Like a Hollywood studio, industrial policy creates zombies

by Eric Shierman

With the collapse of Solyndra, the government seems to be picking more losers than winners, but alas that is not the case. The greatest harm from industrial policy often comes from the successful prevention of loss.

Like all too many bad Obama administration policies, the recent rebirth of American industrial policy was a Bush innovation of big government conservativism. From ethanol subsidies to the promotion of home ownership, the Bush administration’s Federal manipulation of entire sectors of the economy were many and have had their due criticism, but somehow the harm done to our airline industry goes unnoticed.

The Bush administration worked hard to prevent several airlines from going out of business, but that was the problem. Long before 9/11, United, Northwest, US Airways, Delta, and many others were well on their way to liquidation. Teetering upon bankruptcy even when the economy saw its strongest growth in the late 90s, these airlines could not handle the sudden loss of first class business travelers as the dot-com bubble burst. There were already two longstanding policies that delayed the inevitable reduction of capacity. The uniquely American bankruptcy option of Chapter 11 allowed flawed businesses to survive way past their expiration date, and anti-trust policy made it difficult for weak businesses to be bought. Then came the terrorist attacks.

One would think 9/11 hurt companies like United, but it saved them. Few would fail to see the legitimacy in the government compensating airlines for their lost revenue due to the temporary suspension of air travel, but that would have amounted to small potatoes compared to the $15 billion in aid that Congress authorized (which used to be a lot of money).

The bigger bailout came later. With the help of his token Democratic cabinet member Norman Mineta, Bush pioneered the government orchestrated bankruptcy. The trick of filing Chapter 11 is figuring out how to arrange exit financing. These companies were encouraged to use bankruptcy to wipe out their creditors and renegotiate their labor contracts with the foreknowledge that low interest government loans would be waiting for them on the other side.

In the airline industry, the greatest losers from 9/11 were the well managed companies like Southwest and American Airlines. Of course nothing can get in the way of Southwest Airlines making money hand over fist due to its pioneering of minimal service and a non-hub network, but American Airlines long before its first bankruptcy filing last month was a tragic casualty of our transportation industrial policy.

From my news intake the general narrative has gotten it all wrong; American was not torn down by its high labor costs and irascible demands of its unions. The highest paid employees in the business work at the fully unionized Southwest Airlines. American was torn down because there are too many full service airlines. American has done everything right, consistently executing on strategic, long-term decision making.

Take the acquisition of aircraft. Over the years, United has been an impulse shopper of any handful of planes it can buy on sale at a given time, paying a higher price in operational complexity as different makes and models require different parts and maintenance schedules. In contrast American buys big coordinated orders of used but relatively new planes and maintains them well, getting a higher return on investment than anyone else in the business. It has taken a great deal of discipline, but American has been flying MD-80s for more than a decade. Only now are they making a transition to the most advanced and fuel efficient Boing 737 whose service life their corporate culture will no doubt extend long into the future.

Have you wondered why American planes are hardly painted? Weight! All that paint on an aircraft to make it look pretty adds a considerable amount of pounds that in addition to the maintenance cost of repainting, adds fuel cost. Like no other airline, American has long been weight conscious to save money.

Good management at American has kept it out of bankruptcy until now, but there has been no advantage to paying its bills. American faced higher interest rates than its peers who have repeatedly stiffed their debts, because lenders assumed American would have to enter bankruptcy some day just to compete with its inferior rivals.

Since deregulation, the price of air travel has dropped dramatically but our market structure has not been allowed to adjust. These legacy airlines have been hit on both ends of the market. They lose first class business to private jets and they lose coach business to no-frills discount carriers. There is room in the middle of this market for the higher level of service that American Airlines can provide, but there is no room for three players, starving each other for cash flow. If Delta and United were allowed to liquidate a long time ago, American would be in a position to easily finance its high wages for the high level of service its employees would perform for that market niche that is willing to pay for it. There would be plenty of room for price competition as more discount carriers would enter the market and compete with Southwest on the mere commodity of getting from point A to point B. We would in essence have the choice of high quality and low prices, having sidestepped the travel writers’ frustration with air travel where cheap prices are plentiful, but those seeking a higher quality of service have nowhere to go.

While Bush reintroduced us to industrial policy, Obama has taken it to a frightening new level. Because he seems bent on campaigning on the auto bailout as a rare morsel of economic success, I will use it as my example. The auto bailout cannot be touted a success if it threatens the long-term viability of American auto manufacturing competitiveness. Just as the artificial excess competition of legacy carriers has threatened the global competitiveness of American Airlines, the support of excess competition among our car companies threatens the global competitiveness of Ford. Obama tries to sell the short-term survival of Chrysler for his short-term political need for reelection even though his own Council of Economic Advisors (CEA) warned him in no uncertain terms that it would threaten the long-term viability of the rest of the industry.

Two incredibly detailed and credible accounts of Obama’s first year of economic policy have come out. They don’t paint a pretty picture. The first was Overhaul, Steve Rattner’s memoir of his time as Obama’s auto Czar. Rattner left on good terms and continues to support Obama like the progressive Democrat he is, but for some reason he wrote a very candid account of what happened. I guess he has no more plans to work in government.

