Cutting versus Building

Posted below is my Globe and Mail column this week raising questions about whether troubled companies can really “cut their way to viability.”

When companies face trouble, the knee-jerk response is always to cut back: close plants, reduce headcount, cut compensation.  Reflecting their shorter-term time horizon (and their consequent hunger for a faster payback), financial markets favour the most determined and ruthless cutters (which explains why financiers are now in charge of Chrysler, GM, and Air Canada alike).  But you can’t build an industry, or an economy, by cutting.  You build an industry, well, by building.  And we’re not seeing a lot of that these days.

My column discusses two examples of the limits to this knee-jerk approach with which I am all-too-painfully acquanited: the auto industry and Air Canada.  Both have been trying for years to solve their problems by cutting.  Yet the arithmetic has worked against them, in both cases.  Unit costs increased, not decreased, as the companies downsized and shedded “non-core” assets.  They are ever less competitive, the smaller they get, in terms of their ability to develop and supply a product or service that works.  Instead of questioning that logic, the assumption is made that the past cuts didn’t work because they simply weren’t deep enough.  More cutbacks, far from restoring “viability,” eventually throws into question the reason for these companies’ existence.

Indeed, there’s an even deeper issue at stake here that I didn’t get into in the Globe column.  What do we mean when we talk about “viability,” anyway?  Obama wants more cuts to make the auto companies “viable.”  Rovinescu wants more cuts to make Air Canada “viable.”  What they actually mean is to try to make these companies “profitable.”  In other words, viability is equated with a company that generates profits.  Yet there are other ways to think about the viability of a company, or an industry.  Does it produce a necessary product or service?  Does it generate so-called “external” benefits (jobs, incomes, supply chain effects, productivity, innovation, exports, essential public services) that are important and valuable, but that do not show up on the company’s private profit-and-loss statement?  And are there deeper factors explaining the continuing failure of these companies, other than their “size”?  Equating viability with profitability is akin to equating social cost-benefit analysis with private cost-benefit analysis.  It will almost certainly result in decisions that are socially sub-optimal.  (This begs a bigger question, of course, regarding how we sustain activities that may be socially useful but privately unprofitable.)

In both the auto and the airline industries, I think the deeper problem is related to conditions of excess competition and excess supply — in the auto case resulting from globalization and trade imbalances, in the airline case resulting from deregulation combined with the economies of scale and scope which characterize this business.  Re-establishing true “viability” would require some rethinking of the free-market fundamentalism that has guided both industries (both of which have lurched from one crisis to another).  It’s far easier, when in doubt, to simply call for more and deeper cutbacks — and to take a swipe at the unions, while you’re at it.

OK, enough belly-aching, here’s the full column:

From autos to airlines, desperate executives are wielding a mighty axe in an effort to survive the devastating consequences of the global recession.  The common assumption is that “getting viable” is synonymous with “getting much smaller.”  In wildly swinging the axe as a universal solution to corporate woe, the downsizers are felling many trees – but missing the forest.

Consider last week’s stunning events at two of Canada’s largest employers: General Motors and Air Canada.

On Sunday, GM’s CEO Rick Wagoner was fired – not by directors or shareholders, but by President Barack Obama.  Financial analysts felt Wagoner was “too slow” to downsize.  This knee-jerk view was reinforced by the demand from Obama’s auto task force (which consists mostly of financiers, not auto experts) that GM must cut deeper (more closures, more cutbacks) to prove its “viability.”

Of all the things Mr. Wagoner can be accused of, failing to downsize is certainly not one of them.  GM lopped more than 100,000 positions from its U.S. workforce since 2001 (more than half).  In Canada, GM’s manufacturing workforce is slated to fall (including plant closures already announced) to about 6000 – compared to 22,000 a decade ago.

Yet the more GM responded to tough times by shrinking, the worse things got.  Fixed costs (for engineering and design, capital, marketing, and retirees) got bigger per unit of output, not smaller – making it all the harder to develop and manufacture competitive products.  GM’s experience proves forcefully that you can’t dig your way out of a hole … yet Obama’s task force tells GM to keep digging.  Soon a point of no return is passed, below which the company’s essential critical mass (its ability to design and manufacture innovative products) is destroyed.

Air Canada is a different company, in a different industry, yet it equally epitomizes the impossibility of shrinking your way to viability.  Air Canada’s CEO, Monte Brewer, lost his job one day after Wagoner.  (And, like Wagoner, he was replaced not by a hands-on manager, but by a financier.)

