The "Bernson Plan"

The country of Bubblia has a problem. It's a fairly large country, and there are 100 million cars in operation. The cars are essential to this economy, and if the cars don't work, the country will experience economic disaster.

For the last 30 years, Edsel, Inc. and all the other car makers in the country have been reliable. When any one of them sold you a car, you knew there was little risk of it breaking down. Some did break down, of course, but not very many. The default rate on cars was very low. Unfortunately, however, the companies recently came out with new models boasting the latest technology. These were based upon fancy mathematical modeling, and the promise was that they would be cheaper and more reliable than any other car ever.

But it turned out they weren't reliable at all, they are breaking down in massive numbers, and here's the thing. It's impossible to know which cars are lemons and which aren't. You'll be driving one of them, and one day, all of a sudden, it just blows up. When that happens, the car is basically totaled.

Every one of the 100 million cars could blow up at any time, and nobody knows when or which car it might be. The actual percentage of cars that have problems is not known, and there's no way to tell from inspection if the car is bad or good. And it's been a huge problem. Every day, in every major city several cars break down per hour on the freeways, streets, etc. and it completely clogs up transportation - this is a country that relies upon cars for its economy to function and it's causing economic distress. It cannot have frozen roads.

Alan Bernson, a loyal government servant in charge of the Federal Car Reserve, has an idea. We'll call it the "Bernson Plan". Currently, because of all the lemons in the car market, and all the uncertainty, cars are estimated to be worth $4,000 each, on average, though nobody knows for sure since hardly any are trading right now. But, if the estimate is correct, it would cost 400 billion dollars to purchase them all.

The initial plan is to buy up the all the cars and give people $4,000, on average, for them. The government will then spend six months, or longer as needed, determining which cars are bad and which are good (through driving them or some other procedure). After the test period is complete, the government will then take the cars that are just fine - however many that might be - and sell them back to the public at market prices. The hope is that once the bad cars are out of the mix, the price of the cars will rise above the $4,000, and in fact rise enough so that even with a fraction blowing up, they still make money. But so long as prices rise and the number of cars that blow up isn't too large, and they don't think it will be, the government shouldn't lose too much in any case.

But before the plan is put into place, Brad DeKrugen and others point out (in their best Swedish accents) that this won't work. There are losses, cars that no longer work. People need cars, that's what makes the economy tick, and $4,000 isn't enough to buy a new car. People need to be recapitalized for this to work - the cheapest new cars are $7,000 so people need at least that much to replace the old cars. If we only give them $4,000, they aren't going to be able to survive in most cases. Without a car, they go out of business, can't get to work, etc. Sure, the roads will be unfrozen, but not in the way we want as it will be because there are no cars on the roads at all, or very few. In fact, people are unlikely to even sell their cars in this case - better to keep the car and take a chance that it won't blow up than to have $4,000 and no way to get a car at all. And if they decide to keep their cars, the problem with the clogged roads persists until, after a long drawn out period of clogged roads and a clogged economy, perhaps a period of years, enough of the cars die on their own to solve the problem.

So Bernson is forced to reevaluate the plan. Dang, he thinks, I should have asked for way more than I needed up front. I'm going to have to offer $7,000 for these cars even though they are only worth $4,000. So I need $700 billion, not the $400 billion I have approval to spend, to get the job done.

So, Bernson goes back to the legislature, and, with a little bit of salesmanship (if you don't give me $700 billion, we may have to declare martial law!), the legislature reluctantly agrees. Their agreement is helped by the fact that members of congress have many constituents who are in the car industry (as cars are so essential to the economy). But the big push comes from car makers. Though they created the problem by producing lousy cars, car makers stand to benefit greatly from selling new cars to replace the old, so they lobby hard - and successfully - for the bill. The lame duck president, who seems not to care much one way or the other, signs the bill between bike rides.

So the trades finally begin. You show up at the designated agency in your town, give up title to your car, and in return get a certificate valued at $7,000 that can be used as a down payment on the purchase of a new car (and is enough to buy the cheapest model outright so everyone can get some type of car).

