Dec 17 2008

The questions no one seems to be asking about the auto industry bailout!

FT.com | The Economists’ Forum | Will Americans demand the cars that Congress wants the big three to build?

It’s been driving me nuts, this whole bailout debate. My frustrations are definitely appartent to my students, who have had to put up with my occasional rants about the insanity of the whole affair since the issue came to the media forefront over a month ago. Here are some of the issues that just don’t add up from the perspective of a high school economics teacher:

The three companies asking for a bridge-loan supposedly want the money so that hundreds of thousands (some reports say as many as 2.6 million) jobs can be saved. But how could Ford, Chrystler and GM possibly maintain their labor force in a time of a recession when nobody is buying new cars in the first place? In the parlance of AP or IB Economics, automobiles are normal goods, ones for which demand falls as incomes fall. By definition, a recession in the United States means falling incomes. A government loan may allow the Big Three thttp://hybridfueltech.com/media/cartoon.jpgo keep making cars for the time being, but WHY WOULD THEY KEEP MAKING CARS when falling incomes point to falling demand in the immediate future? Making cars that nobody will buy represents a gross misallocation of the nation’s productive resources, not to mention taxpayers’ money. What is required of these industries is precisely what the government loan will prevent them from doing, DOWNSIZING, meaning the shrinking of their labor force as well as the number of plants in operation.

The US recession can not be avoided by allocating the nation’s scarce resources towards a bailout of the auto industry. In fact, it will be worsened because the capacity of any nation to emerge from a cyclical downturn requires the flexibility of the country’s labor force to adapt to the structural changes the country is experiencing in the era of globalization and free trade. America’s future does not reside in labor-intensive manufactured goods, especially in the production of a very expensive durable good for which demand falls drastically during recessions; specifically, automobiles.

The Finanacial Times Economists Forum approaches the issue of long-term falling demand for automobiles from another perspective. One of the conditions of the Big Three accepting a loan from the federal government is the mandate that Detroit will begin producing more fuel efficient automobiles to assure Americans more affordable, more environmentally friendly alternatives to the gas-guzzling SUVs that have dominated the industry for the last two decades. But here’s the problem, gasoline has fallen to a price as low as it was when SUVs were at their peak popularity back in the early 2000s! As any high school economics student knows, gasoline and SUVs are what we call complementary goods, or two goods for which demand and price are inversely related. As gas prices fall to their 2000 levels, demand for SUVs promises to rise once again, while demand for fuel-efficient automobiles will likely decline, creating market pressures for the Big Three to make not more fuel-efficient cars, but more SUVs instead! From the Financial Times:

The basic problem is that Americans like to drive sport-utility vehicles, minivans and small trucks when gasoline costs $1.50 a gallon…

Consumers may have regretted their behaviour when gasoline prices soared above $4 a gallon, but as gas prices descend, there is no reason to believe that left unchecked they will not return to their gas-guzzling ways.

Indeed, there is a distinct possibility that if they really do increase their small car production, in a few years the big three will be back asking for more help, on the grounds that they are losing money by doing exactly what Congress asked.

The only reasonable solution to this dilemma? If Congress DOES begin mandating that Detroit increase its production of fuel-efficient cars and phase out its manufacture of SUVs, any such requirement should be accompanied by a government-set price floor on gasoline. Several months ago, my colleague and fellow blogger Steve Latter blogged about a proposed price floor of $4 per gallon on gasoline. Such a scheme would likely prove nearly impossible to initiate politcally, but may be exactly what’s necessary to add legitimacy to any government requiremens of Detroit to manufacture fuel efficient automobiles. The FT appears to support such a scheme:

Congress should put their mouths where their money is. They should make binding commitments to ensure higher US oil prices and thereby sufficient demand for fuel-efficient cars and trucks in the future.

Discussion Questions:

  1. What message does falling demand in the auto market send from buyers to sellers, and what contradictory message does a subsidy from the government send to auto makers?
  2. If the auto makers receive a low-interest bridge loan (subsidy) from the government, how will this actually undermine the efficient functioning of markets in America?
  3. Why would a price floor on gasoline be needed to accompany a government requirement that the Big Three make more fuel efficient automobiles after receiving a government loan?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

13 responses so far

13 Responses to “The questions no one seems to be asking about the auto industry bailout!”

  1. Sohoon 17 Dec 2008 at 7:19 am

    Basically it's like this if GM and/or Chrysler are allowed to go into bankruptcy, it will force Ford in the same direction because 80% of the suppliers are tied to all three and the suppliers will also face bankruptcy. If all that happens, the banks holding the credit paper on the auto industry companies will all face a major crisis because they will have to write off billions of dollars in loans to auto companies, suppliers, small supporting and ancillary businesses, dealers, etc. A bankruptcy process would have dire consequences for the economy and the U.S./world financial system. The big 3 as well as the Japanese manufacturers are all interconnected through these suppliers and it's not just the American financial system that will flounder. Whether they make it in the future or not this is not the time to mess with the already weak financial system.

    I believe it's macro economics. Understanding this should help you with your dilemma.

