Shortly after Congress and the White House finished enacting legislation to prevent a collapse of the financial sector, other companies started lining up to petition the federal government for aid.  First in line are the Big 3 car manufacturers — Ford, General Motors, and Chrysler.  Already, the car companies have received $25 billion in loans from the government.  President-elect Obama has indicated his willingness to consider additional aid, presumably in the form of capital injections.  While government intervention in the financial sector was distasteful, but necessary, the next Congress and Administration would do well to refrain from assisting other companies outside of the financial sector.

Many Americans are still confused as to why the financial sector needs public assistance because bank runs and financial panics, which used to be fairly regular occurrences, have been notably absent in recent years.  During a panic, depositors rush to withdraw their money from banks out of a fear that the banks will go out of business.  When this happens, banks that made prudent investment decisions can find themselves out of money to continue operations.  Thus, the fear that a bank will go under becomes a self-fulfilling prophesy.  As the number of banks the fail grows, the panic spreads as more depositors decide to withdraw their money and put it under the mattress.  The uniformity of banks’ product (money from one bank spends just as well as money from another) and the overlapping financing agreements (banks borrow from other banks, just like every other company) create conditions for a panic to spread quickly across the entire industry, affecting both well-managed and poorly-managed companies.

Financial panics have a long history of affecting the broader economy.  The Panics of 1873, 1893, and 1907, as well the Great Contraction of 1929-1933 were all followed by a recession or depression.  Businesses depend on financing both for their daily operations and for investment in new, more productive capital.  When the cost of that financing goes up or simply becomes unavailable, businesses are forced to cut back on their activity.  They stop hiring new employees or fire some of the ones they already have.  Panics hit small businesses and start-up companies harder than larger companies because they are more dependent on financing.  Those companies are the ones that provide most of the new innovation, new investment, and new employment.

Bank failures are particularly devastating because the financial sector creates money when it makes loans.  When banks make less loans or even lose money and go out of business, the supply of money goes down.  When the supply of money goes down, the price of money, or the interest rate, goes up.  That’s why it’s harder for businesses to get financing.  The decreased supply of money means that each remaining dollar is more valuable.  The equation of exchange also relates the supply of money to the price level and the amount of real output in the economy, or the gross domestic product (GDP).  With less money in the economy, either prices, GDP, or both will fall because consumers have less money available to pay for goods and services.  The is exactly what is happening in the housing market.  House prices are falling because the credit crunch reduces the number of potential buyers for any particular home, which causes sale prices to be lower than they otherwise would be.  Conversely, the easy credit of the past few years increased the number of potential buyers for any house, which increased prices way above what they were intrinsically worth.  Accordingly, the amount of home sales has risen and fallen with the amount of money.  The same principle applies to markets for other goods and services, though on a smaller scale for items whose transactions are not dependent on credit.

However, car companies are not interconnected to the same degree that financial companies are.  The Big 3 car companies get their financing from banks, not from each other, so the failure of one will not endanger the business of the others (if anything it would help the remaining firms by removing a competitor).  Nor would the failure of one of the Big 3 put other car companies at an increased risk of failure, like in a bank panic.  The number of lenders to the automobile industry is small compared to the number of lenders to the financial industry (everyone with a deposit in a bank), so a panic is unlikely to spread.

A failure of one of the Big 3 would not spread to the rest of the economy in the same way that a failure of several financial companies would.  The losers when a car company goes out of business, the shareholders and lenders, are less than when a financial firm goes under.  Yes, GM’s or Ford’s or Chrysler’s  failure would adversely affect its suppliers and consumers, but the number businesses depend on any one of those companies is small compared to the number of business that depend on access to credit.  Additionally, suppliers can adjust and continue to do business with the remaining firms, because the failure of one car company does not put the others at risk.

Bailout proponents argue that a failure of one of the Big 3 would mean thousands of Americans would lose their jobs.  Yet not once was that argument used to advocate aid to financial companies, despite the fact that they are major employers too.  In 2005, the auto industry employed 1.1 million workers (Department of Commerce).  Yet, the financial services industry employed about 8 million in 2005 (Bureau of Labor Statistics, page 8).  If employment wasn’t a factor in aiding the financial industry, why should it matter when the auto industry employs only one-eighth of the workers? The employment argument reveals the self-serving nature and lack of public benefit behind the auto industry bailout.  Other than the employment justification, bailout proponents have little on which to stand other than, “Why not us, too?’

It’s clear that the financial is drastically different from other industries because of its central position in the economy.  The Big 3 auto makers are no more important to the economy than Microsoft, McDonald’s, GE, Coca-Cola, IBM, Wal-Mart, or any other large corporation with many employees.  So if one of the Big 3 gets a bailout, every other large corporation has just as much of an incentive to come to the federal government for aid.  Where do we draw the line for helping some companies and not others?

Additionally, the federal government, with its large deficit and expanding entitlement obligations, faces the same financial problem that GM, Ford, and Chrysler faced a decade ago.  Expanding aid to businesses will not improve the government’s balance sheet any further.  Who will be around to bail out the government once it can no longer meet its obligations?

Giving aid to mis-managed companies creates what economits call moral hazard.  When insured against failure, companies take more risks and make more bad decisions than they ordinarily would.  The fear of failure in a free market forces companies to be diligent and invest in only the most profitable resources.  Without proper management, companies will depend heavily on public aid rather than take responsibility for their own business.

So to recap, the financial industry is crucial because every company, including other financial companies, depends on banks for financing.  The failure of one major financial firm can spark a panic that can quickly spread to other financial firms and then to the broader economy.  A similar failure in the automobile industry will not spread across the industry in the same way.  Whereas it is in the public interest to provide aid to well-managed, but unlucky, financial firms, the public should not provide aid to mis-managed automobile companies.  If politicians feel compelled to lavish money on the Big 3, they should follow Lynne Kiesling’s suggestion and provide retraining and unemployment assistance to unemployed workers as they transition to new, more productive jobs.

Further Reading:

“Saving Detroit” — The Economist

“Bailout to Nowere” by David Brooks — New York Times

“Bankruptcy and GM” by Jim Manzi

“The Big Three Bailout Debate” — CNN/Money

“Carmakers should get their share of the bailout” by David Greising — Chicago Tribune

“The Big Three are a National Disgrace” by Daniel Gross — Slate