Thinking Things Over March 11, 2012
Volume II, Number 10: General Motors: An Emblem of a Potemkin Economy
By John L. Chapman, Ph.D. Washington, D.C.
There were no private investors or companies out there willing to take a chance on the auto industry. Nobody was lining up to give you guys loans. Anyone in the financial sector can tell you that. If we had turned our backs on you, if America had thrown in the towel, GM and Chrysler wouldn’t exist today. The suppliers and distributors that get their business from those companies would have died off, too. Then, even Ford could have gone down, as well…. [This would have meant] production — shut down. Factories — shuttered. Once-proud companies chopped up and sold off for scraps. And all of you — the men and women who built these companies with your own hands — would’ve been hung out to dry…… You’ve got folks saying, ‘Well, the real problem is, what we really disagreed with was the workers, they all made out like bandits; that saving the American auto industry was just about paying back unions.’ Really? Even by the standards of this town, that’s a load of you-know-what. But they’re still talking about you as if you’re some special interest that needs to be beaten down.
— Barack Obama, speaking to a United Auto Workers audience in Washington, February 28
A thing cannot have value, if it is not a useful article. If it is not useful, then the labor it contains is also useless, does not count as labor, and hence does not create value. — Karl Marx, Das Kapital, Vol. I, Chapter 7
We pretend to work and they pretend to pay us! — Soviet era joke common in State-run factories
Things are Not What They Seem — for the Long Run
This past week witnessed the confluence of three separate but inter-related and highly remarked-upon events:
(1) March 9 was the three-year anniversary of the secular low in U.S. equity markets; the S&P 500 is up a remarkable 105% since then, placing this most recent three year period in the top 2% of all three year investment cycles, in history. On an inflation-adjusted basis the March 2009 trough was back to a level of valuation for U.S. equity markets not seen since 1992, and while one can never forget the immutable wisdom contained in the axiom that “the market” does not perfectly represent “the economy,” this run has been impressive. Corporate profits have been up sharply (though are now showing some signs of plateauing), productivity has soared (though falling from robust 2.5-3% territory, it is still running in a 1-1.5% per annum range in gains), job gains have been broad-based (excepting construction, though housing and commercial building rates are both up year-on-year and have more than doubled recession lows), and auto sales have recovered from depression-levels to recent run rates of 15 million annual units.
(2) Secondly, on Friday, the February jobs report was released by the Department of Labor’s Bureau of Labor Statistics: 227,000 new jobs were created in February (and another 61,000 were added for the prior two months) according to the Labor Department’s Establishment Survey, in every sector excepting slight losses in construction, retail, and government. This marked a six month total of 1.2 million new jobs, the healthiest half-year since mid-2006, and the more granular Household Survey of new employment, less precise but picking up movements in self-employment, was even better, with double the new job totals last month.
(3) Finally, the Greeks availed themselves of a $266 billion rescue package early Friday morning in a deal with Eurozone creditors, the ECB, and the IMF that amounted to a default. More than $3 billion in net credit default payments were likely triggered, and the transaction is essentially a debt-for-debt bond swap: for every $1000 face value of “old” Greek debt, bondholders will now receive $150 in short term bonds issued by the Eurozone’s European Financial Stability Facility rescue fund, and $315 in “new” long-maturity bonds that, at the earliest, do not repay any principal until at least 2023. But these new-issue bonds are already being priced in the gray market at interest rates of 16-17%, and deep discounts of around 80% off of face value. This implies the likelihood of further restructurings (defaults), and is consistent with a zombie economy declining at a -8% per annum pace in output, and unemployment now approaching 22%. For the Greeks, the birthplace of literary tragedy has now spawned its own: for a country ranked 37th in output per capita at income levels approaching 3/5th that of the United States, years of darkness have descended on the economy, in what will be a long slide downward in relative standard of living.