  2. Jason Welkeron 17 Dec 2008 at 7:29 am

    Soho,

    Thanks for connecting the unseen dots tying the auto industry to the global financial system. But your analysis does nothing to convince me that the bailout makes sense. Detroit does not make money from manufacturing cars, it makes money from SELLING cars. In a recession, consumers buy far fewer durable goods, most notably, cars. How will a loan to the big three do anything to increase the demand for cars? If Ford, GM and Chrystler go on making more cars but not selling them, will this allow them to pay back their the banks holding their credit paper?

    If you haven't noticed, the global financial system is already floundering. The housing bubble was the first big cause of this. While I don't have the numbers to support this, I would venture to guess that any losses incurred by a bankruptcy of American auto companies pales in comparison to the losses incurred in the global housing markets. Yes, times are tough, but throwing money into the black hole that is the auto industry will not prevent the inevitable. To make money, the Big three must sell cars, not make them. A loan won't sell more cars, it will just allow them to keep making them… am I wrong?

  3. CELINEon 17 Dec 2008 at 5:34 pm

    The bailout of the auto industy (Ford,GM,Chrysler) would send the message to the auto makers that whatever happens the government will not let tem go bankrupt. Evidently American cars as European cars are not on high demand right now, in fact the demand is soo low that all three American companies are in danger of bankrupcy.

    Well, i believe we should not bail them out and see what the rule of survival of the fittest does to them.

  4. Matteoon 18 Dec 2008 at 4:20 am

    I partially agree with Mr Welker. A bridge loan does not help directly demand or a more efficient production by the GM, Ford and Chrysler. But, at least in the short run, it helps cash-flow. My reasoning is that all three companies need time to resctructure and launch in the market new models. At present GM has about 12 Bill Usd in cash, it means it can survive for about 4-6 months. In these circumstances there is no enough time to rethink, review and launch new models to stimulate demand for cars or fill unused production capacity. The bail-out is only a financial help. To be effective this help should be, to my understanding, subordinate to some key conditions: new management first, attention to environmental costs second (who actually pays for emission of CO2 in USA?), limited time of paying back the money received to force firms to react quickly and producing enough profits to repay back the money received.

  5. Markuson 18 Dec 2008 at 6:52 am

    The obvious message that buyers in the market are sending to producers is that the demand for their products is low. Demand for American automobiles is low, so what should happen is that these companies should decrease the supply. However with the bailout, which is a government subsidy, producers will most likely increase their supply of cars. This is a huge problem, especially when demand is so low. No one wants to buy the cars. In my opinion this bailout will just see these companies running back for more money in the future.

  6. Jenny Zimmermannon 19 Dec 2008 at 11:38 am

    The falling demand in the auto market reflects a change in one or more of the determinants of demand, in this case the worldwide recession (special circumstances). Falling demand signals sellers to lower their prices and/or cut orders. The US Government's proposed bailout plan would act as a subsidy, shifting the supply curve to the right, thus encouraging auto makers to increase their production levels.

    The combination of falling demand in the auto market and a low-interest bridge loan (subsidy) would lead to a surplus of cars in production, indicating a inefficient allocation of productive resources. As part of the proposed bailout plan, Detroit automakers will be forced to increase production of environmentally-friendly fuel-efficient vehicles. Sounds great right? Well, not really.

    Gas prices have fallen recently and since oil is a complimentary good to automobiles, a decrease in the price of oil will lead to an increase in the demand of automobiles. If gas prices remain at their current level, than this increase in demand will most likely encourage consumers to purchase larger, gas-guzzling vehicles. In order to keep demand high for fuel-efficient cars, oil prices need to remain high. The only way to ensure that these fuel-efficient vehicles consistently sell is for the government to set an effective price floor on oil.

  7. Danielon 07 Jan 2009 at 2:47 am

    If the American government does not bailout the big three and the automakers are forced to downsize and potentially go bankrupt, how does the American economy rebound to create replacement jobs for the potential 2 million people that will be unemployed? Moreover, how does the US economy recover to create new jobs for the people who have already felt the consequences of downsizing industry?

  8. Bill Farrenon 15 Jan 2009 at 12:24 am

    In the 1970s, the Japanese govt. put into place minimum mileage requirements that were significantly higher than those in the US at the time. It was costlier for the Japanese manufactures but in the end, it pushed their technology in the right direction. They now have the best manufacturing practices and best technology when it comes to making efficient cars that people actually want to buy. Germany is doing the same with appliances and is putting regulations into place that make clean energy competitive with fossil fuel energy. They are now leaders in many high technology areas like solar panels and efficient appliances. History shows that when companies are pushed to improve their offerings, they meet the challenge–and then end up being leaders in those areas. (from book: http://www.naturaledgeproject.net/NAON.aspx) The US govt. needs to take part of the blame for their lack of vision and leadership back in the 70's. Had they pushed for higher standards instead of letting lobbyists run the show, we would be building better cars today. Of course, this conflicts with the popular view that govt. should not interfere with business. (Unless they need a bailout?)

    I agree. We should not be bailing out companies that are making things or providing services people won't buy. Maybe instead of creating a floor for fuel prices, we can create (higher) floors for mileage standards (and other efficiency measures).