Everyone expects the new CEO, Calin Rovinescu, to fly Air Canada back into bankruptcy protection (right where he left the airline when he last worked there in 2004).  Then, under court protection, he will axe much of the company’s operations, and go after key contractual commitments (like its partnership with Jazz and its pension plan).  The only question is how much he will cut, and exactly where, in this latest effort to become “viable” (that is, “smaller”).

Air Canada’s workers and other stakeholders lived through this same horror movie six years ago.  It didn’t work then, and it won’t work now – for the same reasons why GM’s continuing cutbacks are also doomed to failure.  Despite sacrifices from employees, Air Canada’s unit costs (excluding fuel) increased slightly since exiting bankruptcy protection in 2004.  Why?  The negative impact of shrinking capacity on unit costs outweighs the savings extracted from the hard-pressed workforce.  In airlines, as in autos, you can’t cut your way out of crisis.

If we want to maintain a stable auto or airline industry in Canada (not to mention aiding other strategic but teetering sectors, from telecom to resources), we must resist the knee-jerk tendency to respond to adversity by slashing and burning.  We need a strategy that builds, not cuts.  That’s a better way to save critical companies.  And it leaves the overall economy better-prepared for the next upswing.

Any single business responds to tough times by cutting back and laying off.  Yet the sum total of those individual acts, multiplied across the whole economy, worsens the recession that threatens each business’s survival.  This collective irrationality is why government economic leadership is so essential during crisis.  Government is the only force in society with enough foresight, enough fiscal staying-power, and (hopefully) enough accountability to the broader public interest to respond to crisis by doing more, rather than less.

So whether it’s autos, airlines, or any other fragile sector, government’s role is certainly not to reinforce private sector irrationality with demands for even more cutbacks.  Instead, government should promote building, not cutting.  It should stabilize demand (in autos by guaranteeing warranties and subsidizing the scrappage of old clunkers).  It should relax the do-or-die competition that exacerbates the carnage (in airlines by limiting the continuing over-expansion of capacity in an industry already drowning in red ink).  And it can bridge key companies into a more optimistic future with loans, technology, and partnerships.

Otherwise, the axe will keep swinging, and the economy will keep tanking.

12 comments

  • You admit the problem is related to “excess competition and excess supply”, but the solution is not to reduce supply?

    Following your logic it seems like instead of cutting back at GM and Chrysler, we should leave GM as it is and completely eliminate Chrysler. Consumers Report recommends 0 of their cars, anyway.

    With only two major Canadian airlines, I’m not sure eliminating one is the solution.

  • I agree with your thesis in general terms and certainly as historically accurate, but I wonder if the usefulness of this reasoning – build in times of difficulty in order to capture growth in the recovery phase, and government should and can encourage this – is becoming outmoded. Given the impending brick wall of permanent declining liquid fuel sources, particularly oil, (and I take this as a given), cutbacks to auto and air industries might actually be better positioning them for a future of less credit and less affordable fuel (ie. less overall demand). Even given that unit costs rise with cutbacks, if substantially fewer units will be saleable in the future, shrinkage is going to have to happen anyway.

    Now, I know this is not the reasoning behind the cuts you’re talking about. I agree with you that the reasoning is reactive to the short-term market-approval system and in general counterproductive in the long run. But I think we’re on the verge of the long-run paradigm shifting drastically and permanently into a lower gear. In that environment… cuts might work out as some kind of advantage for completely unintended reasons. Or these companies might be doomed regardless.

  • I’m no economist, but I’ve been thinking along these lines as well. Cutting (jobs) decreases employment and therefore demand. Employment needs to stabilize first, demand will settle at the corresponding point – which obviously may not be the same point as say, prior to 2006. That is, with lower supply (lower conspicuous consumption?).

    The feedback cycle where lower demand leads to lower employment leads back to even lower demand needs to end, though I’ve no idea how.

  • I think Gladwell covered the topic quite well when he explained how pension costs and post-retirement benefits of shrinking corporations simply increase unit cost. Isn’t that why auto workers with a wage around $25 an hour and labour unit costs around $75 per hour? Here’s Gladwell’s article:

    http://www.gladwell.com/2006/2006_08_28_a_risk.html

    Also, peak oil will kill us all, everyone who manufactured large SUVs probably should change jobs, and Air Canada absolutely had to drop from their 90% market share after the Canadian Airlines takeover.

