Can an Automaker Incentive Battle Goose the Economy?

David Ruggles

As the economy wallows in the doldrums, is there any cause for optimism? The outcome of the European debt crisis is still unknown, and we know how markets despise uncertainty. There are still plenty of uncertainties associated with the so called “Arab Spring” uprisings in the Middle East, and those could be with us for a while. While fuel prices have somewhat moderated, they remain high. The country’s credit rating took an unnecessary hit, although plenty of money seems to still be seeking to buy our debt. When the Dow fell dramatically after the downgrade of our credit rating, much of the money that left equities found its way into our “downgraded” Treasury bonds. Either the European debt crisis or our government being hamstrung by ideologues has sent the Dow on a downer after the debt ceiling crisis “semi resolution.” The 12-member “Super Congress” still has an important job to do, and there is additional uncertainty attached to that, that will take weeks to resolve.

The economic recovery that seemed so promising 10 months ago has stalled. Real estate prices continue to drop in many markets with many foreclosed properties not even listed to lessen the perception of burgeoning inventories of distressed merchandise. In Las Vegas a realtor friend mentioned that 50% of her deals these days are cash, as many properties don’t qualify for a certificate of occupancy and can’t meet standards for a mortgage. Only 20% of real estate market sales are “conventional sales,” she says. To put this in perspective, previous Federal Reserve Chairman Alan Greenspan says we shouldn’t expect any kind of robust recovery until home values rise at least 10%. His comment was made in an interview before values retreated another 5%.

Unemployment has plateaued at about 9%, with under-employment and fear of unemployment stifling consumers’ will and ability to buy. The President’s new jobs plan has been met with a collective yawn by Congressional Republicans. It is yet to be determined if can even pass, let alone actually make an impact if passed. The first stimulus package of the Administration managed to stem job loss of 780,000 per month, but did not achieve its stated goal of keeping unemployment below 8%. Despite stemming the job loss, the word “failure” is bandied about in political circles. As it turns out, the initial calculations of how much stimulus might be needed were based on preliminary numbers, which showed the economy contracted 3.8% in the last quarter of 2008. Once all the numbers were in, the real numbers showed a 6.2% retraction in that quarter. It turns out that to do the job promised, Paul Krugman, Nobel Prize-winning economist and New York Times columnist was correct, the stimulus needed to have been twice as large. Regardless, we are where we are, the original stimulus has exhausted its funds, the economy is stagnant, domestic auto stocks have tanked, and recovery has been stopped in its tracks.

This economic downturn isn’t like our previous ones. This one was caused by a financial crisis, with a near-collapse of the financial system averted at the last minute by government intervention. In my own business career, I recall the auto business being a major player in dragging the country out of economic stagnation. In late 1971, Pres. Richard Nixon repealed the excise tax on automobiles, touching off a spurt of business that pulled the economy out of stagnation and carried us forward to the first 10 million unit sales year in 1973. That momentum was halted in late 1973 by the OPEC oil embargo, fuel price spikes, and the associated economic downturn. Chrysler and Joe Garagiola helped pull us out of that one in 1975 with the “Buy a Car, Get a Check” promo. We then went through the Iranian hostage crisis in 1979, another spike in fuel prices, inflation, and the recession associated with the Carter/Reagan era and the first Chrysler bailout. Chrysler’s resurgence helped lead the economy out of the depths. In the past 10 years, GM led the industry and the economy out of the doldrums caused by the Sept. 11 attack with “Keep America Rolling” and 0% interest. That was followed by the “Employee Purchase Plan.”

This time around, we experienced the recession, the near insolvency of the banking system, a real estate crisis of epic proportions, and one that stubbornly hangs on, the temporary disappearance of financing of all kinds, bankruptcies of two of the three domestic automakers, and unthinkable job loss. After the restructuring of the auto industry, and a less than perfect “Cash for Clunkers” program, and a brief period of revival, any forward momentum has stalled.

Currently, new vehicle inventories are low. This isn’t a particularly abnormal situation for this time of year, as it is typical for dealers to clear out previous year’s stock to make room for the new model year’s models. But Japanese manufacturers, in particular, have lost ground against their competition because of the supply interruption caused by the tragic Japanese earthquake and tsunami. And they want their marketshare back. According to Kelly Blue Book, Japanese brands were approaching 40% of the U.S. market. Bus since April, that share has fallen to about 30%. Most SAAR projections are running behind pace, including my own. People are talking about an incentive battle from now through the end of the year. As Japanese brands gear up, domestics are expected to respond. And the domestics now have a much lower breakeven point than before their restructuring.

