Bailout Madness

In the auto bailout negotiations, Democratic leaders want the legislation to prevent the Big Three from using any of the money provided to fund lawsuits challenging state emissions laws.

No private investor would ever demand such a condition to making a loan or investment. If it was in the best interest of the auto maker to file such a lawsuit, the investor would support doing so.

So the Democrats want to bailout the auto companies today, and continue to hamstring them in their ability to compete and be profitable.

Looters' Paradise

News reports indicate that Congressional leaders and the Bush administration are working on an interim $14 billion bailout that is intended to keep GM and Chrysler afloat until March until a more permanent solution can be devised.

Characterized as a "down payment" since the Big Three asked for $34 billion, we should assume that once the government starts funding the auto makers, they will get whatever sums are needed to keep them afloat. Otherwise, to have granted money but to have them later fail will be perceived a bigger political failure than cutting off funding.

So while "down payment" seems a poor choice of words to characterize spending $14 billion and 40% of the ask, I suspect it will be a small portion of the money eventually committed to the auto industry before we are through with this

Among the many things that can be said about this, I want to highlight a few.

First, it is deeply offensive that some jobs are more politically-favored than others. It is said that the report that the economy lost 533,000 jobs in November is further encouraging Congress to bail out the auto makers. In fact, it should have the opposite effect. The companies, and their employees, that employed the 533,000 who lost jobs last month, and the nearly 2 million who have lost jobs in the past year, sure would have liked a bail out. I guess UAW workers are more deserving than others.

Second, if the auto makers are correct that customers won't buy their cars if they file for bankruptcy (and I'm not sure that it isn't just a scare tactic), the bail out is helping GM and Chrysler at the expense of Ford. Ford's financial position is much stronger than GM's and Chrysler's, since its restructuring efforts have been more comprehensive and it raised more financing when it could. For those who want to protect the historical American auto makers, bankruptcy won't change that - Ford will thrive.

There is a case for sympathy for the Big Three, but it bears no relation to today's political environment. The auto makers have been severely hobbled by many regulations that have imposed on them excessive costs and limited their flexibility to adapt to changing market conditions:

• Labor-friendly legislation has tilted the negotiating leverage toward the UAW, allowing auto workers to have above-market compensation and benefits that have drained their employers
  

• Fuel efficiency standards have forced them to make more fuel efficient cars at a loss with expensive UAW labor

• State franchising laws have made it more difficult and expensive to reduce the number of dealers as their market share has declined
  

If the government said it was eliminating all of these constraints, then there is a case that the auto makers can be viable and a bailout would be less offensive. Of course, if the government eliminated these constraints, investors might be willing to provide the capital to get over the current period of stress. But no private investor wants to touch such profoundly unsound businesses, given these constraints and knowing that politicians see the auto makers as part of their ideological agenda to produce green cars with expensive union labor.

It is deeply sad what has befallen the industry, particularly to GM. It was once the great innovator, overtaking the early industry leader (Ford) through aggressive competition and new product innovation. It was the world's largest industrial enterprise for many decades, during which it took a principled stand for free markets in its lobbying efforts. And its vast industrial capacity helped us win World War II.

So by virtue of its strengths, it became a target for government regulations to extract concessions and be the vehicle for pursuing political goals.

Its current state is a tragic and profound example of the results from this politically-driven looting, with no end in sight.

The Doomsday Clock: 11:55 pm and Counting

For years, the Bulletin of the Atomic Scientists has published its Doomsday Clock, a hypothetical countdown to the midnight of a nuclear holocaust.

The disturbing news reports this week on Iran's progress toward enriching uranium remind me of this vestige of the Cold War. The International Atomic Energy Agency says Iran has 630 kilograms of low-enriched uranium. Since about double that amount is needed for a nuclear weapon, and since Iran apparently is enriching about 2.5 kilograms per day, Tehran is about eight months away from having a key ingredient for a bomb. They would still need to enrich the uranium to a higher level to make it weapons-grade, and work to turn the material into a bomb, which take some time.

But the Doomsday Clock is already close to midnight and ticking.

After the failures of the five year European-led diplomatic effort to convince Iran to abandon its nuclear program, with the resulting mild UN sanctions having no meaningful effect, a more radical effort is needed if we wish to avoid a military confrontation or meekly acquiesce to a nuclear-armed Iran.

Today's low oil prices allow us to more easily consider a total economic embargo of Iran - with a boycott of Iran's oil exports the central element of such an effort. The lack of oil export revenues, along with preventing Iran from importing gasoline and shutting the country off from international financial transactions, would be economically devastating to Iran - quickly.

Increased production from Saudi Arabia, and if needed a release of oil from the U.S. Strategic Petroleum, can mitigate the loss of Iran's oil exports - and the current depressed state of the oil market makes this a more viable time to consider such a strategy.

Unless the impact is quick and profound, sanctions and diplomacy will have no realistic chance of stopping Iran; the strategic benefits of being a nuclear power are too great for another "package" of incentives to stop them.

While this approach could lead to war, since Iran may lash out in response, it at least has a chance of success.

Crisis Redux

The Wall Street Journal is reporting that the U.S. Treasury is considering a plan to lower mortgage rates to 4.5% to new home buyers who qualify for a traditional mortgage (documenting income, etc.) to spur a rise in home prices.

While it is true that falling home prices are driving the financial crisis as it increases defaults on mortgages held by financial institutions, what this proposal entails is artificially propping up asset prices by lowering interest rates.

We need asset prices to fall to those levels that induce buyers to return to the market on their own accord. That is a necessary predicate for recovery to begin.

