Detroit and New Orleans

Detroit’s Recovery

Edited from a May 14th, 2013 post by Marybeth Benjamin on the Econ 244 web site

The eye opening drive through the city of Detroit during our weeklong trip perfectly showcased the devastation and the challenges that the city faces. The trip was particularly poignant for me because of the striking similarities between my city, New Orleans, and Detroit.

I saw the beautiful neighborhood of Indian Village, well-maintained mansion after mansion, bordered by crumbling buildings and abandoned homes. Everywhere I looked outside of such intact neighborhoods I saw abandoned street blocks, some with only one house in livable condition. It reminded me of the moment I returned home to New Orleans a few months after Hurricane Katrina. It devastated the city, but disproportionately affected some of the poorer areas.

The similarities did not stop there: During the last decade following hurricane Katrina, the population in New Orleans decreased by almost 30%, which parallels Detroit’s 25% population decline in the past 10 years.

After viewing the city and the extent of the decline, I couldn’t help but wonder if Detroit will ever make a full recovery some day.

Oliver Liu added on May 14, 2013 that Detroit will never return to its heyday. At the Detroit Institute of Arts in the exhibition Motor City Muse: Detroit Photographs, Then and Now there were exercises in rephotography; pictures that showed the city in the mid 20th century bustling and pictures just recently taken of the same places showed just a shadow of past activity. Over time more mechanization will take place in factories and I doubt the population of the city will ever approach peak levels, which is a real problem as the city which can’t pay its debt and has large pension obligations to retired public servants.

"G" Jeong commented on May 14, 2013 that as per class discussions during our time in the city, the decline in Detroit was not sudden. It took a long time for Detroit to become a “devastated” city. Remembering what I saw from DIA, I also agree with Oliver and Professor Smitka that it is not possible for Detroit to recover unless something happens (government involvement?). By recovery, I meant it will be extremely difficult for Detroit to go back to its 1 million population days [much less its peak of nearly 2 million].

the prof wrote on May 15, 2013 that a city has tremendous fixed costs. In addition, the down cycle was not governed by any local planning, so no neighborhood in Detroit is totally gone. As a result, it’s hard to close down police and fire stations, or elementary schools, because they need to be close to where people live.

On top of that Detroit has decades of corrupt government – Louisiana doesn’t exactly have a reputation for clean government, either, but Detroit is exceptional, with the previous mayor and various close associates in prison, or heading that way. Tens if not hundreds of millions were embezzled, and (while not necessarily due to corruption) politicians frittered away lots more on projects that with hindsight proved inappropriate to the city’s needs.

Politically the state of Michigan doesn’t want to help Detroit (and is itself hurting), and the Federal government is nowhere to be seen. A slow disaster does not qualify for FEMA assistance. There’s no money to tear down the odd abandoned house in an otherwise intact neighborhood, and that makes it harder for adjacent houses to avoid blight – they lose their resale value. Teachers can’t be paid, with the connivance of city officials the warehouse that’s supposed to hold books and supplies is empty, and with the collapse of employment families are unstable. Kids suffer, through no fault of their own.

Cruise the city and count the grocery stores. It's not hard – in many neighborhoods there are none. For those interested, read a new book (2013), Detroit: An American Autopsy by Charlie LeDuff. It’s a riveting read, but I didn’t pick it up until long after I ordered books for the term.

Paul kuveke wrote on May 15, 2013 that maybe the city of Detroit should not spend resources trying to lower its fixed costs but rather try to draw people back into the city. Detroit has a horrible reputation throughout the country (on YouTube "we’re not detroit" is a popular phrase: watch this example). While Detroit was a lot better than what I’d heard, it's difficult to counter the perception of those who've never visited. It doesn’t help that for the past few years Detroit has ranked in the top 3 U.S. cities for violent crime.

On May 17, 2013 Tyler Kaelin wrote that he agrees with Paul, Detroit has some wonderful things to offer, but it will never return to its former glory until it can escape its less then attractive past. The auto industry hurt Detroit in more than one way in this regard. People see the Detroit 3 as an extension of Detroit itself. At the congressional meetings when people became angry and frustrated with the Detroit 3, they were becoming angry at Detroit by extension.

