VoxEU Column Microeconomic regulation

After the auto bailout

This column proposes ending six policies that hamper the US automotive industry. It suggests replacing discretionary environmental policies with a CO2 tax, addressing legacy costs, ending the distinction between right-to-work and other states, levelling the investment subsidy playing field, resolving uncertainty surrounding the future powertrain, and allowing direct sales to the public.

After weeks of debate, hearings, and negotiations, President Bush finally decided to use $17.4 billion from the TARP funds for a bailout of General Motors and Chrysler. The next day, the Canadian government pledged an additional $4 billion (Canadian) as its proportional contribution. Whether this money was necessary or will prove helpful to guarantee these firms’ long term survival is highly uncertain. In this column, I want to highlight that there are several additional steps the government can take to aid these firms. I discuss six existing policies that are important obstacles for the automotive industry, in particular for the ‘Big Three’ US firms.

Replace discretionary environmental policies with a gas or CO2 tax

The implementation of the Corporate Average Fuel Economy (CAFE) standard, aimed at increasing the fuel efficiency of new vehicles, has several unintended consequences. In particular, it has provided the US companies with perverse incentives against developing smaller, more fuel-efficient vehicles.

Averaging the mileage over all vehicles sold by firm ignores comparative advantages. Consider the situation in the mid-1990s. There was little dispute that US carmakers built the best SUVs, pickup trucks, and minivans. As the economy was booming, these large vehicles were extremely popular and the US companies were doing well. They also offered smaller, fuel-efficient cars, but competition from foreign carmakers was much stronger in those segments. As sales of larger vehicles by Ford, GM, and Chrysler outstripped small cars sales, they were forced to increase prices on large and lower prices on small vehicles to avoid breaking CAFE limits and incur penalties. Perhaps this tempted some consumers to choose a Ford Focus over a Honda Civic, but it proved very hard to steer consumers away from large SUVs to compact cars.

Profits for the US carmakers ballooned towards the end of the 1990s as they kept raising SUV and other large vehicle prices further and further. At the same time, profit margins on smaller cars evaporated entirely and even turned negative for some models. This surely weakened the business case for the teams in charge of small vehicle development within these companies. No wonder Ford did not bother to bring the second-generation Focus from Europe to North America, avoiding a costly retooling of its Wayne assembly plant. No wonder Chrysler never invested a lot in a successor to its relatively popular but unprofitable Dodge Neon. And no wonder General Motors relied ever more on its Korean Daewoo subsidiary to provide it with cheaper, foreign-made compact cars. These second-best choices weakened the competitive position of these companies in the high gas price era. Indirectly, the CAFE norms weakened the business case for investing in small cars for these firms. Ideally, one would hope that the firms would take the externality of high SUV profits into account when allocating development funds to small vehicle programmes, but why make it so non-transparent?

The recently negotiated EU programme to lower CO2 emissions by fining carmakers if their average fleet exceeds the 120 g/km emissions target has similar incentives. One unintended consequence is that a carmaker specialising in highly polluting vehicles, say Porsche, now has an incentive to purchase a carmaker producing smaller vehicles, such as Volkswagen, to lower its average. Clearly this does not generate any environmental benefits, but it is individually rational, especially as fines are increasing convexly.

The Canadian feebate programme illustrates another unintended consequence. Initially, the Honda Fit exceeded the 6.5l/100km fuel consumption threshold by the smallest of margins. Honda could have easily omitted the airbags from the Fit’s base model, lowering its weight and qualifying new owners for a $1,000 government rebate. These savings would have been more than sufficient for customers to re-select the airbags from the options list, should they choose so, for no environmental benefit and a nice taxpayer subsidy.

Finally, more stringent emissions norms makes vehicles more expensive, all else equal. Applying the new norms only to newly purchased vehicles dissuades consumers from trading in their older vehicles, which generate the bulk of all pollution. Exports of second-hand vehicles from the US to Mexico have already been shown to raise fuel efficiency in both countries.1 If all US vehicles faced the same cost of polluting, such trade would be encouraged. As a bonus for the industry, it would likely raise new car sales.

The bottom line is clear. If the goal is to limit CO2 emissions, one should tax (all) CO2 emissions. Simple and clean.

Address the legacy costs

The problem of legacy costs in the automotive industry has been debated endlessly. In short, promises of pension benefits and lifelong health care made to previous generations of workers add approximately $15 to each current worker’s average hourly labour costs. The core problem is that the organisation of the health care and retirement system in the US makes it difficult for a company to shrink down its operations, unless it can wipe out its past liabilities, for example through Chapter 11 bankruptcy proceedings. Paradoxically, the US economy lauded for the strength of its competitive marketplace and the power of the creative destruction that it unleashes has institutions that make it hard for a company to shrink.

One could argue that workers should not be treated differently from bondholders if they fail to properly anticipate that promises of future payments are bankrupting the company. There are, however, some differences. Those promises were made in a vastly different competitive environment, which changed to some extent because of discretionary government policies.2 Current workers will lose their jobs because of payments accruing to a previous generation of workers. In industries that require a lot of worker training, like the automotive sector, delayed pay can be an important tool to provide incentives to remain with the same employer. Finally, as the carmakers’ pension plans are federally insured by the Pension Benefit Guarantee Corporation, the taxpayers will most likely be on the hook for these payments no matter what.