Actions which defer that reality simply increase the length of this recession and sow the seeds for future financial losses.

Promises Made, Promises Broken*

Barack Obama made a central part of his campaign for President his initial opposition to the war in Iraq.

Remarkably, he has chosen for his Vice President and Secretary of State senators who voted for the Iraq war, and has nominated for Secretary of Defense a man who has been waging that war as George Bush's Defense Secretary.

To govern in contradiction to how one campaigns creates a divisive political culture, by misleading voters about one's views and creating or exaggerating divisions.

A profile in courage, it is not.

* An ongoing series that looks at how Barack Obama's campaign rhetoric matches with the reality of his Presidential actions and policies.

The Line of Pigs at the Trough is Out the Door

Governors have joined the bandwagon demanding additional subsidies for their states from the federal government, to which Barack Obama has replied favorably. The budgets of many states ballooned in the recent economic expansion, typically growing much faster than inflation and population growth. With tax revenue declining dramatically, their inflated budgets are now under pressure. If your sugar daddy can plug the gap, so much better than having to cut back.

Auto makers, auto parts suppliers, utilities, railroads, telecoms, and state governments - the line of pigs at the trough is now out the door.

Health Insurance 101

Since health care promises to be a major policy debate in an Obama administration, I plan to write a number of posts on the subject. This first one discusses insurance, one of the most fundamentally misunderstood parts of our health care system.

The first thing to understand is how insurance is priced. Because of its relative simplicity, annual term life insurance provides a good example of insurance pricing. Let's say you purchase a $100,000 term life insurance policy. This means that if you die in the next year, $100,000 is paid to your beneficiaries; if you don't pass away, you get paid nothing.

If actuarial studies suggest someone with your age and other relevant characteristics has a 1% chance of dying in the next year, the expected value of the payment to you is $1,000 - where the expected value is the total payout ($100,000) times the probability of the payout occurring (1%).

So the insurance company needs to charge you at least $1,000 for this insurance policy, to cover their expected insurance payment to you. But they also have to pay administrative costs and earn a profit, so the cost to the consumer needs to be greater than $1,000 - let's say $1,200.

Health insurance, and all insurance, share this basic fact: the cost to the consumer needs to be greater than the expected insurance payment, otherwise the insurance company will lose money and won't offer the policy.

In some ways, insurance is a bad deal for consumers. In the example above, you pay $1,200 to be paid $1,000 on average, for a "loss" of $200. But the key is "on average". You get either $0 or $100,000, and presumably your beneficiaries will need the $100,000 if you pass away (let's say to replace your lost income). Because people are generally risk averse, most are probably willing to lose money on average (the $200 "loss") in order to protect against the risk of a large loss (the income your family no longer has if you die).

Because of this, you ought to buy insurance to protect against large, unexpected losses. For example, although light bulbs burn out at uncertain intervals, their cost is sufficiently low that it doesn't make sense to buy insurance to protect against their demise. Likewise, although an apartment dweller's monthly rent is a very large cost, it is a certain cost. In both cases, you don't want to pay the insurance company's administrative costs/profit for either variable, small losses (light bulbs) or certain large costs (rent).

Another key concept in insurance is moral hazard, which means that a person with insurance may behave differently than if they didn't have insurance - and create more insurance costs than otherwise. While this is a small problem for life insurance and is addressed by preventing payouts for suicide, it is a much bigger problem in health insurance.

For example, if you had to pay the cost of emergency room or doctor's visits out of your own pocket, depending on the nature of your health problem you might choose to see your doctor than go to the more expensive emergency room. If you had an insurance policy that paid 100% of all your costs (as an extreme example), you would bear no direct cost for choosing to go immediately to the emergency room - so you might do so when you wouldn't have without insurance.

Because of this, insurance companies might actually assume that you will incur higher health care spending merely because you have insurance. For example, imagine a health insurance policy that cost $15,000 and paid 100% of all health costs - so the total cost of health care is $15,000 no matter what. Now imagine a second policy that costs $4,000 and has a $10,000 deductible, beyond which insurance pays 100% of all health costs.

This second policy is far better than the first. Why? At most the person pays $14,000 in health care costs ($4,000 for insurance and $10,000 in deductible costs) and very well may pay less (if there are only $2,000 of claims, the total cost for the year is $6,000) - in all cases paying less than $15,000 of certain costs with the first policy.

While my example is hypothetical, the pricing of actual insurance policies can exhibit these characteristics. This can result because of the lack incentives that the first, no deductible policy provides for the insured to minimize health spending.

So here is the point of all this: most health insurance for much of the past 50 years violates these basic principles of insurance. While covering large unexpected costs, health insurance has also typically covered many routine expenditures that may not be both large and unexpected. In doing so, this has given consumers an incentive to over-utilize health care, since if you bear a small portion of the direct cost of providing desired health care, you will use more health care than otherwise.

The solution to this problem is to purchase high-deductible health insurance policies. Such policies have only recently started to gain traction due to changes in the tax code.

Why does the tax code enter this discussion? Because the entire discussion above assumes there are no tax benefits between choosing one type of insurance policy over another. But that hasn't been the case. The tax code allows health insurance to be a tax deductible business expense but is not taxable income for the employee, unlike wages/salary/bonus which is a business expense but is taxable income for the employee.

So this means we have had an incentive to take more of our income in the form of tax-free benefits like health care, with the greater the cost of insurance, the higher the tax savings. As we have seen, greater insurance cost corresponds to health insurance with low deductibles and low co-pays - which is the same insurance policy that reduces significantly the incentives of the consumer to minimize health care spending.

And now you have one of the key elements behind skyrocketing health care costs in America.