And a man's foes [shall be] they of his own household
— Mark's Gospel, 10:36
"What you have told us is rubbish. The world is really a flat plate supported on the back of a giant tortoise." The scientist replied, "What is the tortoise standing on?" "You're very clever, young man, very clever," said the old lady. "But it's turtles all the way down!"
— comments made (perhaps) to Bertrand Russell
Today I will make the crucial link between our unsound economy and the future of manufacturing in the United States. I will focus on the auto industry, which has been so crucial to our past economic health and figures greatly in our future oil consumption. In Should We Save General Motors? I pointed out the important difference between "productive works" like the Chevy Volt and derivatives like credit default swaps (CDS), which enabled gambling (not hedging) leading to pointless but profitable exchanges of paper money in the finance industry.
In No, We Can't? I described the tragic misallocation of capital flowing from the Treasury and the Central Bank into the private banking system. Bailing out Wall Street prevents capital flows into energy, health care and manufacturing. Substantial amounts of money have been funneled through AIG to their CDS counterparties, which are the same banks (like Goldman Sachs) receiving TARP money and loan guarantees. This ultimately self-defeating behavior emanates from the cozy relationship between the Federal government and our out-sized finance sector, which was recently described at length in The Quiet Coup by Simon Johnson (The Atlantic, May, 2009)
At first blush Tim Geithner's extremely dangerous plan for clearing the "toxic" credit derivatives market appeared to offer bribes to private equity and hedge funds to bid on these assets with the public taking almost all of the risk. As further details are revealed, it appears that only a select few will be allowed to participate in the plan (Wall Street Journal, April 1, 2009).
While dozens of banks and insurance companies today hold more than $10 billion in toxic securities, the vast majority are trying to get these assets off their books -- not lining up to buy more. As for asset management firms that hold such a big portfolio -- and are also healthy enough to serve as fund managers -- there is only a small pool, such as Black Rock, Pimco, Goldman Sachs or Legg Mason, as well as a titan or two of the hedge fund industry, such as Bridgewater.
"This is ugly," says Joshua Rosner, the managing director of Graham, Fisher & Co., an independent research firm. "As long as they are experienced, there is no rational reason for creating limitations on who becomes a bidder and manager of assets. It doesn't serve the public good, though it may serve those few large firms that appear to have a privileged relationship with Treasury."
[You must already hold $10 billion of "toxic" securities to be a fund manager. Most hedge funds are too small to participate. Thus Geithner is giving a taxpayer-funded gift to big bond funds like Pimco.]
Apparently I used the wrong wording and punctuation the last time around—it should have been called No We Won't! Obama met with the bankers last Friday. His press secretary Robert Gibbs described the meeting's agenda.
Spokesman Robert Gibbs said the president would seek the executives' input on how the economy is developing. "The president looks forward to getting an update on what they're seeing happening in the economy," Gibbs said on Wednesday of the banking chief executives who are slated to meet with the president later this week.
He said Obama's message at the meeting would be to say that what is good for Wall Street is good for Main Street.
"We're all in the same boat," Gibbs said. "We have to understand that ... what is good for one has to be also good for the other [emphasis added]
Plainly, we are not all in the same boat. Plainly, what transpired before and after the collapse of the Housing Bubble demonstrates beyond any reasonable doubt that what is good for Wall Street is not good for Main Street.
Thus Gibbs has delivered the kiss of the death to Main Street. This phrase derives from Judas' identification of Jesus in the Garden of Gethsemane. Jesus goes on to suffer The Passion, but working Americans are being crucified (sacrificed) this time around. In the Gospels, Judas' kiss is a betrayal.
Only the oldest among you will remember the words of General Motors' CEO "Engine" Charlie Wilson in 1953.
In his closed hearing on Jan. 15, 1953, Wilson defended his investments and his integrity, saying he never could have risen to the top of GM if he had been crooked. Sen. Robert Hendrickson, R-N.J., asked whether, given his investments in GM, he could make a decision that would hurt the company... [Wilson replied as follows]
"I cannot conceive of one, because for years I thought what was good for our country was good for General Motors and vice versa. The difference did not exist. Our company is too big. It goes with the welfare of the country."
Fast forward 56 years later. Try this quote on for size: "Asked whether he could make a decision that would hurt the company, CEO Stan O'Neal replied `I can not conceive of one, because for years I thought what was good for our country was good for Merrill Lynch and vice versa´." Just doesn't ring true, does it? A lot has changed since Charlie Wilson's day, and not much of it for the better from our perspective in 2009.
Finance Versus Manufacturing
Today the President got tough with General Motors and Chrysler (Bloomberg, March 30, 2009).
President Barack Obama said General Motors Corp. and Chrysler LLC. must survive without becoming “wards of the state” and the companies have one last, limited chance to “fundamentally restructure.”
...“We cannot and must not, and we will not let our auto industry simply vanish,” the president said at the White House, announcing new and final deadlines for the No. 1 and No. 3 U.S. automakers to remake themselves [but] “we cannot continue to excuse poor decisions. We cannot make the survival of our auto industry dependent on an unending flow of taxpayer dollars.”
