Global Economic Crisis

In confronting a  crisis of epic proportions, one can do the heavy work of crafting a well conceived, comprehensive strategy. But why bother, when short-term gimmicky is politically more feasible. Thus we have this absurd counter-cyclical gimmick, the so-called “cash for clunkers” boondoggle, being offered by the Washington establishment as their “answer” to the  massive problems confronting the automobile industry, not only in America but globally as well.

Throughout the world, a vast car manufacturing infrastructure has been constructed at great expense and high leverage, designed for global demand of almost one hundred million cars per year. However, the Global Economic Crisis has unleashed massive demand destruction in many key categories of consumer durables. In the case of autos, worldwide demand is currently just above fifty million units per annum, rendering it almost impossible for most automobile manufacturers to generate a profit, whether they are located in Detroit, Tokyo or Stuttgart. The challenge is massive, global and complex. Yet, the geniuses in Washington have come up with a solution that is small, local and simplistic beyond all measure.

The concept of the “cash for clunkers” program is very simple and superficially enticing, as are most gimmicks. Trade in the old jalopy that was on the verge of being junked anyways, since it had no trade-in value on the open market. The federal government will fund  a $4,500 credit that will go towards the purchase of a shiny new automobile, thus stimulating the economy. As to be expected, the response from those with dilapidated vehicles on the verge of being dropped off at the local scrap yard has been  substantial, in the process depleting the original one billion dollar appropriation for the program. Also not a surprise, the politicians rushed to provide another  $2 billion for the program, to the delight of car dealerships across the land.

While on the surface  the program may be seen as an economic stimulus initiative at work, no one should be fooled into believing that this is a carefully designed, long-term strategic answer to the worst economic contraction to occur in the United States since the Great Depression. And most notably, the supposedly strong response to the program actually betrays its supercilious essence. For one thing, four of the the five most popular cars being purchased under “cash for clunkers” are foreign brands, meaning the impact on the domestic auto industry is minor at best.

Beyond the fact that  domestic car manufacturers are only partially benefiting from the program, it must  also be remembered that every dollar of credit being distributed under the program’s auspices is from U.S. taxpayers, at a time of massive, multi-trillion dollar deficits. Using borrowed money to subsidize the purchase of foreign made automobiles, along with domestic models, does not make much economic sense. However, there is another aspect to this program that has thus far escaped scrutiny.

A major driver of the Global Economic Crisis was the stampede of consumers who were enticed into buying new homes they could not afford, due to the Federal Reserve lowering interest rates beyond prudent levels. This created a real estate bubble, and we all know the consequences of that. Now, with “cash for clunkers,” it just may be possible that many of the consumers taking advantage of the credit largesse from Washington are those with incomes that were inadequate for  a new car purchase, but have been persuaded by their own government to take the plunge on a new automobile loan, courtesy of this deficit-financed program. What happens if many of these new car owners end up defaulting on their auto loans, as the recession deepens?  This is by no means a small possibility, given the current dynamics of the nation’s most severe economic contraction since the 1930s. In effect, the American taxpayer may be financing a new wave of consumer loan defaults down the line, further exacerbating what some are now calling the Great Recession.

“Cash for Clunkers” is really a showroom lemon, masquerading as brilliant economic policy. The politicians may think it is ingenious; my own view is that it is symptomatic of the intellectual bankruptcy that has come to dominate Washington’s response to the nation’s descent into financial and economic doom.

Why is it that virtually all of the auto manufacturers are in varying states of deep distress? The answer lies in the nature of the automobile business, and strategic decisions made on the basis of dream-like optimism. This is reflected in the staggering levels of over-capacity in auto manufacturing worldwide. At present, the combined capacity of all the carmakers throughout the world amounts to more than 90 million cars annually. The deadly demand destruction being inflicted by the Global Economic Crisis has reduced purchases to about 50 million units per years, meaning that the world’s auto companies have nearly double the productive capacity that can be absorbed by current consumer demand.

The automobile business is one of the most costly and complex to run. The industry produces a consumer product annually in the tens of millions of units that is costly, complex and customized. The productive infrastructure required is both vast and exceedingly expensive. Before the onset of the Global Economic Crisis, the world’s carmakers bet heavily on a rising global marketplace that could annually absorb up to 100 million cars annually, and leveraged themselves to the maximum extent to finance the creation of the global network of assembly plants, parts manufacturing factories and distribution networks. The business model became far more globalized, adding another layer of complexity. For example, a U.S. customer who purchases a certain VW model will end up owning a car assembled in Germany, but equipped with an engine built in Mexico. In other words, a Mexican VW plant builds an engine, sends it across the Atlantic Ocean to Germany, which in turn sends it back across the Ocean in the form of an assembled car, to be purchased at an American dealership. This global supply chain is expensive, fragile, and only makes economic sense if all the manufacturing components of the business are operating at full capacity. What I just described has all the characteristics of a Rube Goldberg business model, yet virtually every major automobile company in the world conducts their business according to the pattern I have just described.

With the collapse in demand caused by the Global Economic Crisis, practically every major auto manufacturer is faced with the identical problem; over-capacity that was established with high margins of leverage, leading to massive losses with a worldwide demand for only 50 million cars each year. The reaction thus far by the automakers is to besiege their governments with requests for massive bailouts, warning that without the public purse to cover their losses, the result will be layoffs, disastrous collateral damage to the overall economy and the extinction of the industrialized base.

There is no easy solution to the massive economic problems impacting this now globalized industry. What is clear is that the auto industry is in the midst of a deep global depression. And while much of the reason for their distress lies with very bad business decisions and strategies, the leaders of the car industry are probably correct in claiming that their demise would bring about severe consequences. Unfortunately, there may be no alternative, as the issue may ultimately come down to who becomes insolvent first; the auto companies or the sovereigns being asked to bail them out.