without creating any more student loans or taking on any risk.  The essence of the whole proposal is to leave the government on the hook for student loans but to use accounting tricks to “take them off the books”.  It’s similar to the ways the big banks prior to the crisis would take debt and obligations they had and hide them in “special purpose entities” so they wouldn’t have to show them on their books.  There’s no benefit to investors, students, or the government from the proposal. Only the banks benefit.  But maybe that’s why they aren’t talking about the proposal in public but instead try to get it passed quietly through lobbyists.

Jason Delisle of New America Foundation’s Higher Ed Watch explains (bold emphases are mine):

The investment banking industry – and its friends in Congress – have cooked up a scheme they are pitching to the “supercommittee” that they say would reduce the federal debt and cut federal spending. Supposedly, the plan would take the government’s $555 billion direct student loan holdings off of its books. In reality, the plan, which would allow the bankers to earn fees on a $555 billion deal, plus $100 billion more every year, would not reduce the debt or cut spending. But that hasn’t stopped Wall Street from trying.

A proposal that could only have been be cooked up by investment bankers is circulating on Capitol Hill. It would refinance the $555 billion direct student loan portfolio with new debt backed 100 percent by the federal government. But this new debt would not be called U.S. Treasury debt, despite the 100 percent guarantee, and therefore not counted as part of the national debt. In other words, the new debt would be used to pay off the old debt (Treasury bonds) that the government issues to finance direct student loans. To be sure, the mechanics of the proposal are more complicated than that, but the effect of the proposal would be to move all outstanding and future student loans from bonds backed 100 percent by taxpayers to another set of bonds backed 100 percent by taxpayers but not counted as part of the national debt. …

The proposal would increase federal spending because the new securities the government would issue to finance direct loans would have higher interest costs than the Treasury bonds they would replace, effectively increasing the cost of every direct loan. Investors would view the new securities as slightly less desirable than Treasuries (even though they still carry a 100 percent guarantee from the federal government) because they will not be as liquid (easily bought and sold among investors). The new securities would also be subject to prepayment risk…Then there are the fees that the government would have to pay to investment banks (the “syndicate of underwriters”) to put the new securities on the market each year. Those fees could cost taxpayers tens or even hundreds of millions of dollars every year.

Apparently the supporters of the proposal claim that it would “diversify funding sources”.  In other words, if someday, somehow, some investors wouldn’t want to buy U.S. Treasury bonds (something is emphatically NOT happening now since interest rates are at record lows), then maybe they might be interested in something that’s backed by the U.S. but isn’t called a Treasury bond.  In other words, there’s a slight chance that pigs might someday fly away from the farm so let’s have a bunch of hogs that well call “pink cows”.  Jason speaking again:

Some members of Congress – particularly Republicans – would simply feel better if the direct loan program were funded with “private capital” rather than U.S. Treasury bonds….[but] the securities would be sold in the same markets as Treasury bonds and the capital raised to finance direct student loans would be no more or less “private” than it was before.

If the Wall Street proposal to refinance direct student loans doesn’t actually reduce the debt, increases the federal budget deficit, and doesn’t make the program’s financing any more dependent on the private market than it already is, what does it do? It effectively addresses what some see as the direct loan program’s biggest shortcoming; it doesn’t allow Wall Street to make a ton of money off of it.

So Wall Street wants to do to student loans what it’s done to home mortgage finance.  Have somebody else, such as the federal government, guarantee that they cannot lose any money.  Then, they want to bundle them and re-sell them solely for the purposes of making more fees – just like they did with mortgage-backed securities and credit default swaps and other derivatives.  If I recall correctly, that didn’t really work out too well now did it?  Well it worked out for the banks, but not for the rest of us.

Student Loans and the Building Crisis

Student loans are gradually becoming a crisis.  At the macro level, student loans are the only sector of consumer finance that is growing since the recession began 3 years ago.  Federal student loans outstanding now total more than $1 trillion.  That’s more than total credit card debt.  From Mybudget360.com:

Student loan debt only segment of household debt expanding

The Federal Reserve tracks federally backed student loan debt and the figures are astounding.  The only sector of household debt that has expanded in manic fashion during this recession is with student loans:

debt growth by sectors

Every sector has taken a hit including:

-Home equity revolving debt

-Automobile loans

-Credit card debt

-Other debt

Yet there goes student loan debt saddling countless students with back breaking debt.  Make no mistake, much of the for-profits are growing simply because of the government:

“(USA Today) For profit-schools. The highest default rates are at for-profit schools that tend to serve lower-income students and offer courses online. The University of Phoenix, the nation’s largest, got 88% of its revenue from federal programs last year, most of it from student loans.”

