The Great American Automobile Crash
Government is not allowing prices and profits to do their economic jobs, and further interventions will just make the problem that much worse in the long run.
September 1, 2008
Fred Foldvary, Ph.D.
Economist

The automobile industry was once the engine of the American economy. As the biggest or second-biggest purchase by many households, car manufacturing was not only a major employer and contributor to national output, but also a major exporter. But since the 1950s, the US automobile industry has been in gradual decline, and now faces collapse. You can now buy a house in Detroit for a hand-full of dollars, illustrating how land values rise and fall from neighborhood effects. The industry executives are going to Washington to seek a bailout.

Cars are nowadays blamed for pollution, congestion, and urban sprawl, but automobiles have only been the vehicle for these problems, not the cause. The automobile was one of the most liberating inventions in human history. Imagine if a million people had to ride horses into a city — what a mess that would be. With a car, families enjoy great mobility. The car has enabled people to work and shop rather far from their place of residence. This is a benefit, not a curse. It is not a car’s fault that governments have subsidized the pollution and congestion.

What went wrong? All over the world, governments have done next to nothing about the pollution and congestion of car traffic. This has been a gigantic subsidy to automobile firms, as it makes car driving cheaper, passing the social costs on to the general population. But then if car makers have gotten this subsidy, why have they failed?

Part of the problem was bad decisions by American automobile executives. During the late 1950s, demand was shifting to smaller cars, but the car makers failed to respond, thinking “small cars, small profit.” So the Japanese and other foreign cars gained in market share. More recently, US car firms have lagged behind in producing hybrid and electric cars. But the greater problem has been pension and medical costs.

Greedy unions demanded huge pensions — a guaranteed annuity when the worker retired. Pensions can be good for a company when they promote worker loyalty and less turnover, when an employee only gets a pension if he stays with the company for many years. But the unions pushed for ever higher pensions even when workers only stayed for a short time. The unions also pushed for early retirement, escalating the pension cost.

Irresponsible executives and boards of directors gave in to union demands to avoid strikes, but the union bosses were also negligent, as they failed to require the car makers to fully fund the pensions. The reckless car chiefs pushed the problem of paying for the pensions into the future, when the current members would be long gone.

Now the future has arrived. The pension costs are a negative legacy from the past. The legacy costs plus ever greater medical insurance expenses make it more costly to produce cars by American-based firms. The cost problem was compounded by higher and higher wages for the members of the unions in the US car industry, who priced themselves out of the market.

The power of a labor union comes from its ability to strike, which depends on its having a labor monopoly. One cannot blamer workers for seeking monopoly power, because they otherwise have little clout in the face of job insecurity. In a pure free market, there would be no job insecurity, since during prosperous times, wages set by supply and demand would be flexibly set at the level that clears the market, where the quantity demanded equals the quantity supplied. But governments skew the market outcomes with taxes and restrictions, making labor more expensive while reducing the take-home pay of a worker. The US income tax is also vicious in shifting labor remuneration from current money wages to untaxed benefits and to pensions.

Now car markers want to take the “auto” out of cars. The word “auto” comes from the Greek word meaning “self” or “one’s own.” A car is mobile by itself; it moves itself rather than having to be pushed or pulled like a train car. The car industry used to be auto-economic, paying for its own expenses plus profits. Now the car industry has been suffering large losses, and seeks aid from the government, in which case the car industry would not longer be self-sufficient.

Now that financial firms such as investment banks and mortgage-buyers Fannie Mae and Freddie Mac have been rescued by the US government, the car makers say, if they get helped, why not also us? They seek $50 billion and more later in government loans to prevent bankruptcy. The industry still has political clout because it is still important in Michigan and Ohio, states which can swing the coming congressional and presidential elections. The car chiefs are framing this bailout as necessary to help them produce more fuel-efficient cars.

The car executives claim that since these would be loans, it is not a bailout, but they can also borrow money by selling bonds. The bonds would be risky, so by government lending the firms money at a lower cost, essentially without a risk premium, this is indeed a bailout. Is the car industry too big to fail? The problem is that federal loans will not solve the legacy cost problem that gets injected into the cost of cars. The loans just push the problem into the future, just as pension promises not backed by current cash pushed the problem into the future, which has arrived.

There was a bad precedent 25 years ago, when the federal government bailed out the Chrysler Corporation. Now that the whole US automobile industry has failed, declarations of bankruptcy would not be a catastrophe. Other firms would buy the factories, and could start clean with no legacy costs. A bailout would lead to further demands from other industries. It would be best for the American economy to avoid any more bailouts, but also to restructure government policy to stop both the taxes and the subsidies that have distorted the economy.

Government is not allowing prices and profits to do their economic jobs, and further interventions will just make the problem that much worse in the long run.

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Fred Foldvary, Ph.D.
Economist

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.