Collision of mobile business models

It’s no secret that automakers are building fancy navigation and entertainment systems into their cars. The LA Times this morning has a great article about how they’re not doing so well in competition with cell phone makers, who have products that are better, faster and cheaper.

At least in the US, the automakers want to control the customer, selling them expensive add-on systems; the most successful recently has been the Ford Sync, and before that the GM OnStar. But today the consumers who might buy such systems all have smartphones that do most of the same features (and more). They also run headlong into some of the freemium Internet business models (Exhibit A: Google Inc.) that give away stuff that automakers want to sell.

Here are a couple of great passages from the article by Jerry Hirsch:

[C]ar companies are spending millions of dollars developing interfaces, voice recognition software and navigation systems. Many of these functions either already come loaded on phones or can be downloaded at the swipe of a finger. Honda Motor Co., for instance, charges $2,000 for a satellite-linked navigation and traffic system on the premium version of its popular Accord sedan. But Waze, a division of Google Inc., provides the same functionality in a free app.
…
"People today bond more with their smartphones than their car," said Tom Mutchler, the senior engineer at the Consumer Reports Auto Test Center. "Car companies are going to have to live up to the expectations that come with that."

The whole article is recommended and doesn’t seem to be behind a paywall.

The article points out two problems the automakers face. First, in a race of innovative software between Ford and Apple, or Honda and Google, who do you think is going to win?

Second, you keep a car for 10 years and a phone for 2. So for the average consumer, which one is going to provide the better experience?

But the third problem Hirsch misses is that (as any strategy professor will tell you) Apple and Google and Samsung have economies of scale, and the car makers don’t. 700 million smartphones were sold globally in 2012, most using one of two platforms. In the US, 16 million cars were sold, with in-dash entertainment systems fragmented among a dozen makers.

As I teach my students, R&D is a fixed cost amortized as (total R&D) ÷ (number of units). Apple sold 137 million iPhones in 2012 (not counting iPads and iPod Touch using the iOS). Assuming GM or Ford gets 17% share and half buy the fancy infotainment system, that means about 1.4 million Americans are buying each car-based platform. (Toyota, Fiat/Chrysler and Honda sell even less). Given that’s two orders of magnitude less than the #2 smartphone platform, no wonder carmakers have to charge $2,000 for their systems.

It’s clear carmakers are going to lose this fight. Obviously, if you can’t beat ’em, join ’em — which is what Honda, Toyota and Hyundai appear to be doing. The article refers to the Car Connectivity Consortium producing the MirrorLink standard, which includes these three carmakers, as well as Samsung and HTC. In addition to these car companies, the CCC website also lists Daimler, GM and VW as charter members, with Ford and Subaru (“Fuji Heavy”) as a non-voting “adopter” member (BMW, Fiat and Mazda have limited voting rights). Nissan and Kia are nowhere to be found.

Volkswagen was early in partnering with Apple, so they may continue to lead on iPhone connectivity. Android compatibility could be a good foot in the door for the 3 Asian carmakers. But from the article and their market actions, it seems like some automakers (led by Ford) Ford are stuck in the slow lane trying to sell overpriced, soon-to-be-obsolete dashboard systems as though they can dictate what options American auto buyers will use on the road.

Klunky clunker plan

From the Boston Globe:

It has been nearly a month since the car-buying frenzy of the Cash for Clunkers program ended, and many area auto dealers are longing for the good old days of July and August.
…
Manager Adam Silverleib said business was “pretty intense’’ as a result of the federal stimulus program, with the dealership hustling to accommodate customers and handle the piles of paperwork required for them to receive reimbursement on vouchers. “Now we’re kind of back to where we were in the spring,’’ he said.
…
Nationwide, customers snatched up 700,000 new cars, most of them foreign-made, and the government ended up paying out nearly $3 billion toward the purchases. But from the start, analysts predicted that Cash for Clunkers would not boost sales for the year. September’s sales swoon seems to be making their case. Car sales are usually slow after Labor Day, but because of the recession consumers this year are especially reluctant to say yes to major purchases. To make matters worse for dealers, most are still waiting for voucher reimbursements.

“It was probably, in the end, a complete waste of taxpayer money,’’ said John Wolkonowicz, a senior auto analyst at IHS Global Insight, Lexington forecasting firm. “The dealers, who were supposed to be the primary beneficiaries, many were forced into cash flow problems because the government didn’t pay them in a timely fashion.’’

Hat tip: Economist John Lott

Protesting unfavorable business climate

On the likely closing of California’s only auto plant, SJSU economics dept. chair Lydia Ortega summed up the state’s problems in an interview with KPIX-TV tonight: “We want to do more to protect wetlands than we want to do to protect jobs.”

This was the postscript on a videotaped report that the United Auto Workers were outside the Fremont plant with protest signs says “Save NUMMI Jobs.” KPIX has video of the protest but not Prof. Ortega.

Somehow I must be missing something: how is having a bunch of angry union workers out there protesting in front of the Toyota facility going to make the employer more likely to keep the plant open? (For example, wouldn’t a rational employer want to get rid of a plant filled with angry workers who march around with protest signs?)

Prof. Ortega is right: business climate is a longstanding issue. Nevada is running ads to aid the ongoing migration of businesses to the casino state. In April, a dozen state legislators heard why

Attendees heard from more than a dozen businesspeople who complained of high workman's compensation insurance, "predatory" regulators, an unfriendly business climate, a "never ending paper trail of business forms," exorbitant utility expenses, fees, taxes, quality of life and overpriced overhead.
…
Steven Patmont, president of the company that manufactures "California Go-Ped" motorized scooters, said his company left California for Nevada because California doesn't appreciate business. He described how California regulators hit him with hundreds of thousands of dollars of small fines even though his company has a stellar safety record.
…
Villines said he was disturbed to hear so many speakers say that no one from California tried to convince them to stay while Nevada officials have helped businesses scout potential factory sites and have generally made themselves available to business people. Villines said the testimony clearly indicates California isn't business friendly.

