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The Ground Shifts Under The Auto Industry

The Ground Shifts Under The Auto Industry

By Francis Cianfrocca - May 20, 2009

In case you were lulled by the anodyne headlines which announced the event, a tectonic shift has just occurred in the US auto industry. The managements, the labor union, the lobbyists, and the Congressional champions for the eleven global automakers operating in North America, all of them, just signed on to massive changes in the way the industry conducts its business. And they did so with somber but willing faces.

That they did so in almost no time at all and without raising much of a fuss indicates that we're seeing a ratification of trends that have long been hidden under the surface, but in motion nonetheless.

In short, the automakers have all committed themselves to meet steadily rising fuel-economy standards and steadily falling emissions allowances, both for individual models and across their fleets. The fact that individual models are part of the mandate rules out the standard trick, used for decades, in which an automaker made or imported small, fuel-efficient models, which balanced out the poor fuel economy of the profitable, large vehicles that consumers really want.

The short-term trend which drove the industry into the waiting, willing embrace of Barack Obama, was the ongoing reduction in demand by US consumers, which fell by anywhere from a third to a half last October and has shown not the slightest sign of coming back since then. This crisis drove GM and Chrysler LLC into bankruptcy, but it (and a relatively stronger yen) also created massive hardships for the automakers that weren't already on the edge when the crisis began.

The long-term trend, which has been brewing for decades, is that there's no room for sustained experimentation and risk-taking in a large, slow-moving industry. Particularly one that has long enjoyed the sustained attentions of government regulators, and whose labor-cost flexibility is extremely limited.

It takes anywhere from three to seven years, and several billion dollars, to invent a new car model. Given that logic alone, you can see how a capital-poor entity like General Motors would be on the verge of going out of business now, even without the recession and all the rest. Their last significant product push was about a decade ago, when they went all-out into huge new SUVs and light trucks for the consumer market. As a business decision, this was 100% correct. The oil price was headed for long-term lows, and the buying power of consumers was high
and rising. The strategy paid off, but when the cycle turned as it always does, GM had no capital left to develop the next cycle. They last turned a profit in 2004, and they've been adrift ever since.

So today had to come for GM, at least. Chrysler just doesn't have the size to be globally competitive, and the die was cast for them on the day they spun out of Daimler. The private equity firm that bought them got the timing wrong. Chrysler was supposed to be a quick spin back to the greater fool, aka the public stock market, with a 40% annual internal rate of return. But time, and financial leverage, ran out for them.

Now as I've said quite a few times, the real winner in all of this is the UAW. They serendipitously arrived at this moment with a great friend in the White House, a remarkable man who saw an outsized opportunity to (in Holman Jenkins's words) eat up every last shrimp at the buffet.

Why do I say that? Because the reality of GM and Chrysler is that they have been bailed out for the benefit of the labor union. Regardless of what happens to them from a business point of view, the union will be supported by the government. Which means these companies no longer have to be competitive in any meaningful sense, and they're also no longer subject to the iron law of free-market capitalism: if you're not winning, you're dying.

Ford Motor have been making a brave face of it, saying they would survive and thrive without government assistance. But that's simply ridiculous. Ultimately you can't compete against someone who has the game rigged in his favor. Ford was facing powerful long-term headwinds from the permanent government support committed to GM and Chrysler, and don't forget the government support received by the foreign automakers operating here.

So in retrospect it was inevitable for all the automakers to become government-protected entities. And the dimensions of the government's support are simple enough. If your product-planning horizon is measured in decades, but you get funded in capital markets that change direction in microseconds, the thing you want and need the most is to manage the total risk you face.

And the auto industry faces long-term risks that they can't easily control. One is the price of oil. And the other, quite candidly, is the price of government.

As long as the government found it impossible to corral the industry as a whole (that whole freedom thing can be a sticky wicket), they had to be satisfied with messing with automakers on a piecemeal basis. They periodically enacted safety regulations and stricter fuel-economy standards, over vicious protests from Michigan lawmakers as well as the industry. And the states, particularly California, went their own ways, legislating industry standards so as to create a different set of operating rules in each part of the country.

