Monday, 16 February 2009

BMW cuts 850 jobs and one shift

It's been accepted by most analysts for years that the global car industry has substantial overcapacity and that factory closures, or even closures of whole companies, are needed. Now BMW is cutting 850 jobs at its Mini plant - even though Mini sales are up this year. So is this a good thing?

Probably not - at least not right now - because it causes a reduction in aggregate demand, and that means reduced GDP growth, or a deeper recession.

But that's true of capacity reductions at any time. So why would it have been good before and not good now? What is the difference?

The first thing to understand is why a cut would have been desirable. Let's imagine that, in more normal times, a car company (Chrysler for example) shuts down. The immediate beneficiaries of a company closing would be the other car companies. With less competition they could sustain higher prices; some people who would have bought Chryslers will now buy other cars, boosting both revenue and profits at the remaining companies.

But this isn't just a matter of companies better off at the expense of consumers and ex-employees. The people who were making (and marketing, and financing) Chryslers would, after a while, find work making something else which is more valued by society - I assume this on the basis that if customer won't pay for Chryslers at the breakeven price, but they will pay for some other product, the other product is more highly valued. Ultimately resources would be employed more usefully.

There are certainly adjustment costs - both in the obsoletion of useful capital (machinery and those big factories in Detroit) and in a period of unemployment for employees. But in the long run - and even the medium run - these costs are outweighed by the greater productivity and usefulness of the alternative use of resources. The reduction in aggregate demand is another one of these short-term costs.

So far so good - orthodox economic theory at work.

But what about now, in the middle of a recession? The period of unemployment is likely to be much longer, and the leftover capital is likely to find no other profitable use for a while. Thus the adjustment costs of closing down a factory now are higher.

And will the reduction in aggregate demand have a greater effect now? It will certainly be more noticeable - but will it really make more of a difference?

Probably, yes. A reduction in private demand has a multiplier effect, just the same as an increase in government spending. One of the main determinants of the multiplier effect is the proportion of idle resources in the economy, and that proportion is certainly higher now. Thus, an immediate reduction in demand of around £40 million per year (a conservative annual cost for these layoffs) will have a total impact of say £80 million now, while in an economy running close to full capacity it might have an impact of only £20 million.

This does not necessarily mean that BMW should be prevented from closing factories (and note that they are not closing a factory, just eliminating a shift - so the capital reallocation effects are much smaller). If we try to freeze the economy in its current state by retaining the capacity of all firms, economic growth will probably be damaged even more, by missed opportunities for innovation and productivity growth. But we also don't want whole swathes of the economy to close down in a vicious cycle of reduced demand.

These cycles are largely a function of the friction that I described in my article of a few days ago. Because of frictional phenomena, adjustment takes time to happen. In a recession, demand is more sensitive to levels of unemployment, and equally unemployment is more sensitive to falling demand.

Naturally this presents a strong argument for fiscal stimulus, where the government helps to stabilise total demand so that the knock-on effects are less likely. It also suggests that, where possible, closures should be staggered so that they don't all happen at once. While there is obviously reduced demand for cars, there is certainly someone somewhere who will pay for a Chrysler (or a Mini) at some price, just not the prices that are being asked for them now. It's likely that in poorer or emerging markets, the marginal utility of one more car is higher than it is in the UK. Perhaps Indian or Zimbabwean families could be buying up Minis if we offered them at a reasonable price? Perhaps even unemployed people in the UK.

Setting the right price would be an interesting task - and allocating the cost of the subsidy between the government and BMW would be another one. But rather than pay all the adjustment costs and lose all the tax revenues from that £40 million, it would be a lot cheaper for the government to subsidise low-income people to buy the excess Minis for 18 months until the recession is over and it's safe to let the factory fail on its own merits.

In the meantime, shift workers who know they are likely to lose their jobs over the next 18 months will have a strong incentive to retrain for new industries, and this is definitely a role for government-subsidised adjustment assistance. If they finish training and find jobs before that, so much the better.

Danger: metaphor alert

In physics, there are two kinds of friction. Kinetic friction acts as a continuous force between objects that are moving relative to each other. It continually uses energy and generates heat, but in practice rarely affects the ability of the objects to keep moving, and therefore does not change the qualitative behaviour of the system.

The other kind, static friction, acts on objects which are not yet moving, and makes it harder for them to start moving. This kind does change the behaviour of the system. Static friction is usually stronger than kinetic friction, and in the economic analogy this is true too. A car engine is harder to start than to keep going once it's running.

An economic system which is moving at high speed can absorb friction much better than one which is stuttering or stagnant. Thus we need counter-cyclical adjustment assistance - encouraging excess capacity to close when the economy is doing well, so that it won't all happen at once when the brakes are thrown on. That, incidentally, is an argument for targeting higher levels of productive investment (relative to consumption) in a growing economy. But that's an argument for another time.

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