So at least two SJSU professors would ask: if blue-collar workers want more manufacturing jobs in California, how about demonstrating in Sacramento to make the state a more favorable business climate for manufacturing?

I can only speculate at possible reasons. Is it because that the unions don’t want to antagonize their customary political allies? Is it because they are so trapped in their Marxist class warfare mentality that they don’t understand the basic economics of job creation? Is it because confrontation is a better career move for union leaders than cooperation?

(BTW, Toyota denies that it’s decided to close the Fremont NUMMI plant, while other reports say Toyota is seeking another partner).

Clunker of a law

The House voted Friday to throw another $2 billion at Cash for Clunkers after the first $1 billion (apparently) ran out.

The program destroys working vehicles, prevents recycling of the most valuable components, and creates unimaginable bureaucratic hassles and invasive spyware for car dealers. Of course, the evidence is that it will have no long-term benefit — after all, it’s a perfect example of the Frédéric Bastiat broken window fallacy.

So in other words, this is a smash success by the standards of the politicians spending like drunken sailors. (Oops, retract that — it might be defamatory to naval personnel.)

Finally, if Congress is unable to accurately predict the cost of encouraging auto trade-ins — a simple transaction with a known pool of eligible vehicles — will they do any better predicting the cost of their stealth Single Payer health plan?

Money for nothing

Cash for Clunkers is out of money, and some politicians say the answer is to spend more.

I think the Mises Economics Blog has it exactly right:

let's just pause and reflect on these people who were surprised. Here is the amazing turn of events:

1. The government starts handing out free money.
2. People start grabbing it as fast as they can.
3. The bureaucrats quickly realize that they are hitting the program's budget in mere days (of the program being finalized) and suspend the program.

What is the reaction to this perfectly foreseeable sequence of events? "...dealers were amazed...", "the explosively popular... program."
…
How do you get an economic recovery going? Start raining free money down on everyone's heads. I grew up thinking that the people from the Middle Ages were idiots... They believed the earth was flat! Turns out they didn't actually. But Rep. Miller (and how many Americans?) really does believe this nonsense. I have found the Dark Ages and it is us.

Economic ignorance is expensive and we’re paying the price.

One way to save the auto industry

Instead of financial restructuring and bailing out failed labor contracts, perhaps the auto industry could be saved by coming up with a new way to make better products. (Could happen, right?)

A great article by Charles Mann in the June Wired quotes Henry Chesbrough as recommending open innovation. Noting the slow rate of change in the industry, Henry said

“It's as if the computer industry were still dominated by Wang and Data General and DEC, and they were still selling minicomputers.”

Despite my disagreements with its lousy PR efforts, I think Tesla Motors (a Silicon Valley car company) is well ahead of Detroit in implementing open innovation. For its electric sports car, Tesla utilizes car bodies and assembly from Lotus Cars (using external innovations), as does one competitor. Meanwhile, it has just agreed to sell its batteries to Daimler (licensing internal innovations).

The article also quotes another very smart innovation economist, Steve Klepper of CMU.

A radical reconfiguration may be the only way this vital industry can survive on these shores. "They're going to have to swing for the fences," says Steven Klepper, an economist at Carnegie Mellon University who studies industry innovation. "The only way I can see for them to win the game is to change it entirely."

In his article, Mann reveals his great love for the US auto industry and desire to see it rise again:

I should declare a personal interest here. My father worked as a Big Three executive for much of my childhood, most of that time at Ford. He left to run his own marina, but he always remained loyal to Detroit. He never bought a foreign car. I didn't buy one until after his death, and even then I felt like I was thumbing my nose at his memory. I would like to return to a US product. More than that, I would like millions of Americans—people who don't share my sentimental ties—to come back to vehicles from US companies.

Keppler is right. Ford could survive as the last man standing of a sickly US auto industry (think Renault or Fiat), but on the current trajectory the other two companies have very long odds.

Chrysler’s solution is to become a subsidiary of Fiat, which is likely to bring more of the same — a two-country vertically integrated car company (didn’t work last time). Since it has the least to lose, perhaps GM could take the lead in using external sourcing of technology.

Nationalized and free markets

The NYT report this morning on the pre-packaged GM bankruptcy makes it clear that the Obama administration is going to force the Chrysler model of cramdown on the GM bondholders:

A coalition of small bondholders protested the terms of G.M.’s offer in Washington on Thursday. Larger, institutional bondholders have also opposed the deal, which calls for them to receive 225 shares of G.M. stock in exchange for each $1,000 worth of debt.
…
G.M., which is subsisting on $15.4 billion in government loans, has until June 1 to meet the broad criteria for restructuring spelled out by a special presidential auto task force.

Under a plan announced last month, the Treasury Department would control at least 50 percent of the stock in a restructured G.M. A health care trust for union retirees would have about 39 percent, with bondholders getting 10 percent and current shareholders the remaining 1 percent.

Advisers to a committee of G.M.’s biggest bondholders, representing about 20 percent of the $27 billion in bond debt, have repeatedly criticized the plan as unfair and designed to fail. They have also accused the government of seeking to use them as scapegoats for a potential bankruptcy filing. Under their own proposal, G.M. bondholders would own 58 percent of the reorganized carmaker. These advisers have said that they are willing to negotiate with the company and the government but have made no headway thus far.