The second book is even more surprising. Ron Suskind is an extremely left-wing journalist that has written a scathingly critical book of Obama’s handling of the economy in Confidence Men.

The Bush administration was involved in the creation of a bridge loan, but to be fair, they were ambushed by GM CEO Rick Wagoner. After TARP’s approval, all kinds of industries understandably came looking for a bailout too. Wagoner managed to get a special audience with Hank Paulson and told the US Secretary of the Treasury that by GM’s comptroller’s best estimates, they will go bankrupt the week before the election. It was “Hand over $10 billion or we time our bankruptcy to hurt McCain.” Paulson said no. Election Day came and went without a bankruptcy. It was this brinksmanship with the previous administration that prompted Obama to fire Wagoner, but during the transition Obama personally lobbied Bush to give a bridge loan to GM and Chrysler so the next administration could have the time to decide what to do; Bush acquiesced.

Obama was politically and ideologically disposed to bailing out GM and Chrysler, but once in office with a team of experts analyzing these companies and data-driven economists running the numbers it became clear this would threaten Ford’s viability. The political pressure was so great to do something, it became clear to Christina Romer, CEA Chairwoman that the policy line in the sand to draw was around Chrysler. CEA’s argument would be GM cannot survive unless we let Chrysler liquidate. Suskind shows how the interagency Auto Working Group was split right down the middle with economists on one side and political advisors on the other:

Rattner gives a more detailed account lasting an entire chapter. Unlike Suskind he was actually in the room and writes in his book that it was close, but the meeting clearly ended in favor of letting Chrysler fail. As they left the room he heard Larry Summers pull Alan Krueger aside. Krueger was then the Assistant Secretary of the Treasury for Economic Policy and firmly opposed to bailing out Chrysler; he is now Obama’s CEA Chairman. Summers was also Krueger’s dissertation advisor at Harvard, and like a mentor Summers told him “I hope you understand that it’s different being the decision maker than being an economic adviser. There are other factors I have to consider.” Rattner then writes: “He knew how strong the case was that Alan and Austan had made, and didn’t want his star student to think he’d gone all wobbly.”

Summers then proceeded to draft a Presidential Decision Memo that told the President that the Auto Working Group overwhelmingly supported bailing Chrysler out. The final discussion was set for a Presidential Daily Economic Brief so that junior officials like Krueger and Goolsbee would not be there, but Romer was. Strongly opposed to bailing Chrysler out too, she was probably the smartest person in the room. The President gave her an opening when he asked “Is this unanimous?” What followed next defies summery so I will give you the whole block quote from Rattner:

They never did, the economists that is. Rattner claims he does not know when it was decided or who convinced the President, but the next thing he got was an order from the President to bail Chrysler out. Suskind reports that a meeting of political advisors led by Rahm Emanuel and Charlie Gibbs pointed out to the President how many Chrysler factories were in the most Republican Ohio neighborhoods. The economic argument lost; the political argument won.

During this election, expect to see many trips to Ohio’s Chrysler plants with Obama incorporating some kind of “I saved your job” into his stump speech. Obama will be out of office when workers at Ford are forced to forego wage increases and the Chrysler workers get laid off eventually anyway. In trying to save a few jobs in the short-term, Obama willfully and consciously has risked an entire industry and many more jobs in the future.

This is not so much a question as to how soon these auto companies will collapse again. Surely even Chrysler might survive another full presidential term. The damage Obama’s industrial policy inflicts is in the opportunity cost that is less apparent. Ford could have a consolidated domestic market for people that buy an American car just because it’s an American car. Its real competition should not be a scavenging GM and bottom fishing Chrysler. Ford should be allowed to focus on its real domestic competition of the future Toyota’s factories in Tennessee and Honda’s factories in South Carolina.

If it could be allowed to hold its own at home, Ford could grow its export business to meet the demand of rising middle class consumers in the emerging market economies that do not aspire to drive a Prius or a Civic. Koreans, Brazilians, and Indians want to drive a Ford Explorer. By reinvesting its revenues from the sale of muscle vehicles to a domestic market, Ford could grow into an exporter unrivaled by anything made in Japan or Germany. Instead it must now deal with artificially suppressed margins at home.

Industrial policy is then a classic way in which government policy favors elites at the expense of workers. The liquidation of United Airlines meant management would get fired while its pilots and flight attendants would be hired by American Airlines. Chrysler managers have retained their jobs but the factory operators with their scarce skills in the use of robotics and machine tools will lose the opportunity to work for a stable company with a sound future. By rewarding failure, we punish achievement. Industrial policy creates zombie competition: United Airlines and Chrysler are dead firms but still competing, eating away at the flesh of commercial success.

Eric Shierman is a partner at Creative Destruction Investment Partners, writes for the Oregonian under the pen name “Portland Aristotle” on the MyOregon blog, and is the author of the forthcoming book: A Brief History of Political Cultural Change. His articles can be read at:http://connect.oregonlive.com/user/PortlandAristotle/posts.html