Back to the Beginnings

Well, today came the first steps towards the de facto reorganization of GM without going through the de jure process of bankruptcy court. The game has switched from softball to hardball ... squash. No more finesse, whoever has the most power wins. It's not GM's bondholders and it's not the UAW. But it may be the collapsing economy that proves the most powerful, not the Obama administration.

Arguing that issue will take time -- my outline is 5 single-spaced pages, not the sort of thing for which a blog is suited. Instead let's do a little applied IO (industrial organization), beginning about a century back. The auto industry evolved in a manner familiar from that perspective, at least in its stages if not the overall process.

After the formative years of playing with multiple technical standards and marketing strategies, as well as corporate structures, Henry Ford latched onto a combination that worked. He assembled parts and sold his Model T to dealers, collecting money up front, and paid suppliers in arrears. Vanadium steel alloys and ultimately the moving assembly line enabled him to push down the weight of his car, and up the speed of assembly. Inventory turns, all that -- though since the old man hated accountants, there are no books to trace the financial evolution of the firm. In any case, he soon dominated the market, in the US, in Europe, in Asia.

Now Henry owned the firm, or at least he did after forcing out the other shareholders, something he'd done twice before in the forerunners to the Ford Motor Company. (He was not a nice man.) No one could dissuade him from his policy of ever-lower prices as he improved the basic model and (for many years running) lowered his costs. But there was a bottom to how low he could push costs, and others began attacking his position from upmarket. GM succeeded, and the Model T began a gradual decline, until in 1926 Ford was forced to pull it from the market while he rushed the development of the Model A. By the time he launched it in 1927, Chrysler had also emerged as a player. Monopoly power made Henry insensitive to the shifting market, and the lack of outside shareholders meant there was no restraint on his whims. Ford was free to give away market share; if he wanted to bankrupt his firm, that was his business.

Fast forward 50 years for a variation on that story, to which I will provide another spin. From the early 1950s into the early 1970s GM was the dominant firm in the US auto industry (and with the exception of Japan, number one or two in the markets that mattered outside the US). For twenty years running it was the most profitable manufacturer (and often the most profitable firm) in the world, earning a 20% return on assets. But with just over 50% of the US market, antitrust considerations constrained additional expansion; it had to allow Ford and Chrysler a share of the market. Through price leadership it could nevertheless coordinate pricing policy with them; its economies of scale were considerable, and it was the low cost producer. The other two firms thus wanted to avoid a price war; though they could set prices below GM's umbrella, they could not be unduly aggressive.

Eventually such high profits did encourage new entry. Via imports the Scandinavians had a modest presence, as for a while did British, Italian and French firms. Of course there was also American Motors, an amalgam of US firms that emerged -- or rather merged -- after WWII. More successful was the German firm VW, particularly when a fad for small cars swept the US in the late 1960s, making the Beetle a hit. But as had happened in the late 1950s, the small car fad passed and the market for that low-profit segment shrank. Detroit was relieved, because if they all entered, it would have been a bloodbath: flooding the market with low-margin products was not an attractive business proposition. When there was another swing towards small cars in the late 1970s, following the first and especially the second oil crisis, VW stumbled and it was Japanese firms that captured the small car market. Again, the Detroit Three wisely sat on the sidelines. But US government policy worked against GM and the others. Ronald Reagan's VER ["voluntary" export restraint] policy effectively asked the Japanese government to organize a cartel to raise prices in the US. Carter's CAFE [corporate average fuel economy] standard and the earlier Clean Air Act bolstered the position of these new entrants, because they favored small cars and imports. The profits of the VER and the breathing space of other policies gave the Japanese time to build a distribution network and to move upmarket. We know the rest of the story.

Back to substance: over the next quarter century GM steadily ceded market share to these and other entrants. (At present 14 firms assemble vehicles inside NAFTA -- ignoring equity ties, two are Korean, three German, three are Detroit-based, and six are Japanese.) Doing so was rational. GM could have lowered profits to preserve share. But why should it do so when it was so dominant? The modest increment garnered by the new entrants was no more than a burr on its side, and shareholders would rightly have screamed if it gave up its bounteous profits that it earned on its 50% share of the market in an effort to scare off these entrants. Henry Ford was irrational in his strategy. But GM was rational in its refusal to fight. Making way for fringe firms to enter the market is the only sensible strategy for a dominant firm.