  9. Bjorn Borgerson 15 Jan 2009 at 5:03 am

    The U.S. tends to be rather anal retentive when it comes to their national industries, but lets face it… forcing all of these companies to become "greener" now is just not realistic. These companies are years of R&D behind many European (especially German) and some Japanese companies, and trying to bridge these deficiencies is very difficult. In the end, it really is the peoples fault… if they really would have wanted economical cars they could have bought an Audi or a Lexus, but since the prices of petrol were so low, they decided to buy American, not forcing these companies to adapt to the trend. I just don't feel that the bailout is right, especially because they have to fulfill these criteria. Lets not forget that the largest polluters are still industries in general, and not just cars. Therefore the manufacturing techniques in general should be improved first, which would cost even more money. The whole Auto-industry is in turmoil, even well priced, economical and qualitatively good companies like Toyota. In the end its just the survival of the fittest, or economic Darwinism.

    Overall the daft idea of encouraging production with something similar to a subsidy (a determinant of supply) whilst people are simply not willing or able to consume will simply lead to even more debt for the U.S. The embarrassing 10 trillion dollar debt mark has already been surpassed… how far will this go?

  10. Chris Hoferon 21 Jan 2009 at 12:37 am

    According to the principles of economic Darwinism, the obvious solution would be to reject the "BIG THREE" automakers requests for a bail out and allow the theories of survival of the most efficient to distinguish the weak from the strong. However, in my opinion i feel that in doing so millions of innocent workers, who have had nothing to do with the errors made by auto industry businessmen, would be left jobless. If the government chooses to reject the bail out then i feel that its is their obligation to create alternative job opportunities for those affected.

  11. Michelleon 31 Jan 2009 at 2:21 am

    What you haven't addressed here is marketing and its relation to demand. Detroit made bigger profits on SUVs, so they created the demand for SUVs with slick marketing campaigns which discouraged fuel efficiency and attitudes toward smaller cars. Had Detroit been responsible and marketed smaller cars, things would have turned out differently. Another variable here is quality control – manufacturers like Honda created cars which became known for ease of maintenance and reliability, while American manufacturers didn't. In my opinion, Detroit had its head in the sand for too long, while the rest of the world moved forward – they are responsible for their own downfall.

  12. Christian Clausenon 03 Mar 2009 at 5:43 pm

    The message is clear; the gas-chugging SUV is no longer what the consumer wants, mainly due to the gas prices and all the fuzz on the media. And if the government was to subsidize the automakers in the US, they would display themselves as an incompetent government, not only to the US people, but also to their allies in Europe.

    They would most likely make the same mistakes again, and literally slack in innovation and allocation of resources, which would eventually lead the the exact same thing. There has also been a large discussion on the big companies using these money as large bonuses. This is of course wrong is two ways; the money shouldn't be given as extra large wages, and the people working in these large car-companies has apparently not been efficient, because there are other car manufacturers around the world who's still managing to get by.

    Because they would know that in order to start making profit again, since the SUVs aren't selling, they would have to make more fuel-efficient cars. So if they thought the demand would not have been increased enough before the price-floor, they would now have the opportunity for even greater demand.

  13. Duy Anhon 28 Sep 2009 at 6:01 am

    1. What message does falling demand in the auto market send from buyers to sellers, and what contradictory message does a subsidy from the government send to auto makers?

    When demand in auto market falls, that means the consumers are trying to say: "I don't want to buy any more cars", or maybe just "I don't want to buy anymore of these kinds of cars". The government might think that by subsidizing the car industries, they might help to save the Big Three from bankruptcy. However, that will only lead to the fact that GM, Ford and Chrysler is going to make more and more cars, while there are less and less demand for cars, and they will end up having the cars flooded in all of the showrooms without being able to sell any of them. The Big Three live on the profits they make by selling cars, not the car itself.

    2. If the auto makers receive a low-interest bridge loan (subsidy) from the government, how will this actually undermine the efficient functioning of markets in America?

    As I said before, if auto makers receive the bridge loan, they will end up having cars surplus, a lot of them, because people cannot afford to buy cars when their incomes are low. So, the resources used to make cars are actually not very efficient, because they didn't bring back profit.

    3. Why would a price floor on gasoline be needed to accompany a government requirement that the Big Three make more fuel efficient automobiles after receiving a government loan?

    After receiving a government loan, the Big Three can produce whatever they want. If gas is cheap, people will start to buy big SUVs and trucks, because they want big cars, Americans always do. On the other hand, when the Congress set a higher price floor on gas, and subsidize car industries to make hybrid and fuel efficient, people might start to buy more of those cars, and the Big Three can be saved. Why? Because their incentives have changed. Before, they like SUVs, and the big Hummers (sold to China, what a huge loss!) simply because gas are affordable, and driving big cars are more "cool" and comfortable. Now, if a higher price floor for gasoline is set, people will see that they cannot afford that much gas anymore, and eventually they will turn to models of cars that cost less money to drive, demand for compact cars will rise, Big Three make profit, and it seems to be a good way to survive the recession.