As for the government, it holds onto the 100 million cars it bought for six months during which time it identifies the clunkers. It turns out one third of the cars were bad - a huge number. But the other 2/3 were just fine and with the bad ones out of the mix, the market price for used cars rises from $4,000 to $9,000 on average (these aren't all the cheapest models so the average can be above $7,000). The government then sells the 66.67 million good cars at $9,000, raising $600 billion on the sale. So the government loses $100 billion overall.

But more importantly, after the trades are complete and people have their new cars, the economy revives, Bernson is a hero, and everyone lives happily ever after.

Or is that a fairly tale ending?

Comments

[uhoh]

> You show up at the designated agency in your town, ...

And, what, get a government-funded three month vacation with pay and health care, so you don't need a car, while the government sorts out the 2/3 of the trade-ins that are good and puts them back on the market?

I mean, if everyone gets a certificate for a new car and goes and gets one right away, then by the time the government sorts out which of the tradeins are actually worth reselling -- there won't be anyone needing one.

I guess this is the McCain plan he announced tonight?

Do we open the borders to immigrants to have buyers for the excess cars (houses)? or export the vehicles to some country we don't like and crush their domestic industry?

At least the cars can be rolled onto ships. The excess houses, I think the analogy breaks down.

[John V]

If only it were that simple. And you KNOW it's nowhere near that simple in any way. From analogy to solution, it's as overly simplistic as those fancy mathematical models that obscure very real complexity on so many matters.

[Winslow R.]

Nice bottom up approach.

On another note.

Great analogy (except the random nature of blowups) of how the credit system should work if cars represent credit access to the Fed window.

In the current case, we millions of people are being driven around on 300 large vehicle trailers recently expanded to 600 by adding corporations to the list of those with Fed access.

At anytime all six hundred vehicle trailers may explode simultaneously due to incestuous interactions and multiple car explosions aboard the trailer.

100's of millions of individual cars makes much more sense as we could design a system to monitor and give more warning of impending failure and take preemptive action.

[ken melvin]

Wonderful idea, if the plan is to ensure the recurrence. Maybe we should just give everyone a bicycle tire pump.

[acerimusdux]

Well, obviously, if new untainted cars are available for $7,000, there must be some people who can afford them without government help, and some who have already purchased them. In addition, there must be others who never bought these newfangled new technology cars to begin with, and stuck with the old fashioned models which had worked for decades.

So, first, I say we should create Edsel free lanes, so that all these folks with vehicles not at risk won't have to worry about being involved in any of these accidents and tie ups. Vehicles from companies which use only this old technology, which we know works, and buyers who choose to buy vehicles which meet proven saftey standards, are the ones we should subsidize first. And we should strictly enforce the lanes seperating them from the higher risk vehicles, for their own protection, instead of allowing them to mix.

Second, if we are going to do something about these higher risk cars, I would question whether the government is really likely to be better equiped to figure out what is wrong with them than the companies who built them. If the mechanics who engineered these things aren't sure how they work, then I doubt the government will know better. I think anything a mechanic puts together, the mechanic ought to be able to take apart. I would first send them back to the companies themselves, and require full disclosure from them. They should be required to explain how they work and to identify all of the bad parts that need to be thrown out.

Now, perhaps becuase all of the problems, the Edsel brand will be so impacted that even when the engineers are able to solve problems and the cars are safe for resale, they will not be able to sell them. This might not be optimal for the public, so at that point I would maybe allow the government to come in and puchase some of the good cars at a fair price, in order to help restore some faith in them, and maybe resell them at a slightly higher price, with government backing. But, as we are still relying somewhat on the engineers and mechanics who created the problems in the first place, I would also insist that the companies certify that these are good cars, that independent experts verify that the government isn't paying more than they are worth, and require the companies to provide waranties to the government with every car purchased, so that if there are losses, the government will have a chance to get its money back.