The Crisis Yet to Come

The Atlanta Fed's blog from October 27, 2010 has a chilling piece on the source of the downturn in revenue at the state level (and by implication the local level, too). Quite simply, they note and then back with data that (duh! - with hindsight) real estate assessments lag the market. Hence the downturn has to have other sources, specifically declines in individual income tax receipts and sales tax receipts. Real estate tax receipts have actually continued to rise, as higher assessments from the era of peak prices continue to track up.

That's chilling, because it implies that state and local governments will continue to see revenues fall as assessments are updated to track the market down. Now the level of dependence on real estate related revenue varies widely. But on average it suggests that even if incomes begin to recover, government revenues will continue to fall.

Indeed, a recent paper by Cogan and Taylor quantifies the magnitude of the downturn: budget cuts by state and local governments fully offset the much-maligned Obama stimulus package. They had earlier taken a stand on the "multiplier" (the extent to which an expenditure increase or tax cut would stimulate activity). [Look for a discussion of multiplier estimates by Brad de Long.] But when they went to check what ex post performance might show, they found a problem that rendered that discussion moot: ex post, there was no multiplicand to be multiplied. Of course that's not reassuring going forward, because in 2011 there won't be a stimulus package to offset what state and local government are doing. When teachers are fired next summer, and as road maintenance crews are axed and parks closed, there won't be anyone stepping in to hire them or pay for them to be rehired. Now Cogan and Taylor think the multiplier is small; I'm not convinced by their arguments. But small multiplier or large, the job losses will be real.

John F. Cogan and John B. Taylor, "What the Government Purchases Multiplier Actually Multiplied in the 2009 Stimulus Package." National Bureau of Economic Research Working Paper No. 16505, October 2010. http://www.nber.org/papers/w16505

If we thought banks were too big to fail, what of the government of the 10th largest economy in the world, California? They are starting their 2011 budget cycle with a $25 billion deficit and a long period of underfunding state and local pension funds. I doubt there's enough available for cutting on the expenditure side, and while I've never lived there, my sense is that there is no ability to enhance revenue, given the demonstrated ability of vocal citizens' movements to impede government via referenda. Pundits may be comparing us to Greece to argue that we need to cut the Federal deficit, but they really don't understand the dynamics of bond markets. But they can and should look at California, and ask whether we will feel compelled to bail them out as the EU did with Greece.

Mike Smitka

Addenda

Readers might see a contrarian position at Slate Moneybox, Default Position: Why we needn't worry too much about municipal bankruptcy by Annie Lowry. She argues first that the incentives are strong to avoid bankruptcy, while a crisis increases policy options. Second, though only implicit in her argument, bond holders can be forced to renogotiate without bankruptcy. While she does not mention it, many bonds are very close to private placements, and that facilitates renegotiating debt. (I handled sovereign debt renegotiations during a banking career decades back.) Third, and again less explicit, the biggest obligations are not formal bonds but retirement systems. It may be possible to renege on those -- tell retirees "no more pension." That may not need Chapter 9. In sum, all of those lessen the role of formal bankruptcy.

Elsewhere I calculated the numbers for California. Their accounting is arcane, but at the state level the budget is around $100 billion with a projected $25 billion deficit. That means tax receipts of $75 billion, so that closing the gap via revenue enhancement would in the extreme require a 33% increase in taxes (and more in tax rates, given exemptions). But in the background California's GDP is approximately $1 trillion, so the gap is on the order of 2.5% of personal and corporate incomes. Of course the state has perhaps $500 billion in unfunded pension obligations. Now in most places where I've lived government salaries are below market so these pensions are in effect part of the total package. I don't believe it ethical to adjust those retroactively. But in any case the magnitude of the problem is well within the taxing ability of the state, without leading to exorbitant rates. The problem is one of politics, not economics.

Back to the Beginnings

Well, today came the first steps towards the de facto reorganization of GM without going through the de jure process of bankruptcy court. The game has switched from softball to hardball ... squash. No more finesse, whoever has the most power wins. It's not GM's bondholders and it's not the UAW. But it may be the collapsing economy that proves the most powerful, not the Obama administration.

Arguing that issue will take time -- my outline is 5 single-spaced pages, not the sort of thing for which a blog is suited. Instead let's do a little applied IO (industrial organization), beginning about a century back. The auto industry evolved in a manner familiar from that perspective, at least in its stages if not the overall process.

