Those who are resisting repeated pleas from the US automakers for a piece of the bailout package argue that only financial firms deserve bailing out because they supply credit, which is an essential market lubricant. While the collapse of firms in financial sectors would have systemic ramifications, the failure of other firms, no matter how large, should be addressed by the kind of business restructuring that is stipulated by chapter 11 of the bankruptcy code. This is supposed to ensure an efficient reallocation of labour, capital and other resources by helping firms renegotiate existing contracts.
Others argue that due to its strong backward and forward linkages, the auto industry?s failure will spell doom for a large part of the economy as millions of jobs depend on its survival. Since chapter 11 does not guarantee successful reorganisation and its proceedings may precipitate liquidation, Detroit ought to be a natural recipient of the US government?s largesse.
The real scenario of the US auto industry is more complicated than the simple-minded views expressed by either of the above camps.
The US auto industry accounts for 4% of its GDP, employing and providing benefits to millions of people. GM dealers alone employ almost 350,000 people all over US. Many of its auto related plants in places like Ohio supply parts to other companies as well. Although the current crisis could throw millions of such people in jeopardy, it is hard to deny that the US car industry has been in a secular decline over the last two decades, thanks to structural problems of its own making.
According to one study, GM and Ford had destroyed almost $110 billion of shareholder value between 1980-1990. Of their combined investment of $465 billion between 1998-2007, almost 40% has been lost in depreciation. The share price of GM has fallen from $92 in 2000 to almost $3 this November. It?s market capitalisation has come down from $46 billion in 1998 to $1.7 billion. The yearly sales of light vehicle GM cars have fallen from 400,000 in 2000 to about 260,000 up until the 3rd quarter of 2008. These figures for the combined big three (GM, Ford and Chrysler) have fallen from 0.87 million in 2000 to 0.55 million so far this year. These summary statistics described reveal a long term decline, which has only been worsened by the current economic crisis, resulting in steep sales declines in the last two months and causing GM?s reserves to fall below $10 billion, scaring up the possibility of the company defaulting on its creditors and suppliers. Lack of innovation, new foreign competition, high labour costs, inept management decisions and the union?s inflexible positions are the main causes of the current state of affairs.
Chapter 11 will alleviate these problems as companies seek Debtor in Possession financing, renegotiate high cost contracts and freeze existing debt payments. But there is a real possibility of customers? switching to other companies, for fear that Detroit automakers may not honour their warranties. This will lead to a further erosion of sales and in turn discourage new lenders from supplying credit even if the new loan is senior to existing loans (possible under chapter 11). If events of this kind unfold, liquidation will be the only option. But if the government directly funds the warranties that are indispensable for durable products such as cars, sales may not plummet. Under this circumstance of direct government intervention, negotiations can continue under the umbrella of Chapter 11.
The main lesson from this crisis is that while private individuals are better at negotiating deals on old contracts, an effective government is better at restoring confidence to lenders, customers and other economic agents. Hence, what is needed is a combination of judicious and targeted government interventions (bailing out warranties to boost buyers? confidence is only one example), which together with the legal and market infrastructure of reorganisation can resolve the economic crisis efficiently and adroitly.
?The author is reader in finance at the University of Essex