Also, if it turns out that some car companies have made so many of these bad cars that they have to close up shop, I would let at least a few of them fail. And, since this is a fairy tale, I'll assume that the markets will do the best job of sorting out which were the least efficient firms, and that the most deserving will survive, and therefore this will have long run benefits by making this less likely to happen in the future.

Finally, as the economy will still be struggling, and there will still be some bottlenecks, I wouldn't ignore the option of also having the government at the same time increase investment in things like building new roads, and perhaps even mass transit, which will help put people to work (incluing some of those unemployed by car companies that do fail), at the same time as it directly addresses the fundamental problem in the economy.

[Gegner]

Um, what if you were still making payments on your 'exploder'?

Would you still have to make the payments or would the amount you owed be deducted from your $7,000 chit?

[Ryan]

This analogy doesn't work for me. I realize it is just an analogy, but I can't seem to put the fact that cars depreciate incredibly fast, and holding them (while sorting out good for bad) constitutes a decrease in value, out of my head.

With that said, financial derivatives are difficult enough to wrap the brain around without obfuscating them with analogies to goods, having completely different properties. I like the names though.

[X Man]

Fine, but you need to take into account the fact that in most cases the cars aren't actually owned by the drivers. The drivers borrowed money to buy the cars, then the original lein holders securitized the loans and sold them off in tranches based on the likelihood of default. Thanks to the magic of structured finance, even those tranches that were most likely to go belly-up were rated "AAA" and were purchased by banks, mutual funds and pension plans. These institutions then entered into a complicated set of arrangements called "credit default swaps" that was supposed to neutralize any risk that might emerge if things started to go wrong, i.e. if a driver missed a car payment. Through these processes the ownership of the original loan was so sliced and diced that it was impossible to determine who had a claim to any given lein, that is, who actually owned any particular car. So giving everyone $7000 might help a few people, but most of the drivers would end up paying out a lot of that money to clear debt, and the end result would be a net reduction of the total number of cars on the road, and this in turn would be a drag on the economy.

[Robert L]

Actually, the government is not going to give you a $7,000 certificate to buy a new car. What they are going to do is pay off the loan that you owe the bank.

However, you must continue to drive and maintain your car until it actually breaks beyond repair. The good news is that if your car does break down, they will send out a tow truck to haul your broken vehicle away. Of course, since they paid off the loan, they will take posession of the vehicle and dispose of it properly leaving you without a car.

In the mean time, you have to go out an get a loan and purchase a new vehicle (or at least a slightly used one) in order to get to work. This is of course extremely difficult. The bank lost a lot of money when they made bad loans to people that bought the Edsel.

Thanks to the government paying off many of the bad loans, the banks were able to survive and now have money to lend. However, they are gun shy and unsure of who they should lend it to. So the bank increases their lending standards and will only lend to those people that can afford to purchase a car without a loan.

Since you had to pay for repairs for a vehicle that was extremely expensive to maintain you unfortunately don't have any spare cash. You spent it all on repairs and oil changes. Those oil changes were expensive because the car leaked oil. So you are forced to walk to work until you can save up enough money to purchase a car outright.

[Richard H. Serlin]

Excellent story, one suggestion though, buses might be better than cars, because the things you're analogizing, packages of toxic mortgages, are owned by and large by a small minority of people. With cars you have everyone having an equal share of the problem assets, exactly one car is owned by each household (I'm assuming you picked 100 million cars because there are approximately 100 million households in the U.S.).

With buses you could have it a lot more like the reality with toxic mortgage packages, where there are a number of bus companies whose transportation is crucial to the economy, but the vast majority of people own only a relatively tiny percentage of bus company stock, or none at all.

With cars, it's not that bad giving $7,000 for a $4,000 value, because everyone gets the money evenly. With buses, the bus companies would get a huge windfall that everyone else pays for, unless the government buys the bus companies first -- before replacing all of their potentially defective buses with only reliable ones -- and then sells the companies back for a profit that would then go to the tax payers, not the existing shareholders and spa loving managers.

[yop]

Is there any way to repair the clunkers, or are they a completely lost cause on the government's balance sheet?

Even if repairing the clunkers doesn't turn a profit, maybe repairing them would be good for the country, anyway.