After the formative years of playing with multiple technical standards and marketing strategies, as well as corporate structures, Henry Ford latched onto a combination that worked. He assembled parts and sold his Model T to dealers, collecting money up front, and paid suppliers in arrears. Vanadium steel alloys and ultimately the moving assembly line enabled him to push down the weight of his car, and up the speed of assembly. Inventory turns, all that -- though since the old man hated accountants, there are no books to trace the financial evolution of the firm. In any case, he soon dominated the market, in the US, in Europe, in Asia.

Now Henry owned the firm, or at least he did after forcing out the other shareholders, something he'd done twice before in the forerunners to the Ford Motor Company. (He was not a nice man.) No one could dissuade him from his policy of ever-lower prices as he improved the basic model and (for many years running) lowered his costs. But there was a bottom to how low he could push costs, and others began attacking his position from upmarket. GM succeeded, and the Model T began a gradual decline, until in 1926 Ford was forced to pull it from the market while he rushed the development of the Model A. By the time he launched it in 1927, Chrysler had also emerged as a player. Monopoly power made Henry insensitive to the shifting market, and the lack of outside shareholders meant there was no restraint on his whims. Ford was free to give away market share; if he wanted to bankrupt his firm, that was his business.

Fast forward 50 years for a variation on that story, to which I will provide another spin. From the early 1950s into the early 1970s GM was the dominant firm in the US auto industry (and with the exception of Japan, number one or two in the markets that mattered outside the US). For twenty years running it was the most profitable manufacturer (and often the most profitable firm) in the world, earning a 20% return on assets. But with just over 50% of the US market, antitrust considerations constrained additional expansion; it had to allow Ford and Chrysler a share of the market. Through price leadership it could nevertheless coordinate pricing policy with them; its economies of scale were considerable, and it was the low cost producer. The other two firms thus wanted to avoid a price war; though they could set prices below GM's umbrella, they could not be unduly aggressive.

Eventually such high profits did encourage new entry. Via imports the Scandinavians had a modest presence, as for a while did British, Italian and French firms. Of course there was also American Motors, an amalgam of US firms that emerged -- or rather merged -- after WWII. More successful was the German firm VW, particularly when a fad for small cars swept the US in the late 1960s, making the Beetle a hit. But as had happened in the late 1950s, the small car fad passed and the market for that low-profit segment shrank. Detroit was relieved, because if they all entered, it would have been a bloodbath: flooding the market with low-margin products was not an attractive business proposition. When there was another swing towards small cars in the late 1970s, following the first and especially the second oil crisis, VW stumbled and it was Japanese firms that captured the small car market. Again, the Detroit Three wisely sat on the sidelines. But US government policy worked against GM and the others. Ronald Reagan's VER ["voluntary" export restraint] policy effectively asked the Japanese government to organize a cartel to raise prices in the US. Carter's CAFE [corporate average fuel economy] standard and the earlier Clean Air Act bolstered the position of these new entrants, because they favored small cars and imports. The profits of the VER and the breathing space of other policies gave the Japanese time to build a distribution network and to move upmarket. We know the rest of the story.

Back to substance: over the next quarter century GM steadily ceded market share to these and other entrants. (At present 14 firms assemble vehicles inside NAFTA -- ignoring equity ties, two are Korean, three German, three are Detroit-based, and six are Japanese.) Doing so was rational. GM could have lowered profits to preserve share. But why should it do so when it was so dominant? The modest increment garnered by the new entrants was no more than a burr on its side, and shareholders would rightly have screamed if it gave up its bounteous profits that it earned on its 50% share of the market in an effort to scare off these entrants. Henry Ford was irrational in his strategy. But GM was rational in its refusal to fight. Making way for fringe firms to enter the market is the only sensible strategy for a dominant firm.

Eventually a dominant firm thus will cease to be dominant. So it was with GM, though it hung onto the most profitable segment, light trucks, and did well thereby. That would be the end of the story if downsizing was easy in the auto industry. Even then it might not have mattered had GM not had to shoulder pensions and especially healthcare obligations for its increasing numbers of retirees. Such aspects must await another post.

Let me reiterate the central point. GM's management certainly made many mistakes. This included such bone-headed investments as Saturn, billions spent on automation and other hoped-for "magic bullets" that ignored basic operational competence, and an overarching role for people with a background in finance rather than manufacturing, engineering or marketing. Nevertheless its core strategy was consistent with earning high levels of profits for its shareholders. Indeed, it was sufficiently successful in this that going into the current recession it was Toyota that was mimicking GM in its strategy in North America, rather than the other way around. Another year or two of breathing room would have made all the difference.