This is absolutely nonsense and shows how the coupling of Wall Street and the government have simply turned education into another commodity to water down and gamble on.  Like the multiple card game tables in Las Vegas higher education is the hottest game in town.

But unlike credit card debt, student loan cannot be reset or forgiven in bankruptcy court.  It’s a permanent burden on the former student.

In theory, the loan shouldn’t be a burden because it was an investment in greater earning power of the former student and now potential worker.  But since this current era of lesser depression or workers depressionbegan, incomes for the college educated have actually declined.  CalculatedRiskBlog quotes from the New York Times recent analyses of U.S. household incomes: (bold emphases are mine)

From the NY Times: Recession Officially Over, U.S. Incomes Kept Falling. A few excerpts:…

And on education:

Median annual income declined most for households headed by someone with an associate’s degree, dropping 14 percent, to $53,195, in the four-year period that ended in June 2011, the report said.

For households headed by people who had not completed high school, median income declined by 7.9 percent, to $25,157. For those with a bachelor’s degree or more, income declined by 6.8 percent, to $82,846.

What’s more, the unemployment rate is also up for graduates (and all other categories). Mybudget360.com puts a graph to the income dynamics:

 Yet if we look at the earnings potential during the bubble years we see a very troubling picture:

earnings-of-college-grads-and-cost-of-college

Source:  BusinessWeek

Since 2000, in real terms college costs are now up by 23%

Since 2000, in real terms real pay for college graduates is down by 11%

This means potential disaster for graduates and other former students. From Leo Komfield at New America Foundation’s Higher Ed Watch:

The Department of Education recently announced that the national student loan default rate has risen to over 8 percent and we know that this measure provides only a limited view of the troubles that borrowers are having repaying their student loan debt. In the current economy, we can only expect things to get worse unless the Education Department tackles this problem head-on.

Among the defaulters are a large percentage of unemployed college students. It’s bad enough to be unemployed; however, when you add to this difficulty with being classified as a defaulter, you are really in trouble. Defaulting on federal student loans results in a lifetime of financial purgatory — it destroys your credit, making it impossible to obtain a credit card, car loan, and home loan, and it puts you at risk of having your wages garnished, and your tax refunds intercepted by the IRS.

The student loan market is back in the news as it makes its unrelenting march to the $1 trillion mark.  This crippling figure comes in the face of a decade of lost wages for middle class Americans.  Just like the housing bubble people were supplementing a disappearing middle class with more debt.  The allure of housing was that never in our history have we seen national home prices fall, until they did in dramatic fashion.  The same cultural nostalgia for education in every respect has created a zombie higher education system that is now expanding like the mortgage markets at the height of the housing bubble.  Why?  For-profit schools have largely lured in countless Americans into a system that has provided very little economic gains for students while enriching these Wall Street listed companies.  It should come as no surprise that the highest default rates stem from the for-profit system and most of these loans are federal loans.  In 2010 there were $100 billion in student loan originations, the highest ever in the midst of the deepest recession since the Great Depression.

But it also spells a crisis on a much larger scale.  Reports are showing that the OccupyWallStreet movement (#OWS) is partially made up of significant numbers of young people and recent graduates in particular.  These are not the “dirty hippies” and “degenerates” that many conservatives have labeled them.  Rather, they are the people who followed the “rules”. They studied. They went to college.  In large numbers they took responsbility for their future by taking on student loans and investing in their human capital – all things society has told them to do.  Now, almost 4 years since the recession began, there aren’t any jobs for them.  They’ve graduated and now face payments on those loans.  But the jobs simply don’t exist.  When young people are educated and then are denied opportunity, there’s danger for society.  That’s the recipe for revolutions as we’ve seen in Tunisia and Egypt already this year.

 

Warning: More Bank Bailouts Possible

One area I haven’t commented on much is the ongoing European “debt crisis”.  The Greek debt crisis is a part of it, but it’s only the tip of the iceberg.  The roots are much deeper.  One reason I haven’t commented is because it’s fairly complex and requires a lot of background explanation which I haven’t had time to write.  Nonetheless, it’s something worth mentioning.  In particular because it’s likely to mean more big bank bailouts.

In short, the crisis involves the way the Euro currency zone is constructed.  Countries that use the Euro have surrendered their sovereignty on monetary policy – that’s now the purview of the European Central Bank (ECB).  This means that government debt levels do matter for countries in the Euro.  They can default because they don’t have control over their own currency.  The U.S., Japan, UK, Canada, Australia, and others can’t default because they control their own central bank and currency.  But Euro countries can.  In the case of Greece and Ireland this means a high likelihood of default.  When the global economy crashed three years ago, it sent the economies of most countries down.  This raised the debt-to-GDP level by reducing the denominator, the GDP number.  But a country in a recession needs to increase government spending and deficits to stimulate growth.  Instead, the construction of the Euro agreement and pressures from the ECB forced these countries to pursue an austerity-based policy of cutting government programs.  But the cutting of government spending has only worsened the recession and shrunk their GDP even more, reducing tax collections.  It’s made default more likely.

