Food for Thought on the Auto Bailout

It’s no secret that the Detroit Big Three auto manufacturers are in serious trouble. GM and Chrysler in particular have admitted to being in danger of running out of liquidity within the next few months. Now I’m no economist, nor do I have a business degree, and frankly, I’m not really qualified to talk on the issue at all. However, while researching the issue for myself, I found a few interesting points that I think need considering before anybody forms an opinion about the proposed loans.

When the bailout bill failed to pass a vote in the United States Congress yesterday evening, a lot of people blamed the failure on the refusal of the Democrats to mandate a salary cut for UAW workers as a condition of the bailout. Republicans were particularily insistent on this condtion, and news outlets ran a story comparing an alleged $71 hourly wage for big three workers to the $49 hourly wage of Japanese auto workers. The true breakdown of the $71/hour figure can be seen in this chart from the New York Times:

NY Times Breakdown of Auto Manufacturers Wages

As we can see from the ‘Legacy Costs’ section of the chart, supporting an aging retiree base accounts for much of the difference between domestic and foreign auto manufacturer wages. This is essentially a fixed cost that isn’t going away unless the Big Three forfeit on their pension promises to retired workers and their spouses.

This article by author Malcolm Gladwell explains the concept of the ‘dependence ratio;’ that is, the number of dependent members of a set of people to the number of active and working members of that same set. The concept is generally applied to countries as a function of birth rate: Simply put, when a country experiences a massive downturn in birthrate, everybody benefits in the short term because the same number of people in the work force have to support fewer dependents with their tax dollars. It works in the other way as well – right now in Canada, we have an aging baby boomer workforce that will soon retire to be replaced by my generation. When that happens, we will have a massive number of dependents in a system with far fewer workers, raising our dependence ratio and by and large, making my generation far less liquid than my parents.

The concept of a dependence ratio explains a lot in economies and societies, but can also be applied to large companies in a pension crunch like the Big Three auto makers. Basically, the pensions for all of the domestic auto maker’s retirees are a linear function. More retirees means more in yearly pension payments, and these companies have a lot of retirees because they’ve been around for a long time. Foreign auto makers have far fewer retirees to support by a long shot, which explains the ‘Legacy Costs’ section of the above chart. Take that out, and domestic auto workers cost about the same as foreign ones do.

But that isn’t the end of the problem. Free market economics state that to stay competitive, and thus profitable, a company must continually increase the quality of the product that it produces while decreasing the cost of production in order to raise profit margins. Manufacturing companies decrease the cost of production by automating processes so that it takes fewer man hours to assemble the same product. The domestic auto makers have done a great job of this, and now employ far fewer people than they used to, and have increased the profit margins on their vehicles significantly since ye olden days.

However, when a company is responsible for the pensions of all of its retirees, this process of improvement actually works against the company – they decrease the number of employees, whose working hours have to pay for the pensions of all of the retirees, thus increasing their dependence ratio by a massive amount. If a company sells cars, it can express the profit made on a sale in terms of the number of man hours that went into creating that car. If fewer man hours went into making that car each year by improving the process, but more retirees had to be paid from those man hours, the ‘wage’ of every worker is artificially increased every year by the overhead of pensions, even though the worker never sees an extra dime.

The only way to offset this artificial wage inflation is to increase the profit margin of your cars proportionally to the rising dependence ratio. Enter the credit crisis: A catastrophe in no way the fault of the auto makers has decreased public demand for new cars. Sales are at their lowest point across the board since the early 80′s. Yes, even Toyota and Honda and all of those other car companies are experiencing decreased sales – however, they’re more prepared to handle it, because they don’t support a fleet of retirees nearly the size of the domestic manufacturers. While the market share of the Big Three is lower than ever (47% this year), I would argue that this number has been falling for some time now, and that these companies have been taking steps to deal with that fact. Only the rise of this credit crisis has been able to push the numbers so far south that there is no recovering from the implications.

So the question arises: even if we do bail these companies out, can they turn things around and become profitable again, or will we be throwing money at a hopeless situation? The market share situation certainly doesn’t look promising:

Big Three Market Share

If nobody wants to buy the product that Detroit is making, then how can they ever overcome their liquidity problems? In all liklihood, without a massive restructuring program that cuts costs by billions a year, they cannot. Remember that even if employee wages stay the same (and they don’t in the real world), the cost of supporting all of those retirees is linear – it will only go up barring some ridiculous epidemic that kills off all of those retired auto workers and their spouses. Even with an immediate cash injection, there would have to be a massive program in place to immediately cut costs before the companies simply burn through the provided money.

Unlike most of the ‘blogosphere,’ I don’t pretend to have the answers. Sure, we could let them sink, but then we’d have thousands out of jobs, and the effect on the economies of both Canada and the USA would be disasterous. On the other hand, if these bailout packages go through, are we just pissing away hard-earned taxpayer money? What I do know is this: When corporations are made responsible for the well being of their employees post-retirement, they reach a point at which they can no longer be competitive in the free marketplace. This is what governments are for, and why a social safety net should be in place that provides health care and pensions to every worker from an account that every company in the country pays into yearly as a part of their corporate taxes. That kind of nationalised pension system would remove the pressure on successful companies to support their retired workforce and let them get on with the business of being profitable, the core purpose of every corporation ever established.

Oh, and by the way: If you were hoping to cash in on a pension from one of the Big Three in the next 10 years, I hope you have a savings account, ’cause you’re gonna need it.

Cheers,

Jon

Edit: Fixed images so that they didn’t ruin my tables. Unfortunately, now my text alignment is disgusting. Whatever.