End the distinction between right-to-work and other states

In the 22 right-to-work states it is unlawful to operate a plant as a "closed shop," in which employees at unionised workplaces are required to be members of the union as a condition of employment. This weakens the power of labour unions and most foreign carmakers have chosen to locate their assembly plants in these states, mostly in the South and the Southwest. This strategy was impossible for the established US-owned carmakers, as it would have signalled a declaration of war on its union, the United Auto Workers (UAW), which has the power to close down all its existing operations.

The salary gap between the domestic and foreign carmakers is partly the result of an older workforce, which will automatically disappear as transplants mature. Part of the gap is the result of greater bargaining strength of unions in Northern plants. The UAW has little incentive to agree to “average” wages. Its raison d’être is to negotiate better-than-average wages and working conditions for its members. Even if labour costs were bankrupting the companies with which the UAW is negotiating, the outcome of a worst-case scenario, such as Chapter 11, are average wages.

The catch is that some workers stand to lose their jobs in the costly bankruptcy proceedings. Any worker preferring certain average wages now over uncertain average wages in the future is trapped in the closed shops created by existing legislation.

Level the investment subsidy playing field

In other work, I have discussed the large sums of money that all layers of American and Canadian governments have bestowed on foreign firms that established new assembly plants in North America.3 Existing plants of the domestic firms have had a much harder time attracting subsidies for equally costly investment and refurbishing programmes. A large fraction of the equipment and tooling in the automotive industry has a very short economic life, as it is specific to the particular model produced. The shortening product cycle and increased automation has pushed up capital investment costs. Firms with expanding market shares building new assembly plants were better placed to extract subsidies from local governments as they played jurisdictions against one another. The latest comparison of subsidy packages is $409m for the Kia plant in Georgia announced in 2006 versus $222m for Ford in Michigan (in 2004).

Irrespective of whether these subsidies are desirable or not, competition between jurisdictions has lead to larger subsidies for new plants than for refurbishing of existing plants, which disadvantages firms with a larger North American footprint.

Resolve uncertainty surrounding the future powertrain

Shopping for a new vehicle with crude oil prices at $147 per barrel and newspapers reporting endlessly on the need to reduce energy consumption, the uncertainty surrounding the powertrain of the future is daunting. It certainly held me back from splurging on an expensive vehicle. The large decline in resale value of poor mileage vehicles was not only extremely costly for the carmakers, it also reminded customers that one should be forward-looking when purchasing a durable good. If a major change would occur in powertrain technology, all existing vehicles would see their resale value decline further.

Buying a vehicle with decent mileage is not that hard, but governments are not making the choice easy. Here is a sampling from the various policies that I encountered shopping for a new vehicle:

  • Environmentally inspired rebates or taxes that kick in at arbitrary fuel efficiency thresholds
  • Annual registration fees that increase at increasing rates with engine size, independent of power output or actual mileage
  • Tax rebates for flex-fuel or hybrid vehicles unrelated to their actual fuel efficiency or fuel used
  • Banning locally produced natural gas powered or electric vehicles that are street legal in nearby jurisdictions
  • Compulsory small particle filters (cleaning diesel engine emissions) on some vehicles, subsidised on others, and entirely optional on yet other vehicles

Governments the world over are also not helping carmakers in the long run by generously subsidising one technology for a while and switching to another favourite technology after a couple of years. The US preference has shifted from electric vehicles, to fuel cells working on hydrogen, to corn-based ethanol, to the latest favourite, the plug-in hybrid. Policymakers’ demand for greenery lowers the credibility of the firms with their customers and tempts them to be unduly optimistic about the arrival of new innovations. Every newsflash that General Motors devotes to its upcoming electric-powered Chevrolet Volt seems to push sales of its current line-up of vehicles lower.

Allow direct sales to the public

A long history of lawsuits has made it illegal in the US for automakers to sell directly to the public. There are certainly arguments in favour of such an arrangement, but it has made it harder for US-owned firms to respond to increased competition from foreign firms.4 First, this decentralised organisation leads to larger inventories of new vehicles in the distribution system. As the number of models for sale increased over time, sales per model declined notably for US firms, making inventory costs increasingly important. It also makes production less responsive to demand variations, leading to large excess inventories every time a model underperforms in the marketplace. Second, most dealerships do not carry all brands of a carmaker, which makes it harder to rationalise the model line-up in the face of declining sales without alienating some dealers disproportionately. On the flip side, when General Motors launched Saturn to compete with the foreign carmakers, it had to build an entirely new dealership network to add credibility to the slogan “a different kind of car company.” Third, several evolutions have diminished the importance of dealerships: to cope with increasing choice, firms started bundling options in packages which are mostly pre-installed at the assembly plant; increased reliability of vehicles lead to less frequent visits to the dealership for maintenance or repair. Both trends have raised the minimum efficient scale for car dealerships, which again disadvantages firms with shrinking sales. Public policy should allow direct sales to the public.


1 Lucas W. Davis and Matthew E. Kahn, “International Trade in Used Durable Goods: The Environmental Consequences of NAFTA,” NBER Working Paper 14565, December 2008

2 In particular, the gradual reduction in import tariffs and voluntary export restraints in the 1980s prompted Japanese firms to establish production capacity in North America.

3 Van Van Biesebroeck, Johannes. 2008, “Bidding for Investment Projects: Smart Public Policy or Corporate Welfare?,” University of Toronto Working Paper 344.

4 The irony is that this arrangement initially protected US firms from foreign competition as new entrants first had to establish a costly dealer network.


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