In the Greek case, default appears inevitable.  The question is how much of a loss do bondholders take and when.  Therein lies a problem.  The people who own the Greek debt are largely big French and German banks. These banks themselves aren’t exactly robust.   If Greece defaults at a level that will actually help Greece find it’s way out instead of simply delaying the crisis, then these banks will likely take very heavy losses.  The losses are large enough to jeopardize the solvency of the banks themselves.  So Greek default also means figuring out how to recapitalize these big banks.  These are so-called “too big to fail banks”.

Currently there are negotiations going on about how to structure a  Greek default, simultaneously prop up the Euro banks, and stop a possible contagion effect from spreading to Ireland, Portugal, Spain, Italy, and Belgium.  But there have been negotiations over this crisis for nearly two years now with much successs.  The German and French leaders have promised a comprehensive solution later this week. It was supposed to be today, but it’s been delayed to mid-week.

What does that have to do with the U.S.?  Nobody really knows.  The devil is in the details.  At first pass, big U.S. banks aren’t supposed to have much exposure to Greek debt, so they shouldn’t be endangered by a large Greek default.  But, the big U.S. banks like Citi, JP Morgan Chase, BofA, and Goldman Sachs have large stakes in the big Euro banks.  A failed Euro bank could have repercussions.  Of greater concern are derivatives, particularly Credit Default Swaps. The U.S. banks, particularly Goldman are known to have been active in selling these derivatives.  Since the derivative markets and positions are largely secret and non-transparent (a failure of the Dodd-Frank Financial Reform bill), we don’t know if a Greek default will trigger significant liabilities for these banks.

In separate news, Bank of America, is on a death-watch by some analysts.  Yves Smith at Naked Capitalism clues us in:

If you have any doubt that Bank of America is in trouble, this development should settle it. I’m late to this important story broken this morning by Bob Ivry of Bloomberg, but both Bill Black (who I interviewed just now) and I see this as a desperate (or at the very best, remarkably inept) move by Bank of America’s management.

The short form via Bloomberg:

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation…

Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.

That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, the OCC data show.

Now you would expect this move to be driven by adverse selection, that it, that BofA would move its WORST derivatives, that is, the ones that were riskiest or otherwise had high collateral posting requirements, to the sub. Bill Black confirmed that even though the details were sketchy, this is precisely what took place.

Part of BofA’s problems, well, actually a very large part of it’s problems stem from the loose and possibly illegal banking practices at Countrywide Mortgage which it took over in 2008.  Yves updates us on this here.

Bottom-line on all this:  expect more big bank bailouts of some kind in coming months.  It might only be big Euro banks.  It might only involve Bank of America.  But there’s significant,if less than probable, chance that we’ll have to see another round of bank bailouts.

Iceland Shows Banks Are Not Too Big To Fail

Few nations were hit harder initially by the financial crisis in 2008 than Iceland. It’s economy had grown rich around four very large (relative to Iceland) banks that were players in the big global casino financial industry expansion.  In the U.S., U.K., and most other large developed countries governments responded with large bank-bailout packages.  The economic logic is that the banks and the banking system is too interconnected, too large, and too important to let it fail.  There’s a part of this argument that has economic truth.  To the extent that the creditors (depositors) of a bank are ordinary citizens and businesses in the country, letting a bank fail will have disastrous macroeconomic consequences.  But this is only true to the extent that these ordinary depositors get wiped out and lose their deposits.  Depositors were in large part not protected in 1929-33 when banks failed across the U.S. and that led to worsening of the Great Depression. It also led to the creation of Federal Deposit Insurance Corporation.  The FDIC is still on the job protecting little depositors (and our economy).

But in the Great Global Financial Crisis, the U.S. government didn’t just try to rescue the little depositors, it rescued the banks themselves.  There’s a huge difference. In rescuing the banks as corporations, the government rescued the large wealthy depositors who should have known better. They rescued the shareholders who selected the managers that caused the banks to get in trouble. They rescued the very management teams that had just failed so spectacularly.  At the time, the argument made by the government for rescuing the banks was that they were “too big to fail”.  This little phrase, often abbreviated as TBTF, came to be a short-hand logic for bailing out the banks.