Bankruptcy courts have given priority to the claims of creditors, not to keeping the company running. In the 2006 bankruptcy of Tower Records, the court chose a liquidation plan over a plan to keep the company running, because its bid was 0.3% higher and thus would give more money to creditors.

Now it is clear that there are two sectors of the American economy: one where the government will use its power to impose the solution it thinks best, and one where investment and the allocation of rights is governed by the rule of law.

Investors who put their money into the nationalized sector — whether in equities or bonds — have to realize that their rights as investor/lenders will be subordinated to the national government’s industrial policy. The business school term for this is “political risk,” normally referring to third world countries where the rule of law is not yet established.

In this case, people who bought Chrysler or GM bonds assumed they would be given preference in liquidation, but the rules changed with the new administration. Knowing what they know now, any Chrysler or GM bondholder should have sold their bonds on November 5 or even earlier.

There is no reason to think this is the last example of political risk under the new government’s policies. The intervention is normally justified in the name of helping struggling industries and saving jobs — which means autos and banking are nationalized sectors. Other industries are in deep trouble — newspapers, Hollywood, real estate — will these be nationalized too?

Where will the government draw the line? Energy is a central part of the administration’s new economic policies — will it be controlled the same way as the automakers and the TARP banks?

For every seller, there’s a buyer. Anyone buying such debt is hoping that there will be political pushback that stops the administration (unlikely) or that the economy has bottomed out and no more firms will be facing bankruptcy (also unlikely).

Cutting your way to greatness

The Big Three auto companies certainly aren’t selling as many cars as they used to. As such, they need to reduce their fixed costs to more closely match their current revenues.

Towards this end, the two sickest “US” automakers are shedding dealers. Thursday, Chrysler gave notices to 789 of its dealers (about 25%) that their contracts end June 9. On Friday, GM gave 18 month notice to 1100 dealers, and is expected to dump another 500 later this year. (GM is also hoping to sell its Saab, Saturn and Hummer divisions, which have their own dealers).

Both claim to have targeted their least profitable dealers. GM said that 18% of its dealers cut account for 7% of sales, while Chrysler says 25% of its dealers account for 14% of sales. GM hopes to cut 42% of its dealers by the time it’s all over. Meanwhile, Ford is also reducing dealers, but in a less confrontational way.

The ailing automakers are in a tough spot. Having too many dealers means that its sales are spread across too many dealers, making it hard for the others to survive. It’s like throwing the sickly out of an overcrowded lifeboat in hope that the rest will survive.

The dealer associations question the logic of the cuts (as in these commentaries in NJ and LA). Dealers are the distribution network for the car companies — more dealers means more sales, less dealers means less sales.

Cutting dealers makes certain assumptions about the substitutability of demand through alternate distribution channels. In some cases, shifting demand is plausible, as when a dealer is closed in a metropolitan areas where the buyer can drive another 10 miles to another franchise.

However, in some cases, substitutability is highly suspect. For example, Chrysler is cutting its only dealer in El Centro, a farming town in Southeast California (population 40,000). Those residents won’t drive an hour to Yuma (or 90 minutes to San Diego) to buy their next Dodge truck: they’ll buy a Toyota or a Ford (or a Chevy if that dealership stays open).

The other problem is that many (or most) of the dealers that GM and Chrysler want to kill aren’t interested in dying. As autonomous economic actors, they are going to find other ways of making money.

Some may become independent used car lots, repair shops, or other auto-related businesses that build on their loyal customer pays and service their previous customers. But clearly some are going to sell new cars for someone else. Multi-brand dealership will just push their other brands; former single-brand locations will be looking for another brand to carry. For example, the (PBS) Nightly Business Report Thursday interviewed one axed Chrysler dealer who’d already signed up to sell Kias.

It’s impossible for a firm to cut its way to greatness: closing dealerships and plants isn’t going to solve the underlying problems. GM, Chrysler (and to a lesser degree, Ford) still have to figure out a way to make cars people want to buy.

At the same time, longer-lasting, high-quality cars mean that per capita auto sales may never return to the levels demonstrated in the 1990s. US sales (for all makers) peaked in 2000 at 17.4 million; early predictions for 2009 were for 11 million units.

Market based incentives

As part of outsourcing economic criticism in these hard times, I quote from the WSJ’s Joseph White this morning on the value of market-based incentives rather than micromanagement:

Can Uncle Sam Sell Hybrids?
… President Barack Obama said during his press conference last week that just because the government could hold shares in GM and Chrysler doesn't mean he intends to micromanage their affairs. Then he added, "I'm not an auto engineer, I don't know how to create [an] affordable, well-designed plug-in hybrid. But I know that if the Japanese can design [an] affordable, well-designed hybrid, then doggone it, the American people should be able to do the same. So my job is to ask the auto industry: Why is it you guys can't do this?"

GM and Chrysler's new management teams will likely treat this question as something more than a suggestion. …

Total small-car sales are down 33% for the year … Demand for hybrid vehicles is in the doldrums. … At $2 a gallon for regular unleaded, the most-enthusiastic purchasers of hybrids are governments and corporations eager to wear green.

