As I write, the United States has seen two major developments. First, the US Treasury bailed out Citigroup: a handout of $20 billion plus government guarantees to cover $306 billion of toxic assets. Second, the Detroit automakers — General Motors, Ford and Chrysler — have been camping at Washington DC to lobby Capitol Hill for a $25 billion dole without which, they claim, there will be bankruptcy and mass unemployment.

By the time you read this, President George Bush may have caved in to Detroit’s demands. So, too, may the US Congress. The automakers certainly have history on their side. Some 29 years ago, when Jimmy Carter was the President and the US was reeling under the second oil price shock, Lee Iacocca of Chrysler went to Washington with a begging bowl. On 21 December 1979, after putting tough conditions, the Congress passed The Chrysler Corporation Loan Guarantee Act. It was a government guarantee worth $3.5 billion to allow Chrysler to borrow from the market with the backing of the Federal government. The economy recovered thereafter; Iacocca introduced two small cars that took the US by storm; Chrysler returned the money in 1983; and the US government earned $350 million profit on this transaction. Detroit will certainly refer to the honourable repayment of 1983 to make their case.

The more important reason why Detroit may get the cash is that US lawmakers care more for the plight of blue collared workers and the regular Joes than the Zegna suited-Salvatore Ferragamo tied-Tod shoe wearing fat cat bankers of Manhattan. If those guys can get billions of dollars of government money because their banks are too important to fail, then why not save the livelihood of 500,000 auto workers? They are the Main Street of real America; they have more voting power; and they will feel the effects of job loss much more deeply than a laid off investment bankers. It is indeed a powerful emotive and political economy argument.

However, it is wrong economics. I have no sympathy for Manhattan’s bankers whose greed and imprudence have got us into the God forsaken mess. Left to myself, I’d love to see a large number of them truly suffer the pains of unemployment, instead of forsaking their next Porsche. But, there is a clear logic for bailing out large banks and financial institutions; just as there isn’t one for the automakers.

Banks have what economists call externalities. It means that the ripple effects of a major bank failure are too large to countenance. These externalities are truly massive. If a bank is feared to fail, it will immediately cause a run on deposits; completely freeze all counter-party transactions; shut corporate lending; and, like dominos, affect a slew of other banks and financial institutions as well. If Citigroup tanked, it would be the mother of all financial So, much as one dislikes the avarice of well heeled bankers, we must accept that big banks have to be bailed out. The alternative will be devastating for the global economy.

Automakers or airlines are different. The US has an efficient and quick corporate bankruptcy reorganisation process under Chapter 11. Companies facing bankruptcy seek protection from the court which orders an immediate stay on the creditors’ dues; creates a committee comprising of creditors and management to prepare a financial, operation and business reorganisation plan; induces all claimants to take appropriate write-downs; forces restructuring and downsizing; and then gets everyone to sign on to the plan. More often than not Chapter 11 works. It forces reduced pay; lower workforce; greater efficiency; right-sizing; and makes equity take the maximum hit, as all risk capital must in bad states. Most companies that exit Chapter 11 do so stronger than before.

Chapter 11 is the logical place for the automakers. However, having seen the bank bailouts, the Detroit trio think they have a fair chance of garnering taxpayers’ goodies. It will be wrong to bail them out. It will open the floodgates for other industries; and will signal to the world if times are bad enough, even systematically poor management can get rewarded by dole. The US government should force the three to go to Chapter 11. It can help with some guarantees at the time of Chapter 11 restructuring, if needed. But it can’t give a cheque for $25 billion and let equity off the hook.

What kind of logic is this? Bankers escaping while autoworkers are punished? The answer: many bankers should have been fired when the doles were handed out, and their bonuses eliminated. It hasn’t occurred — maybe due to the US Treasury Secretary’s own pedigree. But yet another wrong can’t make a right. Fire the most errant bankers; freeze the salaries of others; but draw the line somewhere. Let Detroit go to Chapter 11.

Published: Business Standard, November 2008