Fundamentals will prevail

The market has rallied and people are optimistic about the greenshoots. But what about the blackshoots which are the opposite to the greenshoots? GM has filed for bankruptcy and the new GM will mean closure of some factories and the loss of thousands of jobs. In any other time, such news would have a negative impact on the US Stock market. But it seems some kind of immunity to bad news have set in and the fact that the US Government has stepped in to "rescue" GM is now treated as good news.

GM is like a sick old man and pumping full of vitamins (money) is not going to revitalise the company. Thousands of managers, supervisors and those who made GM the way it was, remains with the company.Will they change their way of working, will they be suddenly more cost conscious, more creative and more efficient? Possible but very unlikely. They need a boss like Jack Welch , or someone even tougher than Jack to shake up the management and replace the management layer with fresh blood. The fact that no private investors are willing to jump in and take over shows that they know one cannot revitalise a sick old man. With the US Government, union and bondholders being major shareholders, I can imagine how impossible it would be for the board to operate!

With GM , AIG. Fannie Mae and Freddie Mac, the US Government has ended up as owners of large corporate entities. Running a company is like a Viking ship. You need strong and forceful leadership to ensure everyone pulls in the same direction. The US Government cannot provide this kind of leadership and the end result will be a slow decline to lower productivity and even higher losses. Government owned companies in the past has never performed so why should it be different this time around? Britain used to nationalised its major industries and have learned to let them go. The best thing is the hardest to do. Let them all fail and let the marketplace adjusts itself. Failure is not necessarily bad. It opens up opportunities for smaller firms to move into the space vacated by these sick giants. Smaller and more efficient firms will gain market share and in turn create more employment.

The impact of GM closure of factories will have greater impact especially when the number of jobless is already high. The focus seems to be on minimising the impact of negative events such as managing the bankruptcies of GM and Chrysler. There is too much of an eagerness to return to the good old days of double digits return on all sorts of investments. There is a need to reduce consumption, to increase and encourage savings. Interest rates should be high to encourage more savings so that these savings and not money created out of thin air by the US Goernment can be used to reinvest in businesses. If a person lost his savings in a bad investment, he should start to save again to rebuild his nest egg rather than continue spending.

The approach should be bottoms up. Take care of the consumers and businesses will take care of iself. Now it seems the mantra is take care of businesses and it will take care of consumers! The consumer must comes first. He must learn to save more and spend less. Saving more will rebuild capital that America so desperately needed. To keep interest rate low is to punish the consumer. Any business that solely relies on low interest to survive and compete is not a healthy business. It should be able to make money from its equity capital and not from loans from banks. A company with an equity capital of $100 million and makes $10 million profit is earning 10% on its equity. If it borrows $100 million and makes $10 million, its return on capital is hlaved to 5%.
The policy of keeping interest rates low to help businesses is flawed. Higher interest will encourage more savings and some of these savings may end up as equity investments which means companies need not even pay interest since it is equity capital. Without savings, consumer have no money to invest in shares and companies have to revert to the more expensive alternative of borrowing.

The huge amount of debt incurred by US Government and the huge amount of printed money it created will come to haunt it in the years to come. Future generations of Americans will find they have to pay more taxes and suffer a lower standard of living. America will no longer be the consumer capital of the world. It will behave like the son of a rich man who has gone bankrupt. There will be years of denial and Americans will continue to hope and believe that its former glory days can be restored.

America has one trump card up its sleeve. It can spend less on its military. Under President GW Bush the 2009 defence budget is US$515 billion. This is ten times higher than Russia's defence budget. America can trim its defence budget to $200 billion and still spend many times more than any other country. It can save trillions over the next decade if it is willing to pare down its military spending. When Obama starts to reduce the number of trrops stationed overseas, troops not only from Iraq but Germany (56,200 soldiers) ,Japan (33,122 soldiers) and Korea(26,339) soldiers, we will know that they are cutting the defence budget out of sheer necessity. All empires end because they did not have the financial resources to maintain their massive armies. The fall of the Roman Empire is because it could not maintain its soldiers to defend itself. This reduction in military spending will give America the space to recover economically. To maintain its huge military bases overseas is like a bankrupt rich man who insists on keeping its mansions in ten countries.

The fundamental of economics is that money cannot be created out of thin air without long term consequences. Sure there may be no short term consequences but in time, the consequences will be felt. To maintain a huge defence budget in the face of its current huge budget deficit is not to face reality . We will watch and see if the Obama's administration has the courage to face reality or prefers to believe in Hollywood's kind of miracles.