As for plug-in hybrids, the costs remain daunting for major car makers on both sides of the Pacific. …

The Chevy Volt, GM's plug-in, won't go on sale until late 2010. But whether that car will be "affordable" at an estimated $40,000 depends on who you are. The Obama administration's automotive task force delivered its opinion of the Volt in blunt terms in a March 30 report: "... while the Chevy Volt holds promise, it will likely be too expensive to be commercially successful in the short-term."…

Around the world, other governments aren't shy about pushing consumers toward certain choices. … Europe uses high fuel taxes and other means to push consumers to pay higher prices for smaller vehicles. …

U.S. car makers have lobbied for higher gas taxes as the simplest way to push consumers into high-mileage cars. The Obama administration is betting on a different approach: Leave gas taxes alone, and instead invest government money in advanced battery development, offer tax breaks of up to $7,500 on hybrids and mandate tougher mileage standards to force car makers to use new fuel-saving technology. Washington now has a big financial stake in getting this right, or billions in public money plowed into Chrysler and GM could be vulnerable to energy markets.

This is probably why Mr. Obama sounded so sincere when he said, "I don't want to run auto companies."

Since taxes and other government policies change behavior, the most effective economic policies are those that are consistent, predictable and easy to understand. Smart people can draft more clever policies, but that doesn’t mean they’re more effective ones.

Potemkin accountability

By deciding who should or should not be CEO at government-funded companies, President Obama has made himself the nation’s CEO-in-chief. As Mike Allen and Jim VandeHei reported in the Politico:

Obama’s move to oust the CEO of GM and put Detroit on notice that he is prepared to let icons of American industry fail if they refuse to bend to his will was a calculated attempt to send a message, said an official often consulted by the administration. And that message was unmistakable: In any business-government partnership, Obama himself expects to play the dominant role.

“He’s realizing, ‘Hey, the economy’s mine now, and I better do it my way,’” said the official. “So the administration is collaring people and letting them know who’s in charge. The days of saying, ‘It’s not our economy’ have come to an end.”

An Obama administration official said the president’s hard-nosed approach will continue. “We’re not going to reward failure,” the official said. “We’re in an economic crisis, which takes shared responsibility and shared sacrifice. The only way that we will recover is if everybody puts a little skin in the game.”

Parts of this sound appealing. I’ve been arguing for more accountability in Detroit for months. As Roger Simon of the Politico concluded, “In a startling departure, the Obama administration has decided that the price of failure in America should be failure.”

However, it’s clearly a bad idea for the President of the United States to think the US economy can be centrally run from the White House. As Allen and Vandhei reported:

Said David Boaz of the Cato Institute in The Arena: “Rick Wagoner may be a bad CEO, or he may be a victim of difficult conditions facing the legacy auto industry. In either case, board members and investors are the right people to make that decision. I don’t know who should run GM, and neither does President Obama.”

Just for the sake of argument, I’ll assume that this was a temporary exception to this rule, made in extraordinary circumstances, and that the Obama administration has no intention of expanding the reach of government to tell private firms how they should pick their leaders.

Even so, there are many signs that this is a symbolic stroke rather than a careful analysis of the best course for GM? It reeks of Potemkin accountability: impressive on the outside, and nothing on the inside.

Was firing Rick Wagner best for GM? WSJ op-ed columnist Paul Ingrassia (whose industry understanding I respect tremendously) argued that it was time for Wagner to go because he was too wedded to the old way of doing things, and that an outsider is needed. Still, I had some reservations that exactly mirrored those of Stanford Prof. Bob Sutton, an expert on corporate culture:

I wasn't surprised to read that Rick Wagoner had been canned as part of the deal to get more bailout money from Washington. Scapegoating is a useful temporary measure for pleasing external critics. But it is often a symbolic act that is done in lieu of any substantive changes. As I have written before, and in detail, I believe that a core problem with GM is their broken culture -- see the first post (which has more hits than anything I ever posted) and the follow-ups here and here, plus the comments are very telling.

I wonder, have people at GM changed their behavior in meetings -- are the new top dogs still doing all the talking? Are they doing anything to actually get in touch with the experience of owning a GM car? Or are they still acting like all that really matters is the GM pecking order, regardless of the quality of the ideas, the cars, and the experience of owning a GM car? That's the real question. Clearly, under Wagoner's leadership, there was an inability (certainly on his part) to grasp and implement the need for a cultural change …

But as the old saying goes, the definition of insanity is doing the same thing over and over again, while hoping that something different happens. This isn't a bad description of how GM has been ran for years.

But here’s my main problem. Since Democrats have controlled both the executive and legislative branches, there has been a big show of accountability for business executives, whether it be the auto industry salaries ($1/year), AIG bonuses, or now Rick Wagoner’s job.

As Holman Jenkins notes this morning, there is little evidence that the White House and Congress want to extend that accountability throughout the auto industry:

President Obama rightly says "sacrifices" must be made if GM is to emerge as a viable company. But there's one sacrifice he won't make: his re-election chances, by leaving the fate of the UAW truly up to a bankruptcy judge.

Keep that in mind amid the defenestration of Rick Wagoner, who was not as popular with UAW Chief Ron Gettelfinger as Mr. Wagoner's replacement, Fritz Henderson. Keep that in mind amid reports the administration favors a "quick and surgical" bankruptcy. It's a bluff. The same administration that inserted itself into GM's corporate governance to order the resignation of a CEO is hardly likely to defer to the prescribed legal order for a failing company, namely bankruptcy. Even a "prepackaged" filing runs too much risk of a judge imposing more "sacrifice" on the UAW than the administration is prepared to tolerate.

GM bondholders understand this: They've been intransigent precisely because they calculate the UAW is too important to Democratic electoral politics for Mr. Obama to risk losing control of the reorganization process to a bankruptcy judge.

The GM bailout has become a political operation run out of the White House. It will stay that way. Talk of UAW layoffs already disguises the fact that UAW workers are actually offered generous buyouts and early retirement -- they aren't just sent away with a last paycheck.

