The Impending Auto Bubble

Right now the big 3 US car makers, GM, Ford, and Chrysler, are hurting. Bad. In fact, they are hurting so bad that they are telling congress that they need a portion of the bailout money in order to stay afloat.

So what happens if they go under? My prediction is that we will see a very short bubble in the auto industry. The reason for this is basic supply and demand. Let’s explore this with a simple example.

Right now let’s say that we have Ford, GM, Chrysler, Toyota, Honda, and Mazda operating in the United States and no others. Each one can produce 100 cars per day at maximum capacity but demand only has them producing at 75% capacity. So right now things are in harmony where demand equals supply with 450 cars per day being produced.

But now we are shutting three of them down because they have been mismanaged for years (or any other of the 1,000 reasons why they are hurting now) and we don’t want to bail them out. So now we must remove their daily production and capacity from the mix – to keep it simple we will assume that none of them are bought by the other auto makers. This takes the supply down to 225 cars per day yet the demand still sits at 400 cars per day. To accommodate this reduced supply the remaining car makers max their output, raising it up to 300 cars per day.

This is still a supply deficit though. The demand is still 100 cars per day higher than the supply is able to accommodate. This will cause two changes.

First, the remaining auto makers will increase production capacity to account for the variance. This will take time and will be a long term solution.

Second, the auto makers will raise prices. In order to try to reach an equillibrium where they are producing at optimal efficiency they will raise the prices to increase profits and lower demand. Likewise, the lessened availability of cars in the market will reduce the purchasing power of consumers, allowing dealerships to raise the prices without an immediate penalty for doing so.

From an economic standpoint this will have a number of effects. First, the dealerships and auto makers will increase their short term profits. Second, the auto makers will grow larger. Third, autos may actually appreciate slightly, at least for the short term. Finally, autos will be overvalued, creating a severe negative equity situation.

The first and second points are pretty straight forward. As the prices rise but costs remain relatively stable the auto makers and dealerships will recognize an increased profit. This increased profit will help to fuel growth, which must occur to stabilize the supply and demand disparity, which will cause the companies to grow.

The third point, that autos may appreciate slightly, comes from the same supply and demand concept that caused the prices to rise. This doesn’t mean that the new car you bought will be worth more than you paid for it. It simply means that the car you have had for a while that has severely depreciated may come back up a bit. For example, if you bought a car at $30,000 and it was valued at $17,000 after two years you may find that this bubble causes the depreciation to lessen slightly, making the value of the car $18,000.

The last point is the most scary from an economic viewpoint. As prices rise they will reach artificial levels that would not stand in the typical economy where supply and demand were fairly close to one another. These artificially high prices mean that, at least in the short term, people will have to pay more for vehicles. This additional purchase price will cause people to have higher payments for less real value. Once the market corrects itself the real value of the vehicles will shift downward, leaving a large chunk of negative equity. This will eventually cause hardships like we hae seen with the housing bubble, albeit not of the same magnitude.

Let’s use an example here. Keep in mind that the numbers are illustrative only and will not add up correctly.

My car breaks down and dies during the height of the auto bubble. I go and buy a brand new BMW for $45,000. This car would ordinarily be priced at $35,000 but the bubble has artificially inflated the price. I am forced to take a monthly payment of $650 per month (I had no money to put down) in order to own the car. As the bubble breaks the price of the car drops back down to its standard price of $35,000. So the car that I bought at $45,000 is now instantly worth $10,000 les than it was. In addition, the payments of $650 per month are not reflective of the value of the car so no banks will finance a refinance loan (at least that will drop the payments) because of the extreme amount of negative equity. Likewise, I can’t sell the car on the used market because I need more to pay it off than what you can buy a new car for. The payments eventually become too much – perhaps I lost my job, made some bad decisions, got sick, etc. – and I default on my loan. To recoup some losses the bank turns around and sells my car at a high discount from the current market price, in order to liquify it quickly, and takes a huge loss. Now magnify this situation across the United States.

Sound familiar? It should – this is exactly what happened with the housing bubble. If the big 3 go under and are not purchased by competitors then we could see such a situation. It is our responsibility to be vigalent and prevent another bubble from hurting ours or the world economy. The solution is pretty simple: don’t by things for more than they are worth. If a car is worth $20,000 today and $25,000 tomorrow, that should raise a red flag. Just be a smart consumer and the bubble will remain small, isolated, and insignificant.