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.Â 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).Â But you can’t build an industry, or an economy, by cutting.Â You build an industry, well, by building.Â 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.Â Both have been trying for years to solve their problems by cutting.Â Yet the arithmetic has worked against them, in both cases.Â Unit costs increased, not decreased, as the companies downsized and shedded “non-core” assets.Â They are ever less competitive, the smaller they get, in terms of their ability to develop and supply a product or service that works.Â Instead of questioning that logic, the assumption is made that the past cuts didn’t work because they simply weren’t deep enough.Â 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.Â What do we mean when we talk about “viability,” anyway?Â Obama wants more cuts to make the auto companies “viable.”Â Rovinescu wants more cuts to make Air Canada “viable.”Â What they actually mean is to try to make these companies “profitable.”Â In other words, viability is equated with a company that generates profits.Â Yet there are other ways to think about the viability of a company, or an industry.Â Does it produce a necessary product or service?Â 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?Â And are there deeper factors explaining the continuing failure of these companies, other than their “size”?Â Equating viability with profitability is akin to equating social cost-benefit analysis with private cost-benefit analysis.Â It will almost certainly result in decisions that are socially sub-optimal.Â (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.Â 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).Â 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,Â 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.Â The common assumption is that “getting viable” is synonymous with “getting much smaller.”Â 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.Â Financial analysts felt Wagoner was “too slow” to downsize.Â 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.Â GM lopped more than 100,000 positions from its U.S. workforce since 2001 (more than half).Â 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.Â 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.Â 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.Â 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.Â Air Canada’s CEO, Monte Brewer, lost his job one day after Wagoner.Â (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).Â 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).Â 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.Â 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.Â Despite sacrifices from employees, Air Canada’s unit costs (excluding fuel) increased slightly since exiting bankruptcy protection in 2004.Â Why?Â The negative impact of shrinking capacity on unit costs outweighs the savings extracted from the hard-pressed workforce.Â 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.Â We need a strategy that builds, not cuts.Â That’s a better way to save critical companies.Â 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.Â Yet the sum total of those individual acts, multiplied across the whole economy, worsens the recession that threatens each business’s survival.Â This collective irrationality is why government economic leadership is so essential during crisis.Â 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.Â Instead, government should promote building, not cutting.Â It should stabilize demand (in autos by guaranteeing warranties and subsidizing the scrappage of old clunkers).Â 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).Â 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.