For our part, the question remains, do news items #2 and #3 imply a continuation of the uptrend from #1? In a word, yes and no, for as the great poet Longfellow’s psalmist proclaimed, things are not what they seem. We continue to think 2.5% (or so) GDP growth and higher equity markets in the United States in 2012 are likely, given monetary ease, a front-loading of profit-inducing activity ahead of higher future tax rates, and a perceived easing in both the threat of imminent Eurozone collapse (per the above) and war in Iran (the word in Washington is that the Obama Administration has signalled to both Israel and Iran that a new hot war there would be inadvisable for all concerned, and Israel, primed to attack this spring but unable to obtain desired American armaments such as refueling tankers and bunker-buster precision-guided bombs, will now likely stand down and await further developments). Additionally, given the business and investor classes’ antipathy toward the Obama Administration (which, sadly, has from the start been mutually felt), it is more than possible that if Mr. Obama’s electoral defeat becomes anticipated in financial markets, the Dow’s nominal run-up of 30% in 1980 could be repeated (we think a mini-version of this would obtain with a 5-4 Supreme Court abnegtion of ObamaCare’s costly burdens in their totality in June; currently it is unknown how Anthony Kennedy will vote to break a virtually certain 4-4 split otherwise).
But as our colleague Joe Calhoun has recounted in the past week (here and here), both the the vagaries of the Washington policy mill as well as near term prospects for higher inflation and interest rates serve to crimp the outlook beyond this year. And, frankly, we see no clarity on the one thing that would serve to solidify a brighter future: private domestic investment, still off 20% from its nominal peak in 2006 and stuck back at 1998 levels, is now far off-trend, implying a gap adding to tens of trillions in lost GDP over a decades-long horizon. And without a recovery in investment, the six million jobs the economy is still short and four-year decline in real wages in the United States cannot be ameliorated via sustained expansion. Nor, we would argue, can the official unemployment rate, now a statistic that singularly moves markets, see much sustained improvement without gains in investment. Currently 8.3% in the U.S., the rate would be 10.4% if the same computational parameters describing employment categories were in place today as were those effective on Mr. Obama’s Inauguration Day, and 11.9% if it were 2006 (viz., the labor force participation rate has declined for over five years according to Labor Department estimating techniques, in spite of raw entrant numbers that offer no rationale for this). Saying this differently, while total GDP has returned to its 2007 all-time nominal high of $15 trillion, the categorical mix of spending is far different, with government spending and current consumption totals higher, and investment outlays much lower. This bodes ill for future innovation and job creation, and is in fact a motivating reason for both Congressional Budget Office and Federal Reserve estimates for permanently lower levels of prosperity in the future now (the CBO in fact estimates 2013 GDP growth at 1%, and matches the Fed’s long term estimate of a 2.3-2.6% range for output growth).
Is the U.S. a Potemkin Economy, Then?
But these warning signs about the long term are being downplayed in the midst of the improving news about jobs. Mr. Obama spoke Friday at a Rolls Royce aircraft engine-parts factory outside of Richmond, VA, hailing the job growth of recent months, and asserting that it was his Administration’s pro-active spending policies and priorities in the last few years that had led to the better times of the moment. Preferring to ignore his deeply unpopular health care plan on the stump now, the President instead points to the very visible auto industry as an example of timely intervention: Mr. Obama claims the entire industry, including Ford (which received no government aid in 2008-09), would have collapsed without the government’s help. Private capital was nowhere to be found at the height of the crisis, he says, and millions of job losses throughout the production chain of industry suppliers would have helped collapse the American economy into a new “depression.”
It is worth examining this claim in brief detail, as it is perfectly representative of basic policy coming from Washington now in the years ahead, absent any change. Last week, before a friendly crowd of UAW workers, retirees, and headquarters officials at the auto union’s annual conference.President Obama took to the podium and delivered a rousing 25-minute speech in defense of the auto industry bailouts. The President ripped his critics, most notably in a not-so-veiled reference to Governor Mitt Romney, by asserting that his actions “saved” not only General Motors and Chrysler, in which the federal government invested a combined $85 billion under the auspices of TARP, but the entire industry as well — including, ostensibly, Ford Motor Co. and several dozens of supplier and retailer firms. But as can be seen when looking at the facts, “things are not what they seem” with the auto bailouts, anymore than they are for the economy as a whole.
In the first place, GM received infusions totalling nearly $50 billion from the U.S. government (and another $8 billion from the Canadian government), about $7 billion in the form of 7% interest loans and the rest in equity (the government now owns about 500 million shares of GM for a 32% stake; at the moment this is valued at around $13 billion, with GM shares off 34% from their January 2011 post-IPO high while the S&P 500 has risen 7.4% during that time). The company “repaid back” the initial TARP loans from funds it never removed from escrow; it still still owes the U.S. government at least $26 billion for the government to break even nominally, meaning the shares would have to more than double in value from current levels for the federal government to break even. Both the Treasury and the Congressional Budget Office have assumed the federal government will never recoup its full TARP funding in GM; CBO claims losses will match the total outstanding at this point.
