Cash for Clunkers: Wasteful and Stupid

Aug.19.09 | About: SPDR S&P (SPY)

This is one of the most wasteful and stupid schemes announced in the last 6 months by the current administration. This program allows people to trade in their old gas guzzling vehicles and receive $3500 - $4500 from the government to buy a new car with a higher gas mileage. The purpose of the program is to encourage higher consumption, so the (auto) businesses start earning profits and then hire more people. Here is the problem: People in this country have engaged in massive consumption over the last 20 years, such that their personal debt levels are extremely high. In 2006, the total household debt in the country was equal to the total Gross Domestic Product (GDP) in the country. In short, the consumer debt was extremely high from historical standards. As the graph below shows, the only time in the last hundred years when the debt reached such high levels was in 1929, the year the Great Depression began.

If the debt is high in the country, consumers become more likely to default on their obligations and also increase their savings. Usually, the process of defaults ends only when the debt levels are significantly lower than where they were during the bubble. Case in point is the debt bubble during the “Roaring 20s”, which saw consumers take on an unprecedented level of debt, and the end of the Depression during the 2nd World War, largely caused by a reduction in the total amount of debt. Similarly, the current Recession/Depression will end only when the debt levels become significantly lower as a percent of the total GDP. Until then, the consumers will demand fewer loans, save their incomes, and default on their mortgages, car loans, tuition loans, etc. This process began in 2007, but is far from over since the debt has only come down only marginally since then. The Cash for Clunkers program, however, attempts to force the consumers to go into deeper debt which they can probably not afford to service if they lose their jobs.

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Now, if the government increased the allocation of money to the program from the current $3 billion in August 2009 to $500 billion in December 2009 and started giving away free cars to all who have dropped out of high school in the last 10 years, are obese, or have been divorced more than 5 times, wouldn’t that stimulate the economy? Yes, but in the very short term only. When the government borrows and spends all this money to provide the free cars, this will increase the profits of the auto companies and they will then hire more people to manufacture more cars, so that will increase employment. Later, as the new employees take their salaries to go buy products with, they will not be able to, since nothing was produced by the government with the money that they had borrowed. The government simply used the money for consumption as opposed to production, and that now creates a shortage of goods in the market. As a result of more money chasing fewer goods, prices will rise and the lenders will raise interest rates to compensate themselves for it.

As interest rates rise, less money will again be available for consumption and fewer cars will be bought, leading to lower car prices and losses for the auto companies. Next, the consumers default on their loans to the banks, auto companies default on their loans from the banks and the banks restrict credit again, but also the consumers stop borrowing since the total debt taken by them is extremely high. The consumers default on their loans until the total debt as a % of their income falls, which generally takes a long time. The cycle of lesser borrowing and falling car prices will end once the debt levels of consumers fall to manageable levels.

The cash for clunkers can help the economy in the short term, but it will have simply postponed the problem, which is that the consumers in the country are highly indebted. The only solution to the problem is higher savings, lesser borrowing and also higher defaults. Strangely, the people in the country are doing exactly that, and they will eventually lower their debt levels, though it would mean hardships for the consumers, losses for the companies and banks and higher unemployment. As the graph indicates, it took 10 years for the debt levels to come down sufficiently; this time would be no different.

The other nonsensical part of the program is the plan to crush the old clunkers. Old clunkers, bad as they might be, are still useful to many. They are still of value and could have been used by many poor and old people. Destroying something of value simply to encourage more consumption is as foolish as creating a forest fire in California to burn down the houses so then the homeless can demand more houses and support the Real estate market. If that were to happen, demand for housing will go up, but demand for food, cars, tuition, and clothes will go down since the people will save large amounts as they would then have to pay back their previous debts plus the new mortgage, so the extra spending coming from the new loans will be neutralized by the lesser spending on the necessities from the monthly incomes.

The higher debt that the consumers will take to buy the cars will only pinch the economy even harder since the debt levels must come down first, before they can go up again. Also, since so many chose to raise their personal debt levels to buy cars, the same would now no longer be willing to go into even deeper debt to buy houses, so the demand for houses goes down.

In conclusion, this is a wasteful program that will unnecessarily increase the government debt, to be repaid later through higher taxes.