What the industry gets as part of the grand federal bargain, is the ability to walk away from all that risk, uncertainty, and cost. They will negotiate a uniform, national set of environmental regulations. No more California cars and everywhere-else cars. They would very much like to know right now how much gasoline will cost for the next decade, which simplifies their capital planning. It doesn't matter if the price is high or low; what matters is that it not change much. And government can deliver a promise to raise gas taxes so as to keep the price reliably high.

And what about environmentally-friendly cars? That basically means smaller cars with very expensive new technology, eventually driven by electricity. This was the toughest challenge of all, because consumers have shown no evidence whatsoever of wanting to buy these vehicles for anywhere near what they will cost. (The electric Chevrolet Volt, to be released next year, is a nondescript little sedan that only goes 40 miles on a charge-- and will cost about $40,000. Do you want one at that price?)

Building new generations of automotive technology is simply a reach that is beyond private industry. Why? Partly because their investors have little stomach for the risk. But mostly because there's no demonstrated ready consumer market. There are so many ways to get this wrong, and every one of those ways is strong enough to kill one or more major automakers.

The only way out of this box is for the government to replace the consumer as the automakers's primary customer. This process reminds me a lot of how the Defense Department procures major systems. As in the auto industry, there are only a few major contractors, and they work on multi-decade planning cycles. They negotiate extensively with the government to make sure their risks are covered upfront, throughout the contract lifecycle. The same will apply to the automakers, who simply can't afford to take the risk of building technology that no one will buy. The government provides a guaranteed buyer.

But none of this had to happen. The industry would have been thrilled to keep operating as it always has, basically adrift and in competition with itself, so long as the lifeline of taxpayer dollars kept coming in.

That in fact was the future I had been predicting: something like "American Leyland," a stable industry producing mediocre products, with steady cash flows but unremarkable earnings, and facing no pressure to change.

This is the point at which Barack Obama entered, shrewdly perceiving and ruthlessly taking an opportunity to roll up the whole industry in one stroke. What Obama basically said to the industry was: "The taxpayers will keep you alive permanently, but you don't get a free ride. From now on, you have to play by our rules. No cost-cutting on the labor side, and you make the vehicles we want you to make."

Under the circumstances, the automakers, their lobbyists, their Congressmen, and their beaming labor leaders, heaved a big sigh of relief, and said: "Where do I sign?"

If this all comes off the way the Obama would like it to, we will indeed have a fundamental transformation in an industry that accounts for millions of jobs and about one fifth of GDP. The preferences of government will replace the preferences of consumers.

I'm unabashedly a free-market ideologue. I believe on principle that when free people are suffered to pursue their self-interest in the economic sphere, the resulting outcomes are not only good, but optimal. This is the principle that the state-capitalism model explicitly rejects.

State-directed capitalism has been known to work well enough in Europe, Japan, and China. It does not have a stellar history in America, except arguably in times of total war. That doesn't mean it can't work here, but it does mean, if you'll pardon yet another use of a tired metaphor, that we're in uncharted waters.

I frankly do not believe that the American people will reject state-directed capitalism out of hand. There will certainly be a reduction in consumer choice, as government's preferences supplant ours in the auto industry. But I don't think most people will notice all that much.

What concerns me much more is the efficiency of the whole exercise. When private enterprise and private capital drive the economy, the result always is to maximize efficiency, because that turns directly into profits. But the government isn't seeking to maximize profits. Its goals in taking over the auto industry are to maximize political and environmental benefits, and to reward its friends in the labor movement.

It's simply unavoidable, therefore, that the US auto industry will get far more expensive in relation to the tangible benefits it delivers to consumers. We will certainly respond by buying fewer vehicles and replacing them less often. Government's response to that, UNAVOIDABLY, will be to increase the commitment of taxpayer dollars it makes to the industry.

The choice that we will have made as a society is to forego consumption and investment in other sectors of the economy in order to fulfill the government's objectives for autos. We don't yet know how high, or how sustainable, that societal cost will be.

Interesting times, indeed.

Mr. Cianfrocca is a businessman and investor based in New York City.

Francis Cianfrocca

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