So if it comes to losing UAW votes, I agree with Jenkins that there’s no sign that any tough measures will be taken. Thus far, Obama has indicated that he is like his congressional allies: talk tough when the video cameras are rolling, but no follow through if it means any sacrifices. (Cf. Nancy Pelosi’s failure to implement her promise to “drain the swamp” of corruption.)

Thus far, there has been no accountability for any political failure in the economic collapse. If there is no price for the congressional protectors that enabled Fannie and Freddie’s frauds that took out several investment banks, there certainly will be no accountability for enabling the UAW to stymie any hope of a Detroit turnaround.

This truly would be a depressing outcome: a ruling caste that demands results from the private sector but not for itself. It seems like the perfect way to wreck the economy permanently. Let’s hope that the voters are smart enough to hold the politicians accountable and (perhaps) they’ll feel threatened enough to do the right thing.

GM: don't slit your own throat!

GM is shedding its peripheral brands in hopes of focusing its resources on saving its core brands: Chevy, Buick, Cadillac and GMC.

It has cut Saab loose, and the Swedish car maker filed for bankruptcy this morning.

However, far more troubling is GM’s decision to spin off Saturn — in response to pressure from its Saturn dealers around the country. Reuters reports this afternoon:

GM said on Thursday it was working to spin off Saturn as a distribution company to source cars from other automakers and sell them through the brand's 420 U.S. showrooms.

This passage in Thursday's WSJ set off my alarm bells:

Some Saturn dealers now hope that instead of closing the brand, GM will spin it off as a separate company. A team of Saturn dealers is spending 60 days working with GM to evaluate the possibility. These dealers would sell vehicles under the Saturn brand made by other manufacturers, possibly from overseas.

"This is going to be somebody's low-cost entry to the world's largest car market," said David Fischer Sr., chairman and chief executive officer of Suburban Collection, which operates eight Saturn dealerships in Florida and Michigan.

The articles don’t say, but my guess is that the interested buyers would be low-cost producers from China or India.

If I could offer one word of advice to GM:

Don’t!
This is exactly like RCA in the 1950s. To gain a small amount of incremental income, it licensed its color TV patents to some small, obscure electronics companies in the Far East. The direct result (as recounted by the late Al Chandler) was that the Sony, Panasonic, Toshiba, JVC and other color TVs effectively put RCA out of business.

GM doesn’t have technology, but it does have distribution. It would be foolhardy to sell some of that distribution to enable additional entry (in the already crowded US market) by a low-cost maker of fuel efficient vehicles.

If GM goes ahead and sells the dealer network, that’s confirmation that it’s less interested in long-term business viability and more interested in scoring short-term political points with its new owners in Washington, DC.

Not paying the price for failure

Listening to the radio, I was struck by this audio soundbite of the President this morning:

If we were to allow the free market to take its course now, it would almost certainly lead to disorderly bankruptcy and liquidation for the automakers. Under ordinary economic circumstances, I would say this is the price that failed companies must pay -- and I would not favor intervening to prevent the automakers from going out of business.

Of course, he then went on to explain why he’s handing $17 billion of taxpayer money to the car companies.

In other words, Bush knows that for a free market to work, there must be a price for failure. But when push came to shove, he didn’t believe that the managers, employees, unions and shareholders of the Big Three should pay that price. Not wanting to have two of the Big Three die on his watch, he backed down from strict accountability. (I wonder what kind of dad he was? It’s clear he wasn’t a very good manager.)

About the only thing to be said in favor of today’s bailout is that Bush is a lame duck — and with the change of parties, even lamer than most. So by keeping the car companies alive a few months, our next president and Congress will have the option to do as they please — consistent with the principles of a representative democracy.

Interestingly, our next president is not as big a believer in free and unfettered markets. But my hunch is that he has higher standards for accountability than most. The question is whether he’ll hold political allies accountable or (like most politicians) give them a pass.

Bush blinked

The bailout failed in Congress due to principled objections, offering the prospect of drawing a line for the nonstop series of bailouts.

However, the Bush administration decided to use its own discretion. In other words, as veteran (and prescient) auto industry report Paul Ingrassia noted this morning: “Bush Blinks on the Auto Bailout”

You have to hand it to Ron Gettelfinger, president of the United Auto Workers union, and his colleagues. Negotiating for a living is, you know, what they do. And they're good, very good. They know when somebody's about to blink.

So it was last Thursday night that Mr. Gettelfinger rejected the deal offered by Senate Republicans for interim bailout money to keep General Motors and Chrysler alive for a few more months. The UAW chief was betting that the Bush administration would blink, and that the union would get a better deal from the politicians than it would get from the marketplace or from a bankruptcy judge. It's a ploy we all learned in childhood. When dad won't give you what you want, turn to mom.

Mr. Gettelfinger was right, of course. By the next day the Bush team was rapidly reversing course and declaring its willingness to use TARP money -- from the $700 billion designated to bail out financial firms -- to keep the Detroit companies going without the concessions sought by the Senate GOP.

This is consistent with the Bush kick-the-can economic philosophy of the past 4-5 years. While he articulated some free market principles in his initial campaign, our 9-11 president spent the rest of his term making short-term economic choices rather than spending any political capital on a long-term fix.

Ding dong, the bailout's dead!

The Big Three auto industry bailout died last night in Congress. On a largely party line vote, the last test vote 52-35-12, i.e. 52 votes for a bailout with some strings, 35 votes for forcing the industry to fix its cost structure, and 12 votes too chicken to stick their necks out. Perhaps this will end the habit of bailing out companies that are either badly run, or that have structural problems that cannot be resolved without wiping the slate clean.