Incentive wars usually drive down used-vehicle values. But we have been experiencing an acute pre-owned inventory shortage. Dealers would welcome some relief.

Rental fleet replenishment is still in long-cycle mode. Wouldn’t it be nice to rent a vehicle again with less than 25,000 miles on it, riding on smooth tires? Can a case be made for a production orgy and short cycling of rental vehicles for a period of time as we had in the 1990s? For all the negativity attached to “push-marketing,” could this be an ideal time for it? The idea of manufacturing plants running at full capacity, paying overtime and adding shifts, and the trickle down through the supplier base and the financing community sounds pretty good right now. And the market could use a supply of low mile pre-owned units. Customers of Hertz, Avis, Dollar/Thrifty, etc., would be happy. And perhaps the auto industry could help touch off recovery like it has in the past.

David Ruggles has spent his career in every phase of the retail side of the auto business, new and used, sales and management, including consulting and training in both the U.S. & Japan. Ruggles has been a dealer for Mercedes-Benz, Chrysler, Dodge, GMC, Ford, Mazda, and Subaru, and has consulted for one of the world’s largest privately owned Toyota dealer groups located in Japan. He blogs at autosandeconomics.blogspot.com and writes regular columns for several publications.

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Japan's Twin Earthquakes and other disasters

Japan is well on its way to recovery from the March 11 earthquake that rocked the country’s northeastern region and generated a tsunami that swept clean swathes of the coast.  Automotive output is recovering; between them, Honda, Nissan and Toyota plan to hire over 5,000 temporary workers in an attempt to catch up, which feeds back to help the rest of the economy, as well as the Tohoku earthquake region where Toyota's newest plants are located. But a second and wholly man-made disaster now threatens the return to normalcy.

Despite the magnitude of the March temblor, Japan was well prepared. Few deaths stemmed from buildings collapsing, trains stopped automatically, and factories were relatively unscathed. As roads were reopened and utility service reestablished, the auto industry was ready to resume output. And all along most of the economy trundled on; despite the horrendous scope of damage, the impact of 25,000 deaths and the total destruction of a swathe of coastal land in a society of 127 million is limited. Rapid recovery seemed certain, as was the case after not merely the 1995 Great Hanshin earthquake which struck almost direct under Kobe, but even the 1923 Great Kanto earthquake, which destroyed the Tokyo metropolis.

The auto industry was a hiccup in that process. Today's cars are hi-tech products, and the supply chain is correspondingly complex. Let one example suffice. Making a semiconductor chip takes two months from start to finish, and the ceiling fell in ― literally ― at a plant where an invisible speck of dust results in a bad part. Doing basic repairs, getting the clean room clean again, and then debugging machines is a multi-month process. Given the uniqueness of the chips, symptomatic of their "hi tech" nature, it was just as difficult to transfer manufacturing to a different facility, despite excess capacity elsewhere. Japan is a big place, however, and a river of engineers poured in to help. As a result, even the Renesas' "fab" is back in production, albeit at reduced rates.

The global industry remains vulnerable to disruptions; factories are prone to be unique. One reason is that the industry has not settled upon standards–though a July 26 article noted a new effort in that direction. [See a Japanese-language article in Sankei on a METI-coordinated committee on the issue. It cites Toyota saying that by 2013 they might be able to start purchasing under joint standards, but such standards would not apply to more than 30% of semiconductors.] Part is that things are evolving too fast. But firms also view chips, specialty steels, paints, engine parts, and now batteries as strategic. And there are no institutions in place: the old standard-setter, the Society of Automotive Engineers, is a shadow of its former self. With little commonality, dual-sourcing is not an option, magnifying risk.

