Larry Summers on ABC's This Week

As we have noted before, hedge funds, private equity firms, and their employees donated nearly twice as much to the Obama campaign as they did to the McCain campaign.  After the election, the new administration appointed some of its backers and friends on Wall Street to oversee TARP bailout money.  Few have given much scrutiny to this obvious conflict of interest until now.

On Friday the White House released the financial records of some of the administration’s top advisers.  As it turns out, President Obama’s chief economics adviser, Larry Summers, “earned” $5.2 million advising a New York hedge fund one day a week for the past two years.  Though the President desperately yelped to express his “outrage” at excessive AIG bonuses, he has remained conspicuously mum on the Mr. Summers’s lavish executive pay for such little work in an industry he now oversees.

Some have wondered why the administration has been so harsh on Detroit, threatening bankruptcy and executive firings, while only gently nudging Wall Street banks.  The fact that the administration has drawn so many warm suits and generous contributions from Wall Street suggests Mr. Obama holds his friends in finance to a milder standard.

When the Bush Administration let oil companies draft energy policy and let pharmaceutical lobbyists draft the Medicare drug benefit, Democrats cried foul, and rightly so.

Now Mr. Obama surrounds himself with smart bankers and economists who frequently spin around the revolving door between government and the finance sector, having made a fortune on risky bets and now seeing that the taxpayers are left to clean up the mess.

Photo: Susan Walsh, AP

The revelation of AIG’s extravagant bonuses is renewing calls for the Treasury to replace the leadership of bailed-out firms.  If these people brought their banks to such dire circumstances in the first place, so the thinking goes, they have proven their incompetence.  Fire them all, many say.

Though Monumentality hardly defends failed enterprises, one must wonder if the latest calls for executive firings would bring about the same calamity as de-Baathification did in Iraq.

When in 2003 the Coalition Provisional Authority, under L. Paul Bremmer, dismissed all senior officials of Saddam Hussein’s government, the result was a national Iraqi government devoid of leadership.  By categorically branding former officials as tainted, their replacements— a melange of political hacks, amateurs, and empty seats— ran the new Iraqi government FEMA-style.  We all know how that turned out.

Similarly, in the frenzy for well-deserved executive accountability at AIG and other firms, the Treasury should avoid repeating the mistakes of Baghdad.  Though executive boards and management (and the rank-and-file, too, to some extent) oversaw dodgy deals, they are ipso facto the people with the most knowledge of what deals need undoing.

Certainly it is possible for new-hires to gain the necessary institutional knowledge to lead these firm to a recovery, but it takes time.  Though the President is fond of solving all problems all at once, retribution and recovery are best served in separate courses.

The Treasury must not damage the viability of its (well, our) investments tomorrow for the sake of exacting a pound of flesh today.

Larry Summers on ABC's This Week

The hypocrimeter dinged loudly this morning when Larry Summers, the President’s top economic adviser, described the folly in rewriting bailout terms with A.I.G.  after the ink had already dried.  George Stephanopoulos brought up a breaking story that A.I.G., which had received a bailout loan from the Federal Reserve in late 2008, was issuing $1b in bonuses to some of the same employees who drove the company to the brink.  Since the terms of the Federal bailout did not preclude such compensatory profligacy, Summers said it would not be possible to force the company to withold the bonuses.  Summers told Geroge Stephanopolous on This Week,

Look, if you start changing the rules ex post [facto] on financial contracts— these kinds of contracts— you may get a feeling of satisfaction in the short-run, but the President said something very, very important, George, in his state of union speech: he railed and spoke very powerfully against what has happened, then he said but we can’t govern out of anger. And what’s being done here— no one wants to be doing these things, no one wants to see money going for this purpose with all the needs that our country has— but at the same time if we don’t, um, contain this situation, if we don’t respect laws on which people reasonably rely, the potential chaos, disruption, lack of credit, resulting unemployment will be that much greater.  Those are the agonizing judgments that our financial authorities have to make.

Summers is right.  Upholding contracts is a key part to upholding the rule of law and it reduces the risk of economic ventures.  When contracts are enforced properly, both parties have greater faith in the system and are thus more willing to invest in ventures whose risk would otherwise discourage investment.  If debtor banks learn that the terms of their bailout loans will blow with the political winds, banks will be less likely to take the necessary loans and stockholders in existing banks will lose faith and sell their shares.

The hypocrisy, however, lies in the Administration’s support of “cram-down” provisions that would allow bankruptcy judges to modify the loan terms (principal and interest rates) of mortgages for bankrupt homeowners.  If it is calamitous to rewrite financial contracts ex post facto, as Summers says, why does the Administration support rewriting the financial contracts between lenders and bankrupt borrowers?