The Big Three keep screaming “recession” as the cause of their problems, but the rest of the auto industry will survive just fine. The current economic woes are merely exposing the depth of the companies’ self-inflicted problems, including uninspired product design, unsustainable labor costs, and smoke-and-mirrors balance sheets.

Ford appears able to hang in there for now. Apparently now GM and Chrysler are starting to take seriously the bankruptcy option, which is what most firms do when their problems become unsolvable.
Toughlove means that you say no to a dysfunctional friend or relative and stop acting as an enabler for the pathologies that got them in trouble in the first place. It would be best for the country if the Big Three (Dying Two) will face up to their problems, but it seems more likely that they will keep their focus on lobbying for a better deal — now, from the 111th Congress.

Some semblance of accountability

On Tuesday, Senate Minority Leader Mitch McConnell laid out his party’s position on the proposed auto industry bailout. Some excerpts:

First and foremost, we will not let taxpayers spend their hard-earned money on ailing carmakers unless these companies are forced to reform their bad habits — either inside or outside of bankruptcy.
...
[I]t means that struggling car companies will have to rationalize their cost structures — because a company that does not respond to market conditions is a company that is doomed to failure anyway. And Republicans will not allow taxpayers to subsidize failure.

While some of his other points (particularly about state emission standards) would divide the Congress, it seems like the positions listed above should be above partisanship.

Those who don’t embrace these ideas seem most focused on the short-term consequences of automaker layoffs and their direct economic impacts, I suppose this works for politicians who like to “kick the can” down the road until after they retire.

However, more serious economic policy experts (like the 200 economists) worry about the long-term damage to our economy of (further) breaking the link between firm mistakes and market feedback. Breaking this link will have severe consequences for our children and grandchildren.

When will the bailout billions end?

Financial institutions (led by Citibank) have hundreds of billions of taxpayer money (en route to trillions) to cover their many mistakes. Now the automakers continue to beg for $34 billion more of taxpayer money to bail out their failed business models, and the lame duck Congress seem intent on funding the bailout in exchange for micromanaging the firms and their management, floating lame ideas like merging the two sickest car companies in the world (to make a healthy one?)

The airlines fixed their problems with bankruptcy, but apparently very few people (especially in the ruling party) are giving this serious consideration. The president-elect has written off bankruptcy (perhaps because it would end union contracts?) and seems firmly in the micromanagement-bailout camp. And now pundit Tom Friedman — without the responsibility of ever having to run anything — has shifted his emphasis back to micromanaging camp and away from accountability.

The willy-nilly trend towards bailouts is being decried by at least some who know something about running an economy. Oliver Hart and Luigi Zingales wrote last week:

This year will be remembered not just for one of the worst financial crises in American history, but also as the moment when economists abandoned their principles. There used to be a consensus that selective intervention in the economy was bad. In the last 12 months this belief has been shattered.

Practically every day the government launches a massively expensive new initiative to solve the problems that the last day's initiative did not. It is hard to discern any principles behind these actions. The lack of a coherent strategy has increased uncertainty and undermined the public's perception of the government's competence and trustworthiness.
…
We believe that the way forward is for the government to adopt two key principles. The first is that it should intervene only when there is a clearly identified market failure. The second is that government intervention should be carried out at minimum cost to taxpayers.
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Our desire for a principled approach to this crisis does not arise from an academic need for intellectual coherence. Without principles, policy makers inevitably make mistakes and succumb to lobbying pressure. This is what happened with the Bush administration. The Obama administration can do better.

Absent any sense of principles (or restraint), the temptation for politicians to use Other People’s Money (ours) to intervene in the economy and bail out failed companies is continuing unabated.

In November, Jon Fine of Business Week jokingly proposed under this same logic that the government should bail out newspapers, since their business models are also failing. Apparently Connecticut politicians are now seriously proposing such a plan. (Fortunately, the parent of the Los Angeles Times and Chicago Tribune would require a multibillion dollar bailout and so instead will fix its own problems using bankruptcy.)

The Libertarians over at Reason.tv have taken this bailout fever to its natural conclusion, bringing back Sock Puppet to ask for his own bailout — using the same arguments to save Pets.com as every other failed company.

Detroit's long overdue toughlove

The NYT this morning covers all the opposition from left, right and center to the Detroit Three’s groveling for a Federal blank check. The article concludes:

It all feels excessive to some in Detroit. “I didn’t know that some really, really hate us,” said Ms. Tompor of The Free Press.

No, it’s actually toughlove: a refusal to continue to be the enabler of prior destructive behaviors.

Everyone reconizes the terrible precedent. As Charles Krauthammer asks

Where do you stop? Once you've gone beyond the financial sector, every struggling industry will make a claim on the federal treasury. What are the grounds for saying yes or no?

The criteria will inevitably be arbitrary and political. The money will flow preferentially to industries with lines to Capitol Hill and the White House. To the companies heavily concentrated in the districts of committee chairmen. To clout.

As Detroit native (and Congressional political guru) Michael Barone wrote:

And, of course, the Detroit Three will not be the last flagging enterprises to line up for government subsidy. Michigan is not the only state that has a talented congressional delegation capable of enlisting allies on relevant committees and from states with economic stakes in failing companies. Other unions, noting the UAW’s success in maintaining benefits, will be standing in line.