Obama is adamant that General Motors and Chrysler should not become "wards of the state." And what of an unending flow of taxpayer dollars? And poor decision-making? This all sounds very familiar. Where have we heard this before?
In his description of America's rebirth as a Banana Republic, Simon Johnson touches on the expansion of finance in recent decades.
The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful. The boom began with the Reagan years, and it only gained strength with the de-regulatory policies of the Clinton and George W. Bush administrations....
Not surprisingly, Wall Street ran with these opportunities. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically...
Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.
Johnson is right about the influence of the banks, but Wall Street's galling takeover of our economy (Figure 1) is not the whole story.
Figure 1 — Taken from How might the current financial crisis shape financial sector regulation and structure? by Már Gudmundsson, Deputy Head of the Monetary and Economic Department of the Bank for International Settlements. Also shown are similar rises in Japan and some EU countries. This speech is worth reading.
Gudmundsson's graph displays the growing share of GDP appropriated by what iTulip's Eric Janszen calls the FIRE economy (Finance, Insurance and Real Estate). This alarming growth came at the expense of manufacturing in the United States. The following passage is taken from Manufacturing continues to shrink as a percentage of U.S. economic activity. The analysis was done in 2006 at the height of the madness.
Manufacturing's share of the U.S. economy continues its 50-year decline. Last year, manufacturing GDP fell to an all-time low of just 12 percent of the economy, according to a Manufacturers Alliance/MAPI analysis of recent data from the Commerce Department.
"Both major segments of manufacturing--durable and nondurable industries--declined," according to MAPI. Durable manufacturing accounted for 7 percent of the economy last year, down from 9.2 percent in 1995. Nondurable manufacturing fell to just 5 percent of the economy, from 6.7 percent in 1995.
Manufacturing represented only 12% of GDP while the categories finance and insurance taken together with real estate, rental and leasing represented 20.6% in this survey. As manufacturing activity declined, the U.S. lost more than 3 million manufacturing jobs between 1998 and 2003.
The BEA's final revision indicates that U.S. GDP fell 6.3% in the final quarter of 2008. How did manufacturing fare over the entire year?
President Obama rightly says that "we will not let our auto industry simply vanish," but he continues to coddle finance while chastising the car companies for making poor decisions. The now decrepit state of the auto industry is not just a result of their own mismanagement or the strength of the UAW—it is mostly a direct result of "poor" decisions made by bloated plutocrats on Wall Street. Greed-driven, non-productive investments in credit derivatives have now brought down Main Street, which binged on all the new credit the banks made available.
GM did not make bad or the wrong cars in recent years. However we view it, the domestic automakers gave the people what they wanted. Dubious enterprises like GMAC dispensed loads of credit to grease the wheels. At least General Motors made something instead of selling AAA-rated collateralized debt obligations based on pools of lousy mortgages.
In his State of Union speech, the president asserted that "new plug-in hybrids roll off our assembly lines, but they will run on batteries made in Korea." Those new Chevy Volts aren't rolling off our assembly lines yet, but they will certainly have batteries made by LG Chem of South Korea if and when they do. But who will buy them? What is the prognosis for domestic car sales?
How is Main Street Doing?
President Obama laid out guarantees for car buyers in his speech on the fate of automakers.
“If you buy a car from Chrysler or General Motors, you will be able to get your car serviced and repaired, just like always,” President Obama said during a speech from the White House. “Your warranty will be safe. In fact, it will be safer than it’s ever been, because starting today, the United States government will stand behind your warranty.”
"If you buy a car anytime this year, you may be able to deduct the cost of any sales and excise taxes," the president promised.
"We are working intensively with the auto finance companies to increase the flow of credit to both consumers and dealers," Obama pledged.
How are car sales doing? Economist James Hamilton, who appreciates the role of an ever-diminishing manufacturing sector in America's economic health, gave us his latest update on March 8, 2009.
Figure 2 — Taken from Hamilton's excellent Econbrowser blog. Sales in the first two months of 2009 were approximately half of what they were in 2004. The good years were 2004-2007.
Why are cars sales in the dumper? Listening to the president, you might assume that only a weak flow of credit is preventing brisk new car sales. Once illiquid—not insolvent—banks start making loans again, everything will be fine as auto sales just pick up where they left off a few years ago.
The president's story is seriously incomplete. It's as though he has blinders on, but we know the reason why. Obama can only see the credit extension problem on Wall Street, not the debt obligation problem on Main Street. Pictures tell part of the story. I will rely on some data posted by Calculated Risk based on the Fed's 2008 Q4 Flow of Funds report.
Figure 3 — From Calculated Risk. Annotated to reflect his comment: "This is the Households and Nonprofit Net Worth as a percent of GDP. This includes real estate and financial assets (stocks, bonds, pension reserves, deposits, etc) net of liabilities (mostly mortgages). This ratio was relatively stable for almost 50 years, and then ... bubbles!" A FIRE economy can not "thrive" without bubbles.
Figure 4 — Taken from Tim Iacono's Seeking Alpha report on March 12, 2009. Bubbly total household assets are now starting to revert back to their pre-2002 level. How far will they fall in 2009?
