Politics, Business Loans and Market Failure

A story that is getting a lot of play in London, Ontario:

Diamond Aircraft has raised the stakes in its fight to secure a $35 million Canadian government loan that would allow it to restart the D-Jet programme. It promises to develop unmanned and special mission aircraft for the North American market at its London, Ontario factory if the D-Jet is saved.

The Austrian-owned company hopes the commitment will convince politicians contesting a 2 May federal election to back the loan, warning that the longer the delay, the harder it will be to re-hire 213 workers - more than half its workforce - who were furloughed when Diamond suspended production of the single-engine jet on 28 March.

 

There are some very major questions about this loan that nobody seems to be asking.

To get the D-Jet program off the ground (sorry), $90 million is needed.  The funding is to come from a mix of private, provincial and federal money:

The family of owner Christian Dries, who founded Diamond in the early 1990s, has committed a further $20 million on top of $120 million already spent since the D-Jet was announced in 2003. The Ontario provincial administration has promised $35 million, but only if the national government matches that figure.

I don't know much about the project, though I do know that they are very nice jets:

(Full disclosure: The wife of the company President is a former classmate of mine and current faculty member at Ivey and I consider her a friend.)

The question we need to ask is - "why does Diamond need to borrow money from the government?".  I can think of three reasons, all of which lead to somewhat unsettling conclusions.

1. The project is a financial white elephant. Way too much risk, too little reward.  I have no idea if it's the case (and I have a tremendous amount of respect for Peter Maurer as a businessman, so I'd like to think it isn't).  If it is the case, though, how can we possibly justify having government money go to such a project?


2. It's a worthwhile project and lending institutions would be happy to lend - for a price. But government money is cheaper. The project passes a cost-benefit sniff test and there are lenders out there willing to lend at a reasonable rate. But by going to government, Diamond may be able to get a lower rate.  I fail to see why this is in anyone's interest (other than Diamond's). Why should the government be investing in private sector projects and taking opportunities away from the private sector? Why should governments be providing Diamond with a de facto subsidy?


3. It's a worthwhile project, but financial institutions won't touch it due to some form of market failure. I don't think we can rule this out.  If there is, in fact, some form of market failure than government intervention can be justified.  If the market is failing to provide capital to expanding businesses, however, then we have a problem that goes well beyond Diamond Aircraft. What is the source of the market failure? Is there a way we can systematically eliminate this market failure, so we no longer need governments to be approving and issuing loans on a case-by-case basis.

I'm not sure which one of these scenarios is more likely, but I find all of them unsettling.  Particularly the last one, since it involves larger issues than we are failing to address.

 

Comments

[Joel Wood]

"why does the government need to borrow money from the government?"
Do you mean "the company"?
_

Anyways, it is probably #2. I am basing my guess on the fact that Canada has a long history of subsidizing the aerospace industry, so the firm knows that govt help is available. When subsidies/bailouts/low-interest loans are available, firms have a perverse incentive to invest $$ in lobbying for gov't rather than in production. This is probably the most interesting result of Goldfeld & Quandt's 1988 paper on soft-budget constraints.

[Mike Moffatt]

Whoops - fixed.

"Anyways, it is probably #2. I am basing my guess on the fact that Canada has a long history of subsidizing the aerospace industry, so the firm knows that govt help is available."

Agreed. Then the question becomes "why are we subsidizing that industry"?

[Mike Moffatt]

And it may be because there's some kind of market failure preventing financial institutions from loaning money to aerospace companies, but it's hard to believe that the market failure would be *that* specific.

[Joel Wood]

"why are we subsidizing that industry"
_

As a westerner (despite my brief sojourn in Ontario for grad school) I have been wondering about this to myself for a long time. With Bombardier, I think the usual justification, other than creating jobs, is that Brazil subsidizes Bombardier's main competitor. So maybe we need to look at who the competitors are and what govt aid they may receive.

[Chris S]

I think that some industries fall into #3 because of government intervention; it might be government as buyer, or government as regulator.

