Another Look at the Global Economy, the American and Global Recession, and the Situation in Detroit

A classmate of mine, a financial adviser, forwarded this article to me and, at first glance, it looks like it presents some interesting arguments and insights as to possibilities for the United States, using the Chinese as an example. It also presents a look at the current debate over an automaker bailout from a perspective heavy in social stability.

Failure, certainly, would foster a domino effect of disastrous consequences. Writing a check for $25 billion, however, would do absolutely nothing to change the inherent problems in Detroit and would only delay the inevitable. Perhaps, if the government is not willing to let the automakers undergo a managed bankruptcy, enough funding could be given to keep the companies afloat, but given on a contingency basis — if the Big Three do NOT radically restructure and redefine union involvement, the money stops.

I don’t know. I’m far from a financial genius (in fact, I am very much on the other end of the intelligence equation when it comes to economics). That, however, is all the more reason for weighing different perspectives.

Anyway, read it if you get the chance. It is long, but I think you’ll find it as interesting as I did.

– Jeff

On G-20 and GM: Economics, Politics and Social Stability
By George Friedman, Stratfor

The G-20 met last Saturday. Afterward, the group issued a meaningless statement and decided to meet again in March 2009, or perhaps later. Clearly, the urgency of October is gone. First, the perception of imminent collapse is past. Politicians are superb seismographs for detecting impending disaster, and these politicians did not act as if they were running out of time. Second, the United States will have a new president in March, and nothing can be done until he defines his policy.

Given the sense in Europe that this financial crisis marked the end of U.S. economic supremacy, it is ironic that the Europeans are waiting on the Americans. One would think they would be using their newfound ascendancy to define the new international system. But the fact is that for all the shouting, little has changed in the international order. The crisis has receded sufficiently that nothing more needs to be done immediately beyond “cooperation,” and nothing can be done until the United States defines what will be done. We feel that our view that the international system received fatal blows Aug. 8, when Russia and Georgia went to war, and Oct. 11, when the G-7 meeting ended without a single integrated solution, remains unchallenged. Now, it is every country for itself.

From Financial Crisis to Cyclical Recession

The financial crisis has been mitigated, if not solved. The problem now is that we are in a cyclical recession, and that every country is trying to figure out how to cope with the recession. Unlike the past two recessions, this one is more global than local. But unlike the 1970s, when recession was global, this one is not accompanied by soaring inflation and interest rates.

All recessions have different dynamics, but all have one thing in common: They impose punishment and discipline on economies run wild. This is happening around the world.

China, for example, faces a serious problem. China is an export-oriented economy whose primary market is the United States. As the United States goes into recession, demand for Chinese goods declines. Chinese businesses have always operated on very tight – sometimes invisible – profit margins designed to emphasize cash flow and to pay off debts to banks. As U.S. demand contracts, many Chinese firms find themselves in untenable positions, without room to decrease prices, lacking operating reserves and insufficiently capitalized. Recessions are designed to cull the weak from the herd, and a huge swath of the Chinese economy is ripe for the culling.

If the world were all about economics, culling is what the Chinese would do. But the world is more complex than that. A culling would lead to massive unemployment. Many Chinese employees live on Third World wages; indeed, the vast majority of Chinese have incomes of less than $1,000 a year. To them, unemployment doesn’t mean problems with their 401k. It means malnutrition and desperation – neither of which is unknown in 20th century Chinese history, including the Communist period. The Chinese government is rightly worried about the social and political consequences of rational economic policies: They might work in the long run, but only if you live that long.

Economic Restructuring vs. Stability

The Chinese have therefore prepared a massive stimulus package that is more of a development program to make up for declining U.S. demand. It aims to keep businesses from failing and spilling millions of angry and hungry workers into the street. For the Chinese, the economic problem creates a much larger and more serious issue. It is also an issue that must be solved quickly, and the amount of time needed outstrips the amount of time available.

This is not only a Chinese problem. Wherever there is an economic downturn, politicians must decide whether society – and their own political futures – can withstand the rigors recessions impose. Recessions occur when, as is inevitable, inefficiencies and irrationalities build up in the financial and economic system. The resulting economic downturn imposes a harsh discipline that destroys the inefficient, encourages everyone to become more efficient, and opens the doors to new businesses using new technologies and business models. The year 2001 smashed the technology sector in the United States, opening the door for Google Inc.