In recommending that the Feds help auto workers but not automakers, NYU prof David Yermack notes nearly a half-trillion in private capital squandered by two Detroit auto makers in the past decade:

Over the past decade, the capital destruction by GM has been breathtaking, on a greater scale than documented by Mr. Jensen for the 1980s. GM has invested $310 billion in its business between 1998 and 2007. The total depreciation of GM's physical plant during this period was $128 billion, meaning that a net $182 billion of society's capital has been pumped into GM over the past decade -- a waste of about $1.5 billion per month of national savings. The story at Ford has not been as adverse but is still disheartening, as Ford has invested $155 billion and consumed $8 billion net of depreciation since 1998.

As a society, we have very little to show for this $465 billion. At the end of 1998, GM's market capitalization was $46 billion and Ford's was $71 billion. Today both firms have negligible value, with share prices in the low single digits. Both are facing imminent bankruptcy and delisting from the major stock exchanges. Along with management, the companies' unions and even their regulators in Washington may have their own culpability, a topic that merits its own separate discussion. Yet one can only imagine how the $465 billion could have been used better -- for instance, GM and Ford could have closed their own facilities and acquired all of the shares of Honda, Toyota, Nissan and Volkswagen.

An interesting thought experiment: GM buying Toyota would have been like Yahoo buying Google or the railroads buying the airlines. Alas, in all three cases, I’m sure they would have mucked it up.

Former Northwest Airlines exec Michael E. Levine argues that bankruptcy is the right solution to GM’s problems. After all, they worked for airlines.

The social and political costs would be very large, but if GM fails after getting $50 billion or $100 billion in bailout money, it'll be just as large and there will be less money to soften the blow and even more blame to go around.
…
But unless we are willing to support GM as it is indefinitely, the downsizing and asset-shedding will have to come anyway. Even if it builds cars as attractive and environmentally responsible as those Honda and Toyota will be building, they won't be able to carry the weight of GM's past.
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GM as it is cannot survive without long-term government life support. If it gets that support, it can't change enough and won't change fast enough. Contrary to Mr. Wagoner's brave declaration, bankruptcy is an option. In fact, it's the only option that merits public support and actually has a chance at succeeding.

Not all innovation is innovative enough

This month I’m working on a generalized paper on open and user innovation, a follow up to the encouragement I received for my talk at the User and Open Innovation Conference last august at Harvard. While doing the research for the paper, I found an interesting juxtaposition of two sources with the same argument: don’t bother with half-hearted innovation.

The first reference was in Geoff Moore’s Dealing with Darwin. Since I reviewed the book two years ago, I have been a big fan of the book. As I said in the review:

Certainly his most ambitious book yet, Dealing with Darwin, uses his consulting practice — with a special emphasis on Cisco — to offer nothing less than a grand unified theory of product and service innovation. While academics may be skeptical absent peer reviewed statistical tests, Moore appears to offer a complete framework for innovation that is both mutually exclusive and exhaustive. The hubris is stunning, even by business best-seller standards: still the integration is novel, as are many of the concepts.

Since that time, I’ve used it in every section of my MBA technology strategy class. The students find it approachable and useful, even if (as always) they rebel at the idea of reading an entire book (even if spread across two weeks).

One of the first ideas I use from the book is his proclamation in the first chapter (pp. 5-8) that if innovation is intended to support a differentiation strategy, it must be enought to “achieve separation” in the minds of a buyer. Without differentiation (as regular readers of this blog know), the alternative is commodization, competing on price and plummeting profit margins. Moore concludes that desirable innovation outcomes are either differentiating, neutralizing the differentiation of a rival, or improving productivity (i.e. cost reducing).

However, he argues, a majority of innovation spending is wasted, because they achieve none of these three. The “pernicious” examples of waste including neutralization efforts that overspend by adding “nice-to-have enhancements” that are not necessary for neutralization. Conversely, other efforts underperform, by spending heavily to create differentiation but that is not enough to achieve it.

As a (now timely) example, he mentions the fate of America’s biggest auto maker:

This is a horrible outcome. In effect, you have spent the resources for differentiation but have achieved the outcomes o neutralization. … You are sliding down a hazardous commoditization curve, and if you do not do something drastic in fairly short order, you will find yourself stuck at the bottom of the hill, with neither the energy nor the funds to get yourself back to the top.

This has been the fate of the Chevrolet division of General Motors [and other firms]… It is not that these companies do not innovate. It is that their offers do not achieve separation — and here is the kicker — they were never designed to!

Picture in your mind a Chevrolet sedan from the past ten years. Just try. Nothing? That’s my point. … Innovation for differentiation must be bold enough that, if it wins, it achieves separation. That’s why Chrysler’s failures are more memorable than Chevrolet’s successes— the Viper and the Prowler, for two.

We covered Moore’s book last month in my tech strategy class. This morning, while looking for more general innovation resources, I rediscovered a famous 1991 paper on new product development by Elko Kleinschmidt and Bob Cooper. To quote from the abstract:

While many writers and strategists maintain that innovation is important, research has often demonstrated that product innovativeness does not have a major impact on the rate of success in the marketplace. Elko Kleinschmidt and Robert Cooper demonstrate that the relationship between product innovativeness and commercial success is U-shaped. That means that both high and low innovativeness products are more likely to be more successful than those in-between. The authors suggest that past research has not allowed for this non-linear relationship and that their data show that moderately innovative, middle-of-the-road products are less likely to succeed when measured by a number of performance criteria.

So across two decades of academic and consultant study of innovation is evidence supporting a rather simple idea: innovate enough to make a difference to your buyers, or don’t bother.