A cram-down provision raises the uncertainty of mortgages, since a bankruptcy judge could rewrite the terms in a way unfavorable to a lender.  Lenders will likely respond to this added risk preemptively by adding a risk premium to interest rates.  Thus, to save some current insolvant borrowers, future borrowers must suffer.  But as we have written before, handing out political favors now at the expense of the future is easy. After all, the future can’t vote yet.  At least the Administration will, to quote Summers, “get a feeling of satisfaction in the short-run.”

Here are three varying takes on the potential GM bailout.

On the Left, Jeffrey Sachs believes the Detroit automakers are indispensable employers in several rustbelt states whose economic decline would severely damage the rest of the national economy.  He fails to explain why this is or how Michigan, in economic decline for many years, didn’t manage to bring down the entire national economy with it.

Sachs also claims that there is huge global growth in auto purchases, but somehow assumes that foreigners, like Americans, would be reluctant to purchase vehicles from a bankruptcy-protected company.  That remains to be seen.

Sachs also partly absolves Detroit from the blame of the decades of mismanagement:

Some want to see the industry punished for its neglect of energy and environmental realities, but we should acknowledge that the SUV era reflected poor judgment across society. Yes, the industry ignored warnings about energy insecurity and climate, but so did the public and politicians.

Curiously absent from Sachs’s article is any mention of Toyota and Honda, two companies that invested in and started producing low-emissions and hybrid vehicles even when gas was significantly cheaper.  One wonders why GM, Ford, and Chrysler didn’t do the same.  Perhaps a lack of vision even when the increase of oil consumption was clearly outpacing the increase in supply?  One cannot so easily blame Detroit’s decline on “the system” when both Toyota and Honda are a part of the same system and not flirting with bankruptcy.

What is Sachs’s motive?  He seems intent on nationalizing Detroit automakers as a means of promoting various pet projects such a fuel cell cars, a new technology GM is within two years of producing—so they say.  If such a great revolution is within short reach, certainly there are private investors willing loan the company money for fuel cell vehicle production.  However, many doubt GM’s claims on the fuel cell Volt and Sachs wishes the government to act as an investment house for ideas that, if they were good on their own merits, could easily fetch private investment without the help of the Treasury.

Sachs mentions nary a word on the political realities the government money in any bailout.  Such funds would inevitably be directed to over-employ and over-pay people in politically powerful districts to produce cars that simply won’t sell.  State capitalism is not capitalism as any investment will inevitably be held hostage to various vocal political constituencies.

The Washington Post’s center-right economist Robert Samuelson lukewarmly advocates a bailout.  He asserts that a bankruptcy, even under Chapter 11, will damage the economy (again, unexplained).  However he also asserts that any bailout must not suit political goals (as Sachs would prefer).  Samuelson writes,

But neither does it make sense simply to heave taxpayers’ money at automakers. The goal is not to rescue the companies or workers; it’s to shore up the economy and improve the U.S. industry’s competitiveness. A bailout won’t succeed unless other things also happen.

He lists three things that must be done in order to make a bailout worthwhile to the taxpayers:

1. GM must shutter plants it does not need.
2. Workers’ lavish pay, benefits and pensions must be renegotiated to compete with other automakers.
3. The government must mandate lower fuel consumption, either through mandated increases in efficiency or through hikes in gas taxes.

But the devil is in the details, Mr. Samuelson.  How exactly does Samuelson expect the a recipient of public funds to lay-off thousands of taxpayers?  GM will find it hard to make business decisions that hurt separate communities when their public investment itself was premised on saving “the economy.”  If you’re in a town whose GM plant is about to close, surely you’d think that the closure is not saving your economy.

Furthermore, just as the Bush administration retained close ties to its corporate backers, the Democrats now coming into power will remember who funded their ascent: Big Labor.  Samuelson quotes the UAW President as saying that a bailout is necessary “so that auto companies can meet their health-care obligations to more than 780,000 retirees and dependents.”

At least the UAW is honest in its assessment of GM.  General Motors is an HMO that, by the way, just so happens to produce a few automobiles on the side.

Finally, government mandates for higher fuel efficiency have always met strong opposition from both Detroit’s auto executive and the UAW, the latter fearing that such standards will put their members out of work.  It’s unlikely the UAW is suddenly going to drop its opposition in the name of the public interest.

On the Right, NYU Law School professor Michael Levine, a former airline chief (probably familiar with bankruptcy!), makes a compelling case that Chapter 11 is the most thorough way to free the company from various laws and labor agreements that have served to increase the industry’s employment while diminishing the industry’s efficiency.  The obstacles GM faces are intimidating and better overcome through bankruptcy protection than through political goodwill, which, let’s face it, often favors sound-byte populism to sound macroeconomics.