The business cycle works well, but the human costs can be daunting. The collapse of inefficient businesses leaves workers without jobs, investors without money and society less stable than before. The pain needed to rectify China’s economy would be enormous, with devastating consequences for hundreds of millions of Chinese, and probably would lead to social chaos. Beijing is prepared to accept a high degree of economic inefficiency to avoid, or at least postpone, the reckoning. The reckoning always comes, but for most of us, later is better than sooner. Economic rationality takes a back seat to social necessity and political common sense.

Every country in the world is looking inward at the impact of the recession on its economy and measuring its resources. Countries are deciding whether they have the ability to prop up business that should fail, what the social consequences of business failure would be, and whether they should try to use their resources to avoid the immediate pain of recession. This is why the G-20 ended in meaningless platitudes.

Each country is also trying to answer the question of how much pain it – and its regime – can endure. The more pain imposed, the healthier countries will emerge economically – unless of course the pain kills them. Ultimately, the rationality of economics and the reality of society frequently diverge.

Recession and the U.S. Auto Industry

For the United States, this choice has been posed in stark terms with regard to the dilemma of whether the U.S. government should use its resources to rescue the American auto industry. The American auto industry was once the centerpiece of the U.S. economy. That hasn’t been true for a generation, as other industries and services have supplanted it and other countries’ auto industries have surpassed it. Nevertheless, the U.S. auto industry remains important. It might drain the U.S. economy by losing vast amounts of money and destroying the equity held by its investors, but it employs large numbers of people. Perhaps more important, it purchases supplies from literally thousands of U.S. companies.

There can be endless discussions of why the U.S. auto industry is in such trouble. The answer lies not in one place but in many, from the decisions and makeup of management to the unions that control much of the workforce, and from the cost structure inherent in producing cars in the American economy to a simple systemic inability to produce outstanding vehicles. There might be varying degrees of truth to all or some of this, but the fact remains that each of the U.S. carmakers is on the verge of financial collapse.

This is what recessions are supposed to do. As in China and everywhere else, recessions reveal weak businesses and destroy them, freeing up resources for new enterprises. This recession has hit the auto industry hard, and it is unlikely that it is going to survive. The ultimate reason is the same one that destroyed the U.S. steel industry a generation ago: Given U.S. cost structures, producing commodity products is best left to countries with lower wage rates, while more expensive U.S. labor is deployed in more specialized products requiring greater expertise. Thus, there is still steel production in the United States, but it is specialty steel production, not commodity steel. Similarly, there will be specialty auto production in the United States, but commodity auto production will come from other countries.

That sounds easy, but the transition actually will be a bloodletting. Current employees of both the automakers and suppliers will be devastated. Institutions that have lent money to the automakers will suffer massive or total losses. Pensioners might lose pensions and health care benefits, and an entire region of the United States – the industrial Midwest – will be devastated. Something stronger will grow eventually, but not in time for many of the current employees, shareholders and creditors.

Here the economic answer, cull, meets the social answer, stabilize. Policymakers have a decision to make. If the automakers fail now, their drain on the economy will end; the pain will be shorter, if more intense; and new industries would emerge more quickly. But though their drain on the economy would end, the impact of the automakers’ failure on the economy would be seismic. Unemployment would surge, as would bankruptcies of many auto suppliers. Defaults on loans would hit the credit markets. In the Midwest, home prices would plummet and foreclosures would skyrocket. And heaven only knows what the impact on equity markets would be.

In the U.S. case, the healthful purgative of a recession could potentially put the patient in a coma. Few if any believe the U.S. auto industry can survive in its current form. But there is an emerging consensus in Washington that the auto industry must not be allowed to fail now. The argument for spending money on the auto industry is not to save it, but to postpone its failure until a less devastating and inconvenient time. In other words, fearing the social and political consequences of a recession working itself through to its logical conclusion, Washington – like Beijing – wants to spend money it probably won’t recover to postpone the failure. Indeed, governments around the world are considering what failures to tolerate, what failures to postpone, and how much to spend on the latter. General Motors is merely the American case in point.

