Wednesday, July 2, 2008

The Future of American Automobile Manufacturers

Skyrocketing oil prices combined with a slowing economy has put the brakes on an automobile industry that was already reeling from supplier bankruptcies, labor unrest, and shifting global preferences. U.S. automobile sales fell to an annualized rate of 13.6 million vehicles, the lowest volume since 1993, with declines of 28 percent at Ford and 16 percent at GM. The rapidly accelerating sales declines at American automobile manufacturers are symptomatic of a product mix that no longer meets the needs or preferences of the American consumer. Despite many warning signs and vocal encouragement by prominent members of Congress, the Big Three ignored market signals and charged forward with an emphasis on large cars and trucks. The long design and development times for new automobiles seriously impugn notions that bankruptcy can be avoided at GM or Ford.

The current state of the U.S. automobile industry can be attributed to many factors. An entrenched history of unionization led to regular power struggles over pay and benefits leaving the Big Three constrained by high labor costs and barriers to restructuring. The UAW lost more than half a million jobs during the oil crisis of the 1970s and early 1980s leading to contract negotiations in 1984. A notorious consequence of these talks was the creation of the “jobs bank” that guaranteed downsized or idled UAW members full pay and benefits resulting in more than 12,000 workers drawing approximately $400 million per year. The Big Three, therefore, were unable to react to market forces through restructuring efforts without assuming significant dead weight costs. Additional labor costs were incurred as a result of rich retirement and benefits packages for a growing pool of retirees, thereby placing U.S. manufacturers at a cost disadvantage compared to Asian competitors.

In order to cope with a higher cost structure, the Big Three chased fat margins on large cars and trucks that, in retrospect, are a symbol of the excess and blatant disregard for energy consumption that defines our addiction to foreign oil. As the shift in consumer preferences became more obvious, Detroit stubbornly persisted with its dependence on big gas guzzling vehicles, opting to shun trends towards improved fuel economy and hybrid vehicles. They pursued solutions that required minimal redesign or innovation, choosing instead to embrace oil substitutes such as ethanol in the development of “Flex Fuel” vehicles. The inflationary impact of ethanol on food prices and commodity prices, while painfully obvious now, was not considered when President Bush and Congress subsidized significant domestic investments in corn based ethanol. General Motors and Ford both knew that Flex Fuel vehicles with no improvements in fuel economy would fail to address our insatiable demand for oil. Meanwhile, Toyota and Honda developed innovative hybrid solutions that secured an engineering and manufacturing advantage not easily overcome by the bureaucratic leadership in Detroit.

Ultimately, it is this bureaucracy that impeded the innovation and restructuring that was necessary to save America’s automobile manufacturers. General Motors marketed vehicles under 12 different brands, with management at each competing for resources and ultimately survival. Over the years, the distinction between the brands became blurred and the infighting distracted from the ultimate goal of designing and manufacturing innovative automobiles. Redundant brands, such as Oldsmobile, lingered on life support for years despite a poorly positioned brand and growing customer apathy. While economies of scale promote design and manufacturing efficiencies, the disparate and competing demands on management hindered GM and Ford’s ability to rapidly respond to shifting customer preferences allowing foreign competitors to slowly erode their market share.

The eventual fate of GM and Ford is uncertain. Cerberus Capital Management, one of the largest U.S. private equity firms, acquired Chrysler in 2007 and a majority stake in GMAC in 2006. With the market capitalization of GM and Ford recently falling to $5.6 million and $9.8 million respectively, industry consolidation is not unfathomable, but the large pension and health care obligations combined with a stubborn unionized workforce erects a potentially insurmountable barrier to acquisition. Bankruptcy, on the other hand, is politically unacceptable due to the large, well paid labor force that the automotive manufacturing industry supports. More than a quarter million people work for U.S. automobile manufacturers with another 750,000 employed at domestic suppliers and parts manufacturers. Further job losses in this industry would devastate the U.S. economy and lead to an economic depression across the Midwest, raising the probability of government intervention. A bailout of GM or Ford would perpetuate the market distorting notion of “too big to fail” companies (e.g. Bear Stearns) and create a false sense of security among individuals and corporations alike that a government safety net will absolve them of financial responsibility. Alas, years of mismanagement and blind disregard for market signals has left GM and Ford grasping at straws in a desperate attempt to resurrect what is left of their former glory.