Big Three get a deal to save the day --but not the year

The White House has unveiled an auto bailout package:

The deal would extend $13.4 billion in loans to General Motors Corp. and Chrysler LLC in December and January, with another $4 billion likely available in February. It also would provide the government with non-voting warrants, although the exact amount was unclear immediately. Ford Motor Co. has said it doesn't need short-term assistance.

But there's a poison pill

The deal is contingent on the companies' showing that they are financially viable by March 31. If they aren't, the loans will be called and all funds must be returned.

There is no way that the auto companies will be financially viable by March 31st.  They haven't been financially viable for 25 years.

I've been thinking a lot over the last few days about the quarrel between liberals and libertarians over the bailout.  I will now attempt a fair rendition of how I think liberals think about this; if I fail, forgive me and explain my error.

The liberals who want to save the UAW think of it this way:  Detroit is in trouble because of some combination of economic downturn and unfair competition from southern plants or abroad.  There are a number of different ways to get back to profitability, but conservatives, who are ideologically opposed to unions, are only interested in making sure that the union bears as much of the cost as humanly possible, or in killing off the Big Three altogether so that the UAW will be destroyed.

Recommended Reading

I think this is mistaken, though if you don't follow the auto business, it's not necessarily obvious how this is mistaken.

I will now attempt what I think is a fair rendition of Detroit's history over the last fifty years.    In the early 1950s, for various reasons Detroit developed a cozy three-way oligopoly.  The UAW developed a cozy monopoly on supplying labor service to that oligopoly.  In some ways, the UAW helped sustain that oligopoly.  If you're a big company whose quality suffers, you have problems.  But if you have a union making sure that labor quality cannot vary across the industry, you don't need to worry that your competitors will make a better car.  Detroit competed on styling and power, not reliability or price.

During those years of oligopoly, the Big Three's first loyalty (after their loyalty to management) was loyalty to the union.  The worst thing that could happen to a Big Three manager was a strike.  Making a car that is reliable is only partly a matter of engineering; it's mostly a matter of extremely tight control over the assembly process.  That tight control is necessarily less pleasing to the workers than looser rules.  The unions could severely hurt a company with a strike.  Whereas the customers?  The customers could only go to another company where the same union was negotiating the same loose work rules.

(Yes, yes, I know that Toyota does it differently, with group responsibility.  But Toyota's system was developed in the absence of a strong union; the adversarial model that the UAW had developed along, however historically necessary, made the Toyota example completely unworkable in a Detroit plant.)

After the unions, for the Big Three, the government was the next most worrisome constituent, followed by the dealers, then the suppliers.  The customers were somewhere down there with the mayor of Youngstown, Ohio, in emotional importance to Detroit managers.  It's not that the managers in Detroit had anything against their customers, and I've no doubt that they had lots of meetings in which moving testimonials to the gosh-darned swellness of Chevy or Buick or Mercury buyers.  But the buyers had little power to punish them, and their other constituencies could make their lives miserable.

This showed in a lot of things:  yes, the luscious deals they negotiated with their unions, and the gold plated benefits promised on the theory that Americans would continue to buy their cars no matter what; but also their engineering, and management's willingness to ship cars with known defects, and so forth. 

Two things changed.  First, foreign automakers began to compete in the US; David Halberstam's The Reckoning, though I believe it is out of print, remains the best discussion of this process.  And oil prices shot up, which severely hurt the demand for cars--especially the larger models on which Detroit had historically made all its profits.

Detroit should have reacted, I'm sure, by making smaller cars.  But smaller cars were harder to make for Detroit.  Buyers thought of them as a non-premium product, which meant they wouldn't pay for the lucrative options packages.  And because they used fewer materials, the labor component became a relatively larger part of their cost.  Labor was where Detroit was least competitive.  According to the automotive analysts I've seen, Detroit still loses money on small cars like the Ford Focus, which are sold at a loss to help make Corporate Average Fuel Efficiency numbers come out.

Detroit needed to do a lot of things in the 1970s.  It needed to get better engineering, it needed to get control of its assembly process, and yes, it needed to lower labor costs.  But it did none of these things.  By the early 1990s, Detroit wasn't even trying very hard to make a profit on cars.  Detroit was making profits on light trucks, where the higher sticker price made it easier to hide labor costs (and which foreign companies were not, anyway, very good at making).  It's worth noting that Detroit's focus on light trucks was not merely a management decision; it was what the powerful unions wanted, because they knew the math as well as management.  Light truck plants were better for the UAW than more Ford Focus capability. 

But perhaps more importantly, Detroit turned from making money on cars to making money on financing.  Detroit didn't make a big profit by selling you a Ford Taurus.  It made money on financing your Ford Taurus; often, the car was sold at a loss in order to get the finance business.  The Big Three were banks manufacturing cars as a loss leader.