A trickle up bailout would help citizens who are otherwise trapped on a one way trip to bankruptcy. And since the government now holds title to the clunkers, the trickle up would return much of the money to the government.

[anne]

Excellent story.

[baileyman]

Why should the government, representing the people altogether, determine that making such a public investment in bad assets is a good idea? What's the yield on the investment?

Rather, take the money and rebuild the system, jitneys, cabs, buses, light rail, heavy rail, compact zoning, etc.

By analogy, cram down the lenders so people can rent their own houses from the lenders, then capitalize a slew of new banks with the $700 billion (or more) to do the work the old banks will not. Hire new bankers. No problem.

[Denis Drew]

Once the government figures out how much it lost it can tax the crap out of the firms -- or anyone else -- that made good because of the gov's loss.

[lonesome moderate]

Very nice analogy, thank you.

[Bob Lunchbox]

I think the bus analogy is more accurate.

Why stop all the buses because a few of them may breakdown? Why not just have an emergency fleet that can come out and pick us up if our bus breaks? And shouldn't the bus company be responsible for this? They built the crap. They need to stand behind their product. We all know that they have made a ton of money selling these buses.

Get the spare buses out there however you can but make sure the bus company pays a hefty part of the bill.

[Trust]

The question is, will drivers ever trust Edsel again? Will they buy any more new cars from Edsel after Edsel manufactured so many lemons? The old lemons may be purged via this process, but Edsel will still need to market new cars to drivers in order to stay in business.

Drivers may switch to buying Toyotas instead (foreign savers may keep their money at home, instead of making private loans to domestic citizens). Edsel needs to reassure drivers that it will make quality new cars in the future. Removing the older lemons is only the first step.

[hari]

This story may mean socialism by the back door. Eller hur?

[Winslow R.]

"I think the bus analogy is more accurate."

A bus requires all to have group borrowed to own an apartment building rather than an individual house.

A tractor trailer (as I suggested - representing banks) full of cars is more accurate :)

[PghMike]

Isn't the analogy that the *banks* are the cars, not the mortgages? Because there's nothing in Paulson II that gives me any confidence that the banks themselves aren't still holding onto toxic derivatives of some form, or even know how to value them. Until a serious audit of the *banks* has occurred, I can't imagine buying their stock again.

Furthermore, the houses underlying the mortgages may not recover their price for decades -- the prices are still 20% north of the historical rental ratios, and they're probably down already 20% from their mortgage values. And there are piles more mortgage rate resets coming, which will further depress prices.

In your analogy, the car companies need to be taken over :-(

[JR]

1. The government buys everybody's cars, giving them money to buy new cars.
2. Everybody buys new cars.
3. A year later, the government dumps most of the cars it bought back on the market.

How does this not drive down the price for used cars significantly?

[kris]

Wont the carmakers still have inadequate money to pay for the new working cars? The govt wants to make some money off it, so it will have to price cars proportional to how much it paid for them, so a payout of $400 gives $7000 selling price, while a higher payout gives $9000 (which the banks err. carmakers cannot afford).

[Julio]

And what about me?

I put all my life's savings on the line insuring all those lemons against explosion. Heck, in fact, I've risked 1,000,000 times my life's savings, selflessly providing insurance to all for a modest fee, thus keeping up the price of cars for everyone.

A little help for me would go a long way, no? Wouldn't keeping me happy reassure everyone?

Why talk to 100,000,000 drivers when you can just talk to me?

(Good article though.)

[dd]

"You show up at the designated agency in your town, give up title to your car, and in return get a certificate valued at $7,000 that can be used as a down payment on the purchase of a new car..."

You can neither assign clear title without a release of lien from the noteholder as Xman and others point out; nor can you "give up" physical title as the noteholder retains possession until the loan is discharged. So unless Benson assumes the car payments (which in all cases now exceed the asset market value) or decrees the debt null and void by government fiat, the car owner is still liable for the outstanding balance. Don't see how this helps indebted car owners; although it works for those with a free and clear title.