Figure 5 — From Calculated Risk. His comment: "This graph shows household real estate assets and mortgage debt as a percent of GDP. Household assets as a percent of GDP is now declining rapidly. Mortgage debt as a percent of GDP was up slightly in Q4, and is only declining slowly. It's an old lesson: Assets values can fall quickly, but debt lingers!" [emphasis added]
These graphs show the staggering loss of wealth in American households. This trend is far from complete. Today's Case-Shiller index of house values in 20 cities dropped a record 19% year-over-year in January, 2009. (Economic indicators lag the present.) U.S. News & World Report posted a story about wealth losses in 2008.
The numbers from the Fed's Flow of Funds report for the fourth quarter are ugly:
- The showstopper in today's report was the larger-than-expected $5.1 trillion decline in household net worth. The 9% decline in wealth was easily the largest on record and pushes the much-watched wealth-to-income ratio for the household sector down to 4.83, the lowest since 95Q1.
- Since peaking in the second quarter of 2007, household wealth is down almost $13 trillion. Given where the S&P500 is now (around 740) and recent house price data, we estimate consumers have lost about another $2.5 trillion in the first quarter of the year.
These numbers are absolute death for workers who are more and more dependent on assets rather than incomes for long-term wealth building. This is why the White House can't dismiss the stock market as some sort of mere tracking poll. In terms of wealth destruction, this downturn is already like a half a Great Depression.
[emphasis added. Assets rather than wages have been important to workers because real wages have been flat for most of the last decade.]
To make a long story short, people bought cars (and houses) in large numbers between 2004-2007 because they felt rich. Now all that inflated paper wealth is dwindling away as house and stock market prices continue to fall, despite the recent dead cat bounce in the Dow and S&P 500. Most alarmingly, Figure 5 demonstrates that "asset values can fall quickly but debt lingers!"
Americans are thus increasingly squeezed between their declining net worth and their overlarge debt. At what rate will they be buying new cars, let alone those made domestically, in the future? The outlook does not look good. There are a lot of fairly new cars out there that don't have to be replaced for years. And if you absolutely have to have one, you can always buy something used. Even a restructured General Motors will have trouble surviving as sales tumble in the short-term and remain low for several years to come. It is hard to see how Obama's sales pitch will work if Americans follow their own best interests.
These are the real consequences for manufacturing in an out-of-control FIRE economy. It will not be possible to pile more debt upon too much debt to jump start the economy. Americans must pay off their debt before any new spending spree can begin again. General Motors may need life-support for several years if they are to stay in business. If we had given them even half the money (after a bankruptcy and restructuring) that has been laundered through AIG to its counter-parties the banks since last September, that would have been a good start—if you want to ever see a $40,000 Chevy Volt, that is.
Liquid Fuels Efficiency in a Prolonged Downturn
The downturn on Main Street accompanying our maintenance of a FIRE economy also has severe consequences for U.S. energy policy.The saving grace for Obama's administration is that global oil demand will likely stay low for several years. Unfortunately, so will oil prices. Where is the incentive to buy those pricey Chevy Volts (with their Korean batteries) when they start rolling off our assembly lines? iTulip takes a particularly grim view of the timing of new alternative energy projects (Figure 6).
Figure 6 — iTulip's prediction for an alternative energy bull market.
On this view, even if large-scale 2nd-generation biofuels production from cellulosic feedstocks were technically and logistically feasible—it's not and might never be—we would not see that production until at least 2020 based on the shaky economy alone.
In Steve Chu's Energy Miscalculations, I demonstrated that Energy Secretary Chu's vision for increased liquid fuels efficiency in the U.S. depends almost entirely on higher CAFE standards. A prolonged downturn poses many problems for an already inadequate strategy.
- If few are buying new cars, which lowers the turnover rate for a fleet of 250 million vehicles, CAFE standards have much weaker effects on fuel efficiency over time.
- New technology companies who want to make HEV or PHEV vehicles will be hesitant to enter a very slow global market.
- Even when new companies do start-up, sales for new types of products (like PHEVs) always follow an S-shaped curve. Thus achieving significant market penetration would take more than a decade even without a depressed economy. (See my Energy Miscalculations.)
Now deposed GM CEO Rick Wagoner is aware of the problems.
Wagoner hinted that government may want to consider designing new negative incentives for consumers to purchase highly fuel-efficient vehicles.
He noted that hybrid sales have fallen off a cliff this year due to the relatively high price of hybrid automobiles and the low price of fuel. "Consumers don't have an incentive themselves" to purchase vehicles that stray from the traditional petroleum model, said Wagoner, and he pointed to Europe as an example of governments creating incentives for consumers. (In Western Europe, government taxes push gas prices past $5 per gallon.)
In a prolonged downturn, it will surely be impossible to stimulate spending by means of "negative incentives" like raising gasoline taxes. That would just make a bad situation worse.
The central dogma of every government since Jimmie Carter—ever-greater debt fueling economic growth—is dead. We can not overlay too much debt with more debt—it is not turtles all the way down. We can not buy new cars we can not afford. Sorry, Mr. President, even you can not resurrect the dead.
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And best wishes.