Research

One-on-one with Johannes Van Biesebroeck, U of T economics professor

Q. What is the cause of the sudden decline of the auto industry?

For five years, between 2001 and 2006, cars were very cheap and everyone who wanted to buy or replace a car, bought one. People stocked up en masse, and now we have enough cars for the next couple of years. So there are a lot of cars on the road and they are very new, meaning they will last a long time. So basically, this a durable good and everybody stocked up. Imagine if the price of sugar becomes very cheap tomorrow. People will buy enough supply for the next month. It’s the same thing.

Q. Has this ever happened before to the auto industry?

The scale of the current adjustment is unheard of. Adjusted for population, we’re now selling fewer cars than at any time after the Second World War – and we are now three times as rich as we were in 1945. From 2000-2006, average annual sales of passenger vehicles in the U.S. was around 17.9 million. Today, seasonally adjusted and on an annual basis, sales are below 12 million. And during this time, the U.S. population has grown by more than 10 per cent. That’s a spectacular shortfall. Take GM’s financing arm – it financed half of the $300 billion worth of cars GM sold annually in the 1990s.  During the current financial crisis, the financing arm stopped making a single loan. This is bigger than any of the bank failures.

Q. How many jobs does this account for?

Since 9/11, one-quarter of all manufacturing jobs have disappeared in North America. It’s a wholesale collapse.

Q. How did cars become so cheap?

In 2003-2004, the big three automakers –GM, Ford and Chrysler — started offering significant employee discounts on car purchases. The best discount was on their most fuel inefficient cars, like SUVs. It was bizarre, because as gas became very expensive. You would think that people were going to start changing their driving habits accordingly, but the opposite happened — everybody bought big SUVs because of the huge discounts on them. The auto companies were offering 20 per cent off, which on an SUV is a savings of say, $10,000 versus, say $3,000 on a small, compact car. Then, the second-hand price of these cars collapsed. The four to five year projection on resale was down by about 10 per cent – rather than a car being worth 50 per cent of its value after five years, it turned out to be  more like 40 per cent. In short, when people were ready to trade-in their cars when leases were up, cars were worth one fifth less than expected. The car companies, who get all their leased vehicles back automatically, were not able to get rid of them.

Q. It seemed to happen very quickly. Why?

Just like the stock market, if a company is predicting that it will make less profit four years from now, the stock price falls right away and the prices adjust right away. It’s the same thing in the second hand car market – if people think these vehicles are going to be worth less than they were, at the beginning of their lease or purchase term, the second hand prices plummet immediately.

Q. You’ve said the governments have had a large role to play in the auto industry’s failures – why do you say that?

The U.S. and Canadian governments have contributed to the problems facing GM, Ford and Chrysler because of the way they administered the corporate average fuel economy standards – the CAFE norms. The CAFE norm is the minimum average fuel efficiency that a fleet of cars must maintain before the company faces penalties.

When the economy was doing well, people were buying a lot of fuel inefficient SUVs. So while the volume of cars was going up, the average fuel efficiency for the car companies as a whole – their CAFE score, was falling, putting them at risk of paying penalties. In the U.S., the auto industry was lobbying to soften these penalties or abolish them altogether – but at the same time, environmentalism was getting stronger and the government wanted to enforce these norms. So the governments essentially told them, ‘well, you control the prices, just raise the prices on the SUVs and lower the prices of the smaller cars.’  But the economy was doing so well that people kept on buying the SUVs. At the end of the day, the big three automakers were making spectacular profits on their most fuel inefficient cars –in the range of  $10,000 on an SUV — and selling their small cars at a loss just to satisfy the CAFE norms. The consumer then very quickly flipped around, demanding more fuel efficient cars. The high profits made on the now-reduced sales of SUVs evaporated as a result. I think the way the government administers their CAFE norms made it very hard to for these companies to do the smart thing and look towards the future.

Q. How will a bail out help the industry? Isn’t it just a short term solution?

A short term bailout for the auto sector is inevitable. If the U.S. provides one, Canada will have to follow. A short term bailout will address short term credit problems by providing some temporary cushion for suppliers. But there’s also talk about subsidies for assembly plants that do stay open. In the long term, governments on both sides of the border will have to look at the plants that are going to be sustainable and reliable to stay open for the long term. Pickup truck plants are not automatically unviable – they still outsell hybrids more than 20 to 1 – but we might not need as many as currently exist. The bottom line is that the government is being very explicit that to keep things going for the next year, they’re going to have to provide some money, but then do a whole rethink about the next 10 years.

Tags: Behind the Headlines, Johannes Van Biesebroeck, Society