Eventually a dominant firm thus will cease to be dominant. So it was with GM, though it hung onto the most profitable segment, light trucks, and did well thereby. That would be the end of the story if downsizing was easy in the auto industry. Even then it might not have mattered had GM not had to shoulder pensions and especially healthcare obligations for its increasing numbers of retirees. Such aspects must await another post.

Let me reiterate the central point. GM's management certainly made many mistakes. This included such bone-headed investments as Saturn, billions spent on automation and other hoped-for "magic bullets" that ignored basic operational competence, and an overarching role for people with a background in finance rather than manufacturing, engineering or marketing. Nevertheless its core strategy was consistent with earning high levels of profits for its shareholders. Indeed, it was sufficiently successful in this that going into the current recession it was Toyota that was mimicking GM in its strategy in North America, rather than the other way around. Another year or two of breathing room would have made all the difference.

Cash for Clunkers

Here is an op/ed originally published in the Richmond Times-Dispatch on February 14, 2009 entitled "Detroit's Drop-Dead Day". Go here to see it on their site.

LEXINGTON [Virginia] When the good news is that Honda's U.S. sales are down only 28 percent and Toyota projects losses of only $5 billion, it's clear the auto industry's problems extend well beyond Detroit. Market pro jections by car companies for 2009 vary by 30 percent, while light truck sales are up -- for now. Which cars will sell is no clearer than how many will sell. Yet, in its December "bailout" to the industry, Congress mandated that Detroit produce turnaround plans by Feb. 17 and show progress in implementing them by March 31, or get thrown into bankruptcy.

The reality is that credible planning is impossible. And in an industry with high fixed costs from parts producers -- which employ three times as many workers as the car companies themselves -- down to dealerships, a 40 percent decline in sales means everyone is losing money. Those without a cash cushion will go under. In the past few months 40 suppliers have declared bankruptcy; hundreds of dealerships have closed their doors. The entire "value chain" of the industry is in parlous health, but is so interconnected that if too many firms fail, the normally orderly process of bankruptcy will spiral into a chaotic shutdown of all manufacturing, taking with it 1 million jobs in short order.

LET'S BE frank: There are no easy solutions. Improved engineering processes allow firms to launch new products more rapidly than ever. A vehicle that sells well soon faces competition from all sides. Even before the recession, chronic excess manufacturing capacity and bloated dealer inventories plagued the industry. One indication was the launch by the Japanese and Germans of SUVs and pickups, which they've found hard to sell. There's been excess capacity across producers and product segments, and not just in Detroit.

Then came the bubble. During the four years leading up to our current downturn, the stock of vehicles expanded by 22 million units, leaving us with 248 million vehicles for 202 million drivers. Now population growth adds 2 million drivers a year, and expanding businesses top that off with another million units of demand. The market might more reasonably have grown by 12 million units -- not by 22 million. The overhang created by the bubble isn't just in housing.

One temptation is to try to pile on government-financed incentives. But as the industry well knows -- and the Detroit Three know better than most -- artificially boosting demand with discounts and sales to rental car fleets carries a steep cost: It "buys" sales from the future and leads to an outpouring of used cars a few years down the road. So purchasers receive poor prices on their trade-ins. That, in turn, leads to a perception that these vehicles are low in quality when, in fact, poor trade-in prices reflect supply-and-demand. Incentives thus come back to bite the industry, but high levels of discounting are addictive, as sales plummet the moment they're removed.

ONE POLICY that might help is a version of "cash for clunkers." This would help eliminate the market overhang created by the bubble to get rid of old cars rather than trying to pile on more new ones. To make sense, however, it must really be targeted at clunkers -- and hence should offer more cash for older vehicles. It might start at $500 for a 10-year-old vehicle, bumping the payment up $100 per year, with $1,500 for vehicles aged 20 and above. The new Department of Transportation vehicle tracking system would help ensure that these vehicles are recycled into scrap, and DOT and the EPA also have the expertise to jiggle the details to get rid of a target number of vehicles (say, 2 million).

This policy would be no panacea; if pursued too aggressively, it could make it harder for lower-income Americans to buy a vehicle. Nor are all old cars inefficient; the subcompacts of the 1980s got tremendous mileage. Owners might prefer to drive such clunkers rather that accept cash. But unlike other proposals, this policy would not distort new car purchasing decisions and would thereby avoid another downturn in sales the moment the program ended. Improve access to finance for credit-worthy borrowers, yes! -- and the recent targeting of TARP funds to the finance arms of General Motors and others has helped. But to offer an alcoholic strong drink -- that is, to pile on more discounts -- not only won't work: It's just plain wrong.