How to Grease Detroit's Squeaky Wheels

• Without substantial government aid, the Big Three automakers appear headed for bankruptcy and liquidation.

• This would devastate the economy, resulting in hundreds of thousands of lost jobs.

• Congress is considering a loan to support the car companies until sales improve, but wants to see a new restructuring plan first.

• A better alternative would be to guarantee bankruptcy financing for any or all of the Big Three.

• Only by going through bankruptcy do U.S. automakers stand a chance of becoming viable long term.

The U.S. auto industry desperately needs financial help, and the federal government should provide it. Without aid, the industry seems headed toward a quick liquidation, which would mean hundreds of thousands of layoffs at just the wrong time for the sliding U.S. economy. But the $25 billion loan that policymakers are now debating won't provide the kind of help that's needed, even if the automakers come up with a new restructuring plan as Congress demands. Instead, policymakers should offer financing to automakers that file for bankruptcy so they can restructure and survive as smaller businesses.

Without government help, the Big Three will almost surely enter the kind of bankruptcy from which there is no exit. They could file for a Chapter 11 restructuring, but would most likely end up in a Chapter 7 liquidation. Their plants and other operations would be shut and their assets sold to pay creditors. Given the collapse in the financial system and resulting credit crunch, so-called "debtor in possession" or DIP financing would be all but impossible to get. Bankrupt firms need DIP financing to operate—to pay suppliers, finance inventories and meet payroll—while they restructure. It is risky for DIP creditors even in good times, but they do get first dibs on the bankrupt firms' assets and can earn high rates and fees. But in a credit crunch such as we are experiencing now, nothing will convince creditors to take the risk.

Burning through cash

GM appears to be in worse shape than Chrysler, which seems in worse shape than Ford. GM is burning through cash quickly and at its current rate could be unable to operate by early next year. Chrysler and particularly Ford may be able to hold out longer, but given the poor prospects for vehicle sales and their almost-certain loss of market share, not for much longer.

This would be disastrous for the economy. The Big Three employ some 250,000 workers in the U.S., but with their deep and extensive links to dealers, suppliers and other firms, closer to 2.5 million jobs would be at risk. Automakers produce some of the largest economic multipliers among all industries. For every job lost in auto assembly, another nine jobs are lost in related industries from parts to repair (see table). Hundreds of thousands could face layoffs just as the economy is already set to lose several million jobs. The hit to consumer and business confidence—which are already in the dumps—would be devastating.

The fallout in the industrial Midwest would be catastrophic. The Michigan and Ohio economies have been in recession more or less since the beginning of this decade, and the collapse of the Big Three would undermine their economies well into the next decade. Also hit hard would be Indiana, Illinois and Wisconsin. Exacerbating the fallout, unemployed workers in the industrial Midwest will find it difficult to relocate to states such as Kentucky, Tennessee or Alabama, home to the "transplants" operated by foreign car makers such as Toyota or Volkswagen. Midwestern house prices have fallen so sharply that many homeowners in that region are now underwater; they owe more than their homes are worth. A move could require them to either dip into savings to pay off their loans or default on their mortgages—a Hobson's choice.

Given the economic costs, allowing the Big Three to go bankrupt without government help would thus be a serious mistake. Congress should instead encourage the automakers to begin a pre-packaged bankruptcy, with Washington guaranteeing the DIP financing for the Big Three in bankruptcy. The government guarantee would enable an orderly restructuring and prevent liquidation. All stakeholders—management, creditors, suppliers and the unionized workforce—would be forced by the bankruptcy to make the tough choices they have thus far been unable to confront. It's not that they haven't made strides, lowering labor and material costs and improving productivity; it's rather that the steps required to become viable in the long run are too draconian to take outside the bankruptcy process.

Exit smaller

Even an orderly bankruptcy would still produce numerous layoffs. The companies would come out of bankruptcy much smaller, reflecting the much smaller new car market and their loss of market share. Given current demographic trends, if gasoline prices remain close to $2.50 per gallon and the U.S. job market recovers, total new-vehicle sales would be at best 16 million units annually (see chart). Automakers were able to sell closer to 17 million units during the first half of this decade, but only by offering dramatic discounts and easy financing terms. The recent collapse in sales to below 11 million units annually is partly due to spent-up demand among consumers who bought during the earlier incentive sales. This spent-up demand equals an estimated 10 million units; at its current sales pace, the entire auto industry would have to shut down for nearly a year to catch up.

Sales will return to their underlying 16 million-unit pace only when this spent-up demand is worked off, the job market stabilizes, and credit flows more freely. A consistent 17 million-unit sales pace will not return for well over a decade. The Big Three need to rationalize their operations to reflect this, which in turn means many fewer auto jobs. But if this rationalization is done in an orderly way the job losses should be in the thousands per month, and not the hundreds of thousands. While still painful, this is manageable.

Some worry that if the Big Three file for bankruptcy—even a government-supported bankruptcy—consumers will stop buying Detroit's cars. Who wants a car from a company that might not be around to fulfill warranties or provide service? This is a reasonable concern, but the best way to ensure a future for the Big Three is to rationalize their size and shape via bankruptcy. Without big changes in their operations, a loan from the government of $25 billion or $50 billion or even more won't convince anyone they will be around long. To allay concerns, the government could also guarantee warranties on any new cars sold by the Big Three while they make their way through the process.

Sending a signal

Bankruptcy for the Big Three would also send an important signal to other firms thinking of asking for taxpayer help in these difficult times. Most industries don't hold the stature of the domestic automakers, but that won't stop many from seeking help—unless they know that help will require a trip through bankruptcy court.

A concerted, comprehensive, and consistent government response to the current crisis is vitally needed. The economy needs a large and prolonged dose of fiscal stimulus and a large foreclosure mitigation plan; but the government's resources for addressing the crisis are not unlimited and must be used wisely. The automakers' pleas for government assistance must be answered, but the answer should ensure that they make some fundamental and ultimately painful changes. Government loans to the Big Three will not produce those changes. A government-supported pre-packaged bankruptcy could.