That's why they could afford to pay their workers above market wages.  They were not trying to make a profit on the manufacturing process.  The UAW wages and benefits were not compatible with profitability in the auto business five years ago.  Or ten years ago.  Or fifteen years ago.  The UAW is not being asked to bear the pain of returning the company to profitability in a tough market.  The UAW is being asked to get their wages back to where they would have been in the first place if they hadn't been subsidized by the now-unprofitable financing arms.  Detroit has spent decades buying labor peace with increasingly desperate ploys that have finally run aground.

It doesn't really matter who should have changed their ways twenty five years ago; most of those people are retired or dead now, and there's no just reason that either management or labor should pay for their sins.  Nonetheless, both will, because there's no one left.

It is probably true, as Bob Casey cries, that UAW costs are only 10% of Detroit's costs.  But like executive compensation, and bond obligations, those costs are 10% with room to cut.  Detroit has no room to cut the cost of the steel in its cars, because steel is bought on the open market.  Ditto glass, and so forth.   Aside from squeezing suppliers still further, Detroit has only three places they can claw back significant savings:  bondholders, dealers, and labor.

The bondholders can, and will, take a haircut.  But it is not really particularly just to drive their loss up to 100%, rather than the 70 or 80% they are now facing, in order to keep making unprofitable cars at premium wages--and if you make it clear that the government will intervene to confiscate their money and hand it to the workers, Detroit will face even higher borrowing costs in the future.  In a capital intensive industry, that is death.

Leave aside that you would be taking money from those who lent in good faith, violating a past agreed obligation, in order to satisfy a newly created future obligation to provide the UAW jobs.

The dealers will take some sort of a haircut, too; a lot of them are going to go out of business.  (And check out some of the nasty surprises Detroit has recently handed its already struggling dealers in order to conserve its cash.)  But dealers are not quite as useless as is generally supposed by people who fancy that we should all order our cars the way we order computers from Dell.  I'm not saying such a thing is impossible--franchise laws have made it impossible to attempt that business model.  But that business model is not as flawless as it seemed back when I was a newly minted MBA.,

As I now understand it, thanks to the helpful folks at McKinsey who explained it to me a while back, dealers are a way of handling the fact that auto manufacturing plants break even only at very high capacity usage; you cannot profitably make only 50 cars in a 500 car plant if demand is slow this week, because of your fixed costs (including labor!)  Dealers take non custom inventory and craft deals that make it attractive to their local buyers.  In other words, they haggle.  We hate it--but if we didn't have it, our cars might either have fewer features, or be a lot more expensive, because of the scale problems.

They also provide capital for selling cars.  Dealers have their own independent credit lines, which they use to buy cars, advertise, and so forth.  Dealers may be parasites on the body public 95% of the time, but right now, they're probably helping keep the Big Three out of bankruptcy by carrying unsold inventory, not pushing them deeper into it.

Nonetheless, the consensus is that Detroit needs to trim dealers, to whom it also extends a great deal of credit, and consolidate operations.  But even if we got rid of the franchise laws, getting rid of the dealers wouldn't get Detroit all the way.

Detroit could lean on its suppliers, of course, but that just pushes the bankruptcy--and the UAW job losses--back one level.  Supplying Ford is not exactly a license to print money these days.  And the rest of its components are bought on the open market.

What about management?  I hear you cry.  Management's salaries can (and are) being cut, for the same reason that labor's may be:  they're not set in a perfectly competitive market.  But they're not a big part of Detroit's overall cash problem.  With a burn rate of $4 billion a month above revenues, getting all of Rick Wagoner's cash back, and making him buy his own coffee to boot, will run the company for about a minute.

Most of the rest of management is boring, middle class folks who are not magnificently remunerated:  purchasing managers and payroll supervisors, sales executives and engineers.  Their salaries will be cut, and a lot of them will lose their jobs.  But a fair number of them make less than the UAW, and there are a lot fewer of them.

The really miserable thing is that even a total bankruptcy may not be enough.   Wipe out the shareholders, cut the bondholders to the bone, shuck the gold-plated medical benefits, toss out the UAW contracts, close the dealers--and we still may be left with companies that cannot make a profit without a now-defunct financing business based on ever-growing loans to ever-poorer credit risks.  The Big Three, with the help of the UAW and all their other partners, has spent 25 years building a reputation for poor reliability and ugly cars.  Brands matter.  Once destroyed, they're very hard to repair in the best of times.  These are not, quite, the best of times, are they?

All the quibbling about whether people will buy a car from a bankrupt manufacturer seems to me to be largely beside the point.  If people think the companies can't make it, they will act as if they're bankrupt, whether we use the "B" word or call it "Splendiferous Corporate Reorganization and Restructuring For Most Excellent People's Automotive Concerns".  And right now, they've got very good reason to think that the Big Three can't make it.