The problem is that the economic justification for a “bailout” calls for protecting the little, ordinary depositors, not the banks.  In practice, that’s what FDIC does. It “rescues” the little depositors when the bank fails.  It lets the bank and it’s management fail. But the Bush and Obama administrations did not do that. Instead they bailed out the banks and the bank shareholders, arguing there was no alternative.

Iceland, however, shows there was an alternative. Iceland rescued (guaranteed) deposits by ordinary Icelanders and let the banks themselves fail. It has worked pretty well. Much better than Ireland’s approach that rescued the banks themselves. From the New Zealand Herald by way of Daily Bail:

Unlike other nations, including the US and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its biggest lenders in receivership. It chose not to protect creditors of the country’s banks, whose assets had ballooned to US$209 billion, 11 times gross domestic product.

The crisis almost sank the country. The krona lost 58 per cent of its value by the end of November 2008, inflation reached 19 per cent in January 2009, GDP fell 7 per cent that year and the Prime Minister resigned after nationwide protests.

But with the economy projected to grow 3 per cent this year, Iceland’s decision to let the banks fail is looking smart.

  • “Iceland did the right thing by making sure its payment systems continued to function while creditors, not the taxpayers, shouldered the losses of banks,” says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York. “Ireland’s done all the wrong things, on the other hand. That’s probably the worst model.”

 

Are Banks Necessary?

At first pass the question “Are banks necessary?” strikes a macroeconomist as absurd.  Of course, we say.  But what does the empirical record say?  It actually happened in Ireland some 35-45 years ago. From Wikipedia:

Irish bank strikes 1966-1976

From Wikipedia, the free encyclopedia

The Irish bank strikes between 1966 and 1976 were three strikes of about a years total duration which closed down all the clearing banks in the Republic of Ireland. The strikes provided economists a unique opportunity to study the functioning of a modern economy without access to bank deposits.[1]

The strikes affected all the associated banks which comprise of the Bank of Ireland, the Allied Irish Banks, the Northern Bank and the Ulster Bank. The strikes lasted from:

  • May 7 – July 30 1966
  • May 1 – November 17, 1970
  • June 28 – September 6, 1976

The longest strike was of six months in 1970. The Central Bank made limited facilities available to non-associated banks to issue cash. Not just financial transactions were affected, many property deals were also affected because the documents were kept in the banks.[2] The country came through reasonably well in business terms despite the bank strike, a large firm Palgrave Murphy failed when the strike ended and settlements were made but its failure was probably inevitable anyway. The strike had little effect on the main economic concerns which were unemployment and industrial unrest caused by inflation.[3]

Turns out that while the banks were on strike, people developed their own paper notes and circulated them as currency.  Pubs were main clearinghouses for clearing personal notes (equivalent of checks).  The economy kept moving largely despite the absence of functioning banks.  So how did they do it?  Umair Haque of the Harvard Business Review tells us:

This is no fairy tale, so we don’t have to imagine what happened next. And what did come next was something really, really interesting — and just a little bit awesome. Instead of Ragnarok ripping prosperity to shreds, the economy continued to grow. Though the money supply did contract sharply, neither trade, commerce, nor industry came to a grinding halt.

How? People created their own currencies, to substitute for the collapsing money supply. They kept using checks to pay one another, but then, people’s checks began trading within communities. Here’s how Antoin Murphy, one of the few scholars to have studied these strikes, which took place in the 1970s, describes it: “a highly personalized credit system without any definite time horizon for the eventual clearance of debits and credits substituted for the existing institutionalized banking system.”

The country in question was Ireland — today, in deep crisisbecause of profligate banks.

So why were the Irish of yesteryear able to trade notes with one another, in lieu of credit issued by banks? Well, Ireland was curiously well situated for this kind of resilience. It was an economy full of a very special kind of institution: what I’ve termed in my book, The New Capitalist Manifesto, Value Conversations. Antoin Murphy notes in no uncertain terms that the Irish economy was characterized by intense, frequent, conversational personal contact: tight, dense, solid local knowledge circulating at high velocity within and across communities. Result? Borrowers and lenders could build solid microfoundations of trust. In other words, when you’ve been chatting with Bill every night at the local pub for twenty years, you probably know whether his note is a good bet or not (and further, just how much to discount it to earn a sustainable and fair return, that neither fleeces Bill, nor robs you). Furthermore, if you’re the publican, and you’ve been chatting with me and with Bill, then you’re even better positioned to become a de facto arbitrator of notes — a bank. And that’s exactly the role that pubs began to play

So maybe we need the functions that  banks sometimes provide, but we need personal-level banking relationships built on knowledge and trust.  Hmm.  Institutions do matter and large corporations do not necessarily represent “the market process”.  Fascinating reading and I suggest people read the complete link to Umair’s blog.

 

 

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.