On a brighter note, GM has had two years of profitability, including $5.5 billion in operating profit in 2011. The firm radically reorganized through bankruptcy: its eight brands were cut in half, factories were shuttered, at least 47,000 workers lost their jobs, its supplier parts universe streamlined, and major employee concessions were effected to permanently lower an uncompetitive cost structure (while union workers and retirees suffered some losses in pension plan dollar flows and a diminution of gold-plated health care benefits, management retirees came away with even less than UAW alumni).
While GM’s cost position is improved (and this was its fundamental problem: Dan Ikenson of the Cato Institute has shown that prior to the bankruptcy, average fully-loaded compensation for GM’s UAW workers was $73 per hour, whereas it was $48 for Toyota workers in the United States), its push into “green-energy”-based vehicles and a smaller fleet may or may not resonate with a global buying public (indeed, sales of the Chevy Volt electric model have been disappointing and GM announced last week production will cease for a period after March 19 to clear inventories). The government’s equity stake is now effectively a noose around the neck of investors: any move to sell these shares will depress the price, but the government’s continued shadow over GM’s global operations cannot but distort execution of the firm’s competitive strategy and its decision-making about product investment and marketing.
Chart I below shows the U.S. auto industry is on a rebound from its recent catastrophic fall:
Chart I. Annual Run Rate for Automobile Production in the United States, 1976-Present 
But ISI Global estimated recently that for the government to ever see a break-even on its rescue funds for GM, U.S. sales would have to hit 17 million vehicles for years on a sustained basis, with General Motors achieving a 20% share permanently. Like the larger macro-economy itself, GM shares, currently priced with a P/E below 6, may offer short-term upside in 2012. But longer term, its management, product line-up, supplier ecosystem’s flexibility, depth of customer loyalty, and indeed, competitive nimbleness in a tough global industry are all in doubt (not least because we cannot fully know how the company will survive until it is completely free of any government fetters — until then, we cannot know whether its products will be produced at a profit and freely accepted into a brutally competitive global marketplace). And hence as an example of longer term Obama-led industrial policy the move into GM (and Chrysler) may end up costing U.S. taxpayers close to half of the $85 billion invested, a searing bright example of the destruction of scarce capital. The U.S. government is meanwhile left protesting only that things would have been far worse — the industry would have “disappeared” — in the absence of a government bail-out, because “there were no private investors or companies out there willing to take a chance on the auto industry….. [a]nyone in the financial sector can tell you that.”
As to the industry disappearing, such a counterfactual assertion is of course an unprovable “straw man,” but through casual observation from experience one can adduce the absurdity of this claim. And with respect to lack of private capital willing to invest, this is sadly a demonstrable lie; there are at the moment willing private sector investors in Greek debt, a far less secure claim than the tens of billions of auto sector assets, many the latest products of high-tech capital equipment investment in 21st century modernity, placed in the richest country in the world. Bankruptcy reorganizations for both GM and Chrysler would have, per the norm in the U.S., left both companies in other (better) hands: leaner and smaller, but able to sustain profitable production. The fact that this was not permitted is a testament to the debt owed to organized labor and its $70 million in contributions to Mr. Obama and his allies in the 2008 campaign: a political reorganization for these companies would allow for payback to the UAW, whereas a normal bankruptcy would have enforced property rights of the firms’ claimants without regard to political standing.
Catherine the Great may or may not have ever visited the phony villages along the Dnieper River constructed by General Potemkin according to apocryphal lore. But too many aspects of the current recovery exemplify the Russian supplicant’s stratagem from long ago. And for the Obama Administration to take victory laps after episodes such as the auto bailout or Solyndra-type investments — when both in reality involve massive waste of scarce capital resources, and indeed, perhaps serious corruption — is an explicit warning to the investors of tomorrow in the United States. Crescit sub pondere virtus (“Adversity breeds character”) is, alas, an apt slogan for global business professionals surveying the current American scene.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@4kb.d43.myftpupload.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.
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