I can see aircraft, particularly aircraft with a military potential, easily falling into this area. If the government doesn't appear as a buyer, then lenders would consider a loan risky. If the government does appear as a buyer, then the risk is low - possibly so low that other sources will lend, undercutting traditional financial institutions. As a result, the group in question reasonably turns to the government, saying, "if you're going to be a buyer then you need to be involved now".

Nuclear power seems to face a similar problem, but almost entirely on the regulatory end. In that case, governments inject such a high level of regulatory oversight that the market can't find a viable price point. Since government is unlikely to reduce nuclear regulation, then it falls to them (as the cause of the market failure) to remedy that failure.

Your post reminds me of AECL. The federal government would probably like to privatize AECL - but is almost certainly unwilling to step back from the regulatory depth it currently faces. As long as nuclear regulation is as heavy as it is today - a point I am neither supporting or decrying here - then a logical outcome is that the government will have to continue to fix the market for nuclear power.

[Aaron Holtzman]

I think a good case could be made for:

4) Subsidies are business-as-usual in the international aerospace business. You can't compete without them.

See the long standing WTO case between between Airbus and Boeing over 'launch aid' for starters.

[Determinant]

There is a good argument to be made for (1). I checked out the wiki page on the D-Jet which says it's a Very Light Jet and lists two competitors. I worked on the development of one of those planes at a summer job I had. That plane was cancelled and the US manufacturer entered Chapter 11 and then Chapter 7 liquidation, according to that plane's wiki.

This is a high-risk, low-margin market.

Which leads directly to (2), in that lenders will demand a risk premium.

However, voters see manufacturing as worthwhile and I quote a Bank of Montreal presentation to small businesses I attended: "The purpose of the Chartered Banks under the Bank Act is to provide senior secured financing and transaction facilities to business".

Banks can't and won't provide the kind of investment-grade loan that this company needs by themselves. Since we may reasonably suspect that private lenders will demand a risk premium, government assistance is simply a business tactic.

[Jacques René Giguère]

No equity provider will touch the aviation business even witth a sterilized barge pole.

The aircraft-and airlines business have lost collectively about half-a-trillion dollars since the invention of the airplane. It is an empty-Samuelson-core hellish mess of high-fixed low-marginal costs both in building and operating the sorry contraptions. It went through thanks to the use of government funded military pilot trainig, govt funded airports and air control system, subsidised aluminium, specialty metals and electronics manufacturing, govt research contracts. research done at universities and govt labs and given away to manufacturers. All the good aspects have been externalized and essentially appear as a subsidy to the lifestyle of eurothrash and upper management plus those rich enough to buy tropical fruits flown in from Balounistan.

In Warren Buffet's immortal words: " If a capitalist had been present at Kitty Hawk, he should have shot those bastards Wright brothers.."

And I say that despite having done part of my pilot training in my youth...

[Determinant]

FWIW you're right, though transportation has always been a tough business. Until 1980 US railroads went bankrupt with regularity. Something like 60% of all US route mileage had been in bankruptcy at one time or another by 1975. I quote from Ben Graham in the "Intelligent Investor". He grew up on Railroad Bonds and had a special love for them. They received special treatment in his works.

[Jacques René Giguère]

Railroads have the same problem. Tha's why they were either consolidated or nationalized, both ways to monopoly and survivability. Airlines followed the same route so to speak: national companies or price-fixing regulation. After Kahn forced through the 1979 deregulation, there was a period of joyful expansion followed of course by bankrupties, the hub-and-spoke model, frequent-flyer plans and so on. Does anyone stdy basic micro anymore ( apart from my students)?
( Alfred Kahn's "The economics of regulation" was written by an economist?) To borrow from Nick "C oh C"...

[Flightless Bird]

I think one source of market failure in credit markets is caused by the inability of financial institutions to observe a firm's quality (i.e discounted stream of profits). Thus, collateral becomes the decision rule and capital is not necessarily allocated to the most profitable ends. It's an application of the market for lemons, I believe.

I'm not sure if that applies in this case. Smells like a bit of shakedown.