Hindsight is not foresight. It's impossible to take into account (much less insure against) every eventuality. While a few mayors along Japan's coast had insisted on unusually high flood walls ― maybe reflecting (possibly corrupt) ties to the construction industry rather than prescience ― disaster scenarios didn't anticipate the magnitude of the tsunami. That increased the human cost, even if relatively few plants were located on the coast: most were inland, where land was cheaper

One exception was power plants, which needed access to water for cooling. We all know about the destruction of a set of four of the six nuclear plants at Fukushima I. Less known is that the Onagawa nuclear plant, run by Tohoku Electric Power, was both directly hit by the earthquake and by a higher tsunami; after all, an idle but undamaged plant isn't "news". However, it was of a modern design, on higher ground, and better managed ― and shut down without problems. Even more telling, a second set of four reactors, the Fukushima II complex, were also effectively unscathed. Yet the Onagawa plant and the other well-run utilities with intrinsically safe nuclear plants are being tarred and feathered by TEPCO (Tokyo Electric Power). In the background not-in-my-backyard politics at the local and prefectural level made construction of new electric generation capacity of any sort a slow process. So there is little excess capacity, exacerbated by the division of the country into incompatible power grids. Every power plant has to be brought back online if the country is to avoid brownouts for the years to come.

Unfortunately, Japan now suffers from a second earthquake, entirely man-made. The disaster now unfolding reflects politics.

Why? Prime Minister Naoto Kan of the ruling Democratic Party of Japan (DPJ), facing a divided Diet (parliament), was too quick over the past year to offer compromise to the opposition Liberal Democratic Party (LDP). (Perhaps that reflects his background as a community activist and lawyer, where the key skill is being able to hammer out compromises where common interests are central.) In the process, he alienated many in his own DPJ, without ultimately gaining the cooperation from the LDP that he needed to pass legislation. Then, under pressure from all sides, Kan struck off on his own with a populist measure to keep all nuclear power plants closed once they shut down for maintenance under a routine 13-month cycle. Within a year, then, all will be closed and remain off-line. Most are of the more modern Onagawa design, but they may now never be permitted to resume operation despite providing 30% of Japan's electricity. The economic impact of this will be huge and last for years, even as the economic disruption from the Tohoku earthquake itself ends.

Still, it is useful to remember the basic competitiveness of the auto industry, with multiple suppliers and assemblers following a wide array of strategies. Contrast Nissan, relatively unaffected by the quake, with Toyota. Twenty-five years ago Nissan began moving its production inside Japan to Kyushu, 1,500 miles south of the quake's epicenter, while reducing capacity in the Tokyo region. [Nissan had also been planning to boost output and so had built up inventories of chips and other items with long lead times before the quake struck on March 11th, so there was an element of luck involved, too.]

Toyota's strategy was different. It had acquired Kanto Jidosha and Central Jidosha in the Tokyo area in the 1950s, which together with Toyota Auto Body account for 30% of the company’s Japan-based output. In the 1990s, rather than paring capacity, they added plants to the northeast of Tokyo ― right where the earthquake struck.

That extra capacity left Toyota vulnerable to a second earthquake: an appreciation of the yen, at ¥78.5 per dollar as I write this, over 50% stronger than the ¥121 level of July 2007. With the extra capacity, and a commitment to pay employees whether there was work or not, Toyota increased its dependence on exports; Nissan did not. Toyota also has a byzantine web of domestic subsidiaries, a structure as unwieldy as the General Motors of old, with internal politics to match. So domestic production was attractive not only to alleviate union pressure but to protect the turf of incumbent executives and middle managers.

Now the earthquake itself will have a fleeting impact. Japan is after all a large place, with 127 million people. Horrific as 25,000 deaths may be, that and accompanying losses to the capital stock are tiny relative to the size of the economy. Capital can be fixed, and the size of the economy makes that relatively straightforward: a cumulative 4,200 engineers and other skilled workers poured in from the rest of the domestic semiconductor industry to revive production at the Renesas plant. The same story applies to electric power lines, roads and bridges, and other infrastructure, including the Sendai airport that was but recently under water. Many farmers were unable to plant this year's rice crop, the fisheries industry is only partially functional, and tourism is dead -- and all are important to the rural Tohoku region. But Toyota's plants are running again, and those of their suppliers.

Yes, the Tohoku earthquake was a disaster, as is the ongoing rise of the yen. The impact of both is amplified by dysfunctional politics ― electoral and corporate. Nevertheless, the industry as a whole is remarkably robust: its size and the variety that comes from rivalry lessens the impact of even major disasters. Toyota may be hit, and its recovery will be far slower than most observers seem to believe. A few American consumers may be disappointed, Toyota's U.S. dealerships moreso. But the global industry will hardly notice.

Mike Smitka