Tom Friedman agrees with me

It doesn’t happen very often, but in opposing a blank check bailout of Detroit, NYT scribe (and best-selling author) Thomas Friedman agrees with the WSJ. His column today specifically endorses the Paul Ingrassia plan I cited Monday. This perhaps the first and last time that both Friedman and I agree, and that I’m on the record ahead of him.

His lead is highly personal:

Last September, I was in a hotel room watching CNBC early one morning. They were interviewing Bob Nardelli, the chief executive of Chrysler, and he was explaining why the auto industry, at that time, needed $25 billion in loan guarantees. It wasn't a bailout, he said. It was a way to enable the car companies to retool for innovation. I could not help but shout back at the TV screen: "We have to subsidize Detroit so that it will innovate? What business were you people in other than innovation?" If we give you another $25 billion, will you also do accounting?

How could these companies be so bad for so long? Clearly the combination of a very un-innovative business culture, visionless management and overly generous labor contracts explains a lot of it.

Unlike Ingrassia or my column, he also blames politicians, in even more scathing terms than Monday’s WSJ editorial:

The blame for this travesty not only belongs to the auto executives, but must be shared equally with the entire Michigan delegation in the House and Senate, virtually all of whom, year after year, voted however the Detroit automakers and unions instructed them to vote. That shielded General Motors, Ford and Chrysler from environmental concerns, mileage concerns and the full impact of global competition that could have forced Detroit to adapt long ago.

Indeed, if and when they do have to bury Detroit, I hope that all the current and past representatives and senators from Michigan have to serve as pallbearers.

Consistent with his latest book, Friedman wants to add green car restrictions to the new Detroit Three — something not mentioned by Ingrassia and exactly opposite what the WSJ editorial argued. In particular, he demands cars that “can also run on next generation cellulosic ethanol.”

Friedman wants to micromanage — rather than manage by objective — which is a mistake on principle. But it’s also a mistake in practice, as Detroit needs to spread its bets between electric vehicles, hydrogen cars, hybrids, diesel, ethanol/biomass. (And within electric vehicles, bet on capacitors in addition to lithium-ion batteries). That’s what a free market does — place bets on various technological trajectories to see which one works out to be a winner. Five years ago, hydrogen fuel cell cars were touted as the ne plus ultra, but today firms that bet solely on hydrogen have nothing to bring to the market while hybrids, plug-in hybrids and diesels are sold to energy conscious consumers.

Friedman is a big thinker and a pundit, not a business strategist or executive. This is manifest in his final paragraph, where he offers the (IMHO silly) suggestion Steve Jobs leave his Palo Alto home to spend a year in Detroit in the name of national service. (I suppose if President Obama called Jobs it might happen, but given how long Jobs took to remake Apple in his own image, it would take a multi-year commitment).

Still, the pragmatic realism of his overall conclusions are encouraging. Given the political leanings of the House, Senate and next White House, the question of a Detroit bailout is not if but how. With a convergence of ideas from right and left, perhaps this bailout might be different, and maybe even this time failure will have consequences. If we’re lucky, a failed presidential candidate (who decried wasteful spending and has no auto plants in his state) will lead the charge for protecting taxpayer interests in this latest bailout.

Does failure have consequences?

Reading the WSJ page B1 at lunch, I was struck by the ironic juxtaposition of two stories. The first was about failure and its consequences:

DHL Beats a Retreat From the U.S.
Deutsche Post Unit's Campaign Foiled by Souring Economy, Management Missteps

Four years ago, DHL's parent stormed into the U.S. with an advertising campaign designed to take on FedEx Corp. and United Parcel Service Inc. ...

On Monday its parent, Deutsche Post AG, announced a massive retreat. The company said it will pull the plug on domestic U.S. deliveries by the end of January and cut about 9,500 jobs. DHL will continue to deliver and pickup international shipments in the U.S.

Its foray into the U.S. was done in first by a series of management missteps and then finished off by the slumping U.S. economy.

Deutsche Post expects its U.S. express operation to lose $1.5 billion this year after losing $1 billion last year. In recent months, a number of high-profile customers have taken their business elsewhere. ...

DHL ran into problems almost from the moment it entered the U.S. in 2003 by purchasing Airborne Inc. of Seattle for $1.05 billion. Critics said the company underestimated the intensity of the competition, didn't have a cohesive strategy and failed to retain top Airborne talent. Airborne also proved a less-than-perfect fit because of its threadbare ground network and reputation as a discount service.

In other words, Deutsche Post will have nothing to show for its $1 billion acquisition — other than several billion more in losses since then.

The second was about failure and its lack of consequences:

GM's Shares Tumble on Rising Cash Concerns

General Motors Corp. stock fell to its lowest level since 1946 as concern intensified that the auto maker could run out of cash and be forced to file for bankruptcy protection.
...

GM and sympathetic lawmakers boosted their calls Monday for the federal government to bail out the company. In return for aid, lawmakers in Congress have suggested the government could seek to take a stake in the company, limit executive compensation and require GM to speed the introduction of fuel-efficient vehicles. A GM spokesman declined to say if GM would go along with such requirements.

GM's chairman and chief executive, Rick Wagoner, told the trade publication Automotive News that GM needs financial help before President-elect Obama takes office Jan. 20. But Mr. Wagoner added in the interview that he would not be willing to resign in return for aid. "I think our job is to make sure we have the best management team to run GM. It's not clear to me what purpose would be served" by his resignation, Mr. Wagoner said.

Instead of fixing the problems once and for all — with consequences for management, shareholders and employees — Wagoner hopes to continue on his current path with money from you and me.

In the real economy, failure has consequences. For politically powerful and influential firms — or those firms “too big to fail” — stakeholders are insulated from those consequences.