The Recession in Context

The people arguing for postponement aren’t foolish. The financial system is still working its way through a massive crisis that had little to do with the auto industry. Some traction appears to be occurring; certainly there was no crisis atmosphere at the G-20 meeting. The economy is in recession, but in spite of the inevitable claims that we have never seen anything like this one before, we have. There is always some variable that swings to an extreme – this time, it is consumer spending – but we are still well within the framework of recent recessions.

Consider the equity markets, which we regard as a long-term measure of the market’s evaluation of the state of the economy. In March 2000, the S&P 500 peaked at 1530. This was the top of the market. In October 2002, 18 months later, the S&P bottomed out at 777. Over the next five years it rose to 1562 in October 2007, the height for this cycle. It fell from this point until Nov. 12, 2008, when it closed at 852.30. This past Friday, it was at 873.29.

We do not know what the market will do in the future. There are people much smarter than we are who claim to know that. What we do know is what it has done. And what it has done this time – so far – is almost exactly what it did last time, except that in 2000-2002 it took 18 months to do it, while this time it was done in about 16 and a half months (assuming it bottomed out Nov. 12). But even if the market didn’t bottom out then, and it falls to 775, for example, it will have lost 50 percent of its value from the peak. This would be more than in 2000-2002, but not unprecedented.

The point we are making here is that if we regard the equity markets as a long-term seismograph of the economy, then so far, despite all the storm and stress, the markets – and therefore the economy – remain within the general pattern of the 2000-2002 market at the 2001 recession. That recession certainly was unpleasant, what with the devastation of the tech sector, but the economy survived. At the same time, however, it is clear that things are balanced on a knife’s edge. Another hundred points’ fall on the S&P, and the markets will be telling us that the world is in a very different place indeed.

A massive bankruptcy in the automotive sector could certainly set the stage for an economic renaissance in the next generation. But at this particular moment in time (it’s no coincidence that the crisis in the U.S. automotive industry comes as we enter a recession), a wave of bankruptcies would dramatically deepen the recession. This probably would be reflected by the destruction of trillions more in net worth in the equity markets.

There is a powerful counterargument to bailing out the U.S. auto industry. This argument holds that the auto industry is a drain on the U.S. economy, that it will never be globally competitive, and that if it is dragged back from the edge, no one will then say it is time to push it to the edge and over. The next time it will be on the brink will be during the next recession, and the same argument to save it will be used. In due course, the United States, like China, will be so terrified of the social and political consequences of business failure that it will maintain Chinese-like state owned enterprises, full of employees and generation-old plants and business models. Clearly, short-run solutions can easily become long-term albatrosses.

The only possible solution would be a bailout followed by a Washington-administered restructuring of the auto industry. This causes us to imagine a collaboration between the auto industry’s current management and Washington administrators that would finally put Detroit on a path to where it can compete with Toyota. Frankly, the mind boggles at this. But boggle though we might, hitting the economy with another massive financial default, a wave of bankruptcies, massive unemployment surges and another blow to housing prices boggles our mind even more.

The geopolitical problem confronting the world at the moment is that it has been forced to offer massive support to the global financial system with sovereign wealth – e.g., via taxes and currency printing presses. The world might just have squeaked through that crisis. Now, the world is in an inevitable recession and businesses are on the brink of failure. A wave of massive business failures on top of the financial crisis might well move the global system to a very different place. Therefore, each nation, by itself and indifferent to others, is in the process of figuring out how to postpone these failures to a more opportune time – or to never. This will build in long-term inefficiencies to the global economy, but right now everyone will be quite content with that.

Thus the financial crisis became a recession, and the recession triggered bankruptcies. And because no one wants bankruptcies right now, everyone who can is using taxpayer dollars to protect the taxpayer from the consequences of mismanagement. And the last thing any one cared about was the G-20 concept for the future of the economic system.



  1. Ted Park says:

    The answer is the exact same comment I made for the Romney piece:

    Auto industry must NOT be allowed to implode. BUT they must be forced to undertake every action and remedy available under the current set of laws and regulations FIRST. Then we can have an intelligent discussion of whether any other special arrangements need to be made. So, we are AT LEAST a year away from any credible bailout discussion.