Levine lists several of the challenges:

GM has about 7,000 dealers. Toyota has fewer than 1,500. Honda has about 1,000. These fewer and larger dealers are better able to advertise, stock and service the cars they sell. GM knows it needs fewer brands and dealers, but the dealers are protected from termination by state laws. This makes eliminating them and the brands they sell very expensive. It would cost GM billions of dollars and many years to reduce the number of dealers it has to a number near Toyota’s.

Foreign-owned manufacturers who build cars with American workers pay wages similar to GM’s. But their expenses for benefits are a fraction of GM’s. GM is contractually required to support thousands of workers in the UAW’s “Jobs Bank” program, which guarantees nearly full wages and benefits for workers who lose their jobs due to automation or plant closure. It supports more retirees than current workers. It owns or leases enormous amounts of property for facilities it’s not using and probably will never use again, and is obliged to support revenue bonds for municipalities that issued them to build these facilities.

The political pressure to resist any change to this stifling system is too powerful and will inevitably ruin the solvency of any nationalized (and thus politicized) automaker.  If GM were to receive government money, what’s to stop it from demanding even more cash six months later?  Twelve months later? Two years later?

•••

Lots of people see GM and project onto it different ideals.  Some see a social service provider obligated to provide what the state does not and never did.  Others see it as an environmental and geopolitical silver bullet to reduce environmental strain and reduce the power of oil dictators.  Others see it nostalgically as a symbol of American manufacturing prowess.

A bankruptcy judge is best positioned to see GM in a different view—not GM as cradle-to-grave patriarch, not GM as Jonas Salk of the skies, not GM as Winston Churchill of oil politics, and not GM as Neil Armstrong.  A bankruptcy judge is best suited to view GM in a new light, i.e. as a car company.

My arguments against a Detroit bailout have finally coalesced into a cohesive letter to my Congressional delegation.

Blue-collar work with a white-collar pension will bankrupt an industry.

New York Times columnist Tom Friedman’s articles had become boringly repetitive during the waning years of the Bush Administration.  It was as though in every column he felt to urge to demand the administration adopt his various favored green policies, as though doing so would encounter no political opposition or economic costs.

Well.  Now Mr. Friedman is starting to make sense today.  Now that incoming leadership at both ends of Pennsylvania Avenue is dominantly Democratic and thus aligned with the interests of labor unions and archaic wage and pension scales, GM is now in the position of seeking a government bailout for its long-mismanaged state.  “The market is too tough!” Detroit cries.

Friedman has little patience:

How could these companies be so bad for so long? Clearly the combination of a very un-innovative business culture, visionless management and overly generous labor contracts explains a lot of it.

….

This included striking special deals with Congress that allowed the Detroit automakers to count the mileage of gas guzzlers as being more than they really were — provided they made some cars flex-fuel capable for ethanol. It included special offers of $1.99-a-gallon gasoline for a year to any customer who purchased a gas guzzler. And it included endless lobbying to block Congress from raising the miles-per-gallon requirements. The result was an industry that became brain dead.

Nothing typified this more than statements like those of Bob Lutz, G.M.’s vice chairman. He has been quoted as saying that hybrids like the Toyota Prius “make no economic sense.”

When Detroit auto companies claim that it is simply impossible to manufacture cars economically in North America, they further a notion belied by the mere presence of foreign car companies in Ontario and various southern U.S. states.

Honda in Ohio, Toyota in Kentucky, Mercedes and BMW in the south.  These foreign manufacturers prove that realistic pay scales and a model line that people actually want to buy does not a bankrupt automaker make!

Friedman notes:

Not every automaker is at death’s door. Look at this article that ran two weeks ago on autochannel.com: “ALLISTON, Ontario, Canada — Honda of Canada Mfg. officially opened its newest investment in Canada — a state-of-the art $154 million engine plant. The new facility will produce 200,000 fuel-efficient four-cylinder engines annually for Civic production in response to growing North American demand for vehicles that provide excellent fuel economy.”

The blame for this travesty not only belongs to the auto executives, but must be shared equally with the entire Michigan delegation in the House and Senate, virtually all of whom, year after year, voted however the Detroit automakers and unions instructed them to vote. That shielded General Motors, Ford and Chrysler from environmental concerns, mileage concerns and the full impact of global competition that could have forced Detroit to adapt long ago.

Indeed!  But with the Democratic Party ascendant in American politics, how much do you want to bet that auto bailouts will be coupled with dissolved labor contracts and stricter environmental standards?  Don’t hold your breath: the Michigan delegation and the UAW hold sway in the Democratic Party enough to scuttle any realistic restructuring of American automakers.

If the GM palliative bailout goes through, one must worry that American taxdollars will be put at risk with few concessions from Big Labor and no environmental standards to suit the public good.  We will be throwing good money after bad, enabling an incestuous, luxurious, and unrealistic GM-UAW corporate-social welfare contract, and we will prolong the inevitable death of auto dinosaurs that should have rightly perished long ago.