    Too bad Toyota and Westjet don’t have union certs – is there any way we can help you with that?

  • You re-build after you trim the fat. That way a stronger, more efficient and productive company emerges. Promoting the retention of deadweight just reduces productivity and prolongs the same eventual conclusion-the inefficient and ineffectual will fail.

  • Darcy, that presumes that the company is inefficient as is, or that it’s possible to regrow after making severe reductions in labour capabilities. I think at the least, Jim made a good argument that this can’t simply be assumed in the case of big transport sector companies like GM and Air Canada, especially in pre-peak oil circumstances. Now, inefficiency aside, one could make the case that GM has had awful management taking their production in a direction that would ultimately doom them, but “cutting the fat” isn’t really the solution to that either…

  • Individually rational, but collectively irrational.

    This is the tragedy of the commons, and truly the challenge of our times.

  • Rumor, if the company isn’t inefficient with respect to the market-there wouldn’t be a problem. If management is awful, as could be the case with GM-then some level of bankruptcy is the option. A more nimble and prudent company can pick up the pieces and fill the void. If there is a viable market-which I think we can agree there is-a stronger solution will emerge from the ashes.

    I don’t think all the problem resides solely with labor costs-it is the whole cost structure- as well as incorrect assumptions about the overall market. Simply cutting jobs is not the answer, but adjusting the whole cost structure -and a more nimble production/design response is needed to meet a changing market. I’m not sure GM can achieve that level of restructuring without bankruptcy.

  • I doubt GM can survive in anything resembling its current form, even after restructuring.

    It seems – and this is stating the obvious – that it’s really a contextual question of what approach is appropriate for a given company in its industry, but I think the important message is not to apply a one-size-fits-all method. For GM, I think they’re toast, but if a struggle for survival is in the cards for them, cutting a lot of production is going to have to be part of it, but not sufficient by itself.

  • I think Jim’s argument omits an important consideration: opportunity costs. Jim argues: “There are other ways to think about the viability of a company … Does it produce a necessary product or service? Does it generate so-called “external” benefits … that are important and valuable … Equating viability with profitability is akin to equating social cost-benefit analysis with private cost-benefit analysis. It will almost certainly result in decisions that are socially sub-optimal.”

    Sure, GM produces a useful product and creates external benefits through jobs. But you need to ask what the workers employed by GM could produce if they weren’t employed by GM, and what government subsidies could buy if they weren’t being spent on GM. Just because what GM does is “good” doesn’t mean it’s the “best” allocation of resources. Adding opportunity costs into your analysis would address this.

  • Hi Jim,

    Given all the talk these days of where we are heading, your article hits it squarely on the head-

    CUTTING ON A SYSTEMIC BASIS IS BAD

    It leads to deflation, and has a very real chance of spiraling. It is happening right now and despite the optimism in the press of some form of turn around, the deflationary spiral is now starting to kick in.

    CPI price declines in the US today at a rate not seen since in a generation. Also today several reports from US banks showed a spike in foreclosures and defaults on credit cards.

    To top that of, yesterday the US retail sales declined by a hefty 1.2%, very bad!

    There is no doubt we are starting to see a deflationary spiral.

    Has it just become some form of trend within the CEO circles to cut back. Sure there are needs for bottomline adjustments, but does everybody have that much slack that they view this a a permanent reduction.

    It is such a dangerous practice that we are goig to get caught up into some nasty vicious cycle that will reek havoc for the next 5 years.

    I guess with the hyper sensitivity to the short term quarterly results based decision making that have arisen with the age of the “knowledge economy”, we have decided that some form of ultra efficient ratio between output and employment levels is a maximizing uber accountant goal.

    This of course means that we can cut more efficiently then ever and get a whole lot quicker onto the deflationary spiral trajectory. This is even further lubricated by a pre- civilized employment security safety net.

    It is the ultimate efficiency for accountants and the worst nightmare for economists. Funny how such a dichotomy can exist within such an informed, information economy.

    What a phracking joke our economic “pundits” in this country are.

    The cheer leading going on in the “top” economic shops is nothing short of fascist economics. It really is getting that bad. Surely we must be starting to put a face on this facelessness of decline.

    pt

  • Paul Krugman’s latest NYT column makes the same points as you, Jim, about the US context of wage cuts:
    http://www.nytimes.com/2009/05/04/opinion/04krugman.html

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