  2. Anonymous says:

    Sounds like wealth redistribution. It ain’t all that great for individuals getting free taxpayer money who get to live in slums, so I don’t see how it will be all that great for businesses either. But until they try it, touch the hot stove, there won’t be any reasoning with them.

  3. Anonymous says:

    Damned socialists are controlling the economic situation!

  4. Anonymous says:

    Time to remember where General Motors came from — a string of independent automobile manufacturers who went through various stages of Chapter 7 and Chapter 11 bankruptcies, buyouts, hostile takeovers, consolidations, etc; i.e., the automobile manufacturing business as it’s always been.

    Why was Saturn such a big success for GM?

    What techniques and policies led to Saturn success that were not welcome in Detroit?

    Dudes and Dudettes, don’t fall for the scam.

    They need to go through Chapter 11, clean out the deadwood, the vermin and the toxic mold and the rotten and ill-begotten goods built up after decades of corporate treachery, error and incompetence.

    There are plenty of talented executive who would jump at the chance to take GM through Chapter 11 and emerge as a shining star of American industry.

    Understandably, very few of those people are currently in charge of GM.

  5. Anonymous says:

    What do CEOs do with their trillions? Hedge funds?

    People need to get it through their head that the global business model is primarily designed for the benefit of CEOs. Congress panders not to a free market but to globalism.

    It’s not Detroit’s business model that has failed. It’s globalism’s business model, which has been imposed upon Detroit, that is failing.

    In a few short years, India will have the largest number of millionaires in the world. The Indian economy is based on a model that is not global. India’s goal is to produce and manufacture everything for its own economy.

    Alongside a superabundance of intelligence, India ranks first in gold ownership – at 13,000 tons. The U.S. is second with 8,000 tons and Germany is 3rd with 6,000 tons. The Indians are emerging as the leaders of the 21st Century and we’re stuck with a bunch of comatose brain dead haven’t got a clue politicians who blindly follow their lost European counterparts.

  6. Anonymous says:
  7. Anonymous says:

    I highly suggest you listen to what Rep Thaddeus McCotter has to say on youtube (see The CAFE standards are killing the auto industry. So considering that the federal government’s legislation is the principle reason the automakers are in this mess, then it is fair and just that the feds loan them money to alleviate the problem that they created. We should repeal the CAFE standards and replace it with sane legislation. Obviously, the automakers have other problems (e.g., unions, management, etc), but the CAFE standards force the automakers to operate in North America at a loss. But consider this – perhaps the intent of the CAFE standards is to bankrupt the automakers so that the government can nationalize them. Is that too far fetched? Obama did say he wanted to bankrupt the coal industry.

  8. Anonymous says:

    Sounds like the bankers have this one on the payroll too. The US auto industry in bankrupt because they make garbage. But the auto bailout is a huge distraction from the core issue: the federal reserve system needs to go.

  9. Anonymous says:

    fyi, the auto industry is also responsible for military vehicles and supplies. the politicans need to stop and think, and the GM, Ford, and Chrysler need to do some serious cutting of their personal expenses and padding. there is no reason to let them fail and put hundreds of thousands of people out of work, the retirees have already made big concessions in the health care and prescription benefits. plus. so the need to cut now is at the top of the ladder.

  10. Anonymous says:

    We’ve been sold out, but not so much by the House as by the Senate. The US Senate is malignant and getting worse.

    Time to repeal the 17th Amendment to the US Constitution.

    Time to go back to have Senators elected and serve the way the Framers intended.

    At the bottom of all this current mess is Senatorial hubris. corruption and misfeasance; that and the lack of formal state government representation in the United States Congress, a role that belonged to US Senators before the 17th Amendment freed the Senators to behave as if they were the House of Lords.

  11. | Acneguy says:

    I think we are also seeing some signs of recovery from the Economic Recession. Of course, we have no idea of how long it will take to completely recover, but some say it’s going to be longer than for the other recessions in decades. I also scanned an article yesterday that said business owners need a new set of tactics to do well during recovery.

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