Motown's Ominous Message

By Sebastian Mallaby
Monday, October 24, 2005

It's tempting to blame Detroit's problems entirely on dumb managers. They produced clunky designs. They refused to see that one day -- surprise! -- gas prices would reward foreigners' investment in hybrid engines. But policy types in Washington have no right to sneer. Government encouraged some of the carmakers' mistakes. The trouble in Motown should be a wake-up call to Washington.

Last week's terrible results from Ford; this month's bankruptcy of the big auto parts maker Delphi; and the rising tide of speculation about the potential bankruptcy of GM -- a big cause of all this grief lies in excessive non-wage benefits. Hourly pay may be a little high: It averages about $27 at GM and Delphi, compared with the $17 average for American manufacturing. But health and pension benefits are the real killers. Once you've counted those, workers cost $74 an hour at GM and $65 an hour at Delphi.

The size of these benefits is odd. On its face, non-wage compensation is likely to be inefficient. Cash can be spent on exactly what each individual worker wants. But converting cash into benefits inevitably means waste. Some workers won't want the benefits, perhaps because they have a pressing need for money or perhaps because they would have preferred a different sort of pension or health plan. These workers may value the benefits less than it costs to provide them.

Companies provide benefits nonetheless because government encourages them to do so. Historically, it did this by imposing wage controls, forcing employers to find non-wage carrots to lure workers. More recently, government has pushed the same way by sheltering pension contributions and health premiums from taxes. The resulting company-based welfare system is widely accepted as the way things ought to be. But it's based on a myth of lifetime employment at one firm. And its tax breaks are unfair to self-employed workers who don't get them.

Why did carmakers get to the point where they not only offer pensions and health care, but where these benefits account for the majority of workers' total compensation? Again, the answer has to do with government. The law allows firms to reward workers with valuable benefit promises today, but pay for these promises later. In the car industry, just as in other industries facing a cash crunch, this promise-now, pay-later option has proved irresistible.

The option is clearest in the case of retiree health benefits. The law allows companies to promise health coverage to workers when they retire, but it fails to require them to set aside cash to pay for that obligation. So in bargaining sessions over the years, Detroit's managers and unions have found it easier to make "progress" on health plans rather than on wages that would have to be paid for immediately. For managers, cost-free promises of gold-plated health coverage in the far future bought labor peace. For labor leaders, they impressed rank-and-file members and ensured reelection.

The promise-now, pay-later trick applies to pensions, too, although it is more subtle. The law does require companies to put aside money to fund pension promises -- but not enough money. GM, for example, is allowed by pension accounting rules to report that its pension plans are fully funded. But if the plans were terminated tomorrow, their assets would be worth $31 billion less than GM's promises to retirees. Rules that effectively allow a company to report $31 billion that it doesn't have provide an irresistible temptation. The bigger your pension plan, the more billions in fake assets you'll be able to report. This has done nothing to discourage Detroit's generous retirement promises.

Now the future has arrived. GM is providing gold-plated health plans to more than 1 million retired Americans; its health costs came to $4 billion last year and will top $5 billion this year. These "legacy costs" -- the legacy of bad management decisions encouraged by bad government rules -- are driving the carmakers to the wall. Last week GM forced retirees to swallow cuts in their health plans, and Delphi seems likely to use the bankruptcy courts to impose similarly sour medicine.

In a sane world, Washington would absorb Detroit's painful lesson. Tax breaks and rules that encourage phony corporate promises end up betraying workers. From now on, tax incentives should not encourage welfare systems that depend on the false premise of corporate immortality. And the law should oblige firms to recognize the cost of compensation promises immediately and transparently.

These aren't exactly novel lessons. What the car industry now faces, the steel industry has faced before; and transparent reporting of compensation promises was the principle at the heart of the long fight over employee stock options. But the political system has a formidable ability to ignore even the oldest and most obvious lessons. Congress is considering legislation to force proper funding of pensions, but the reform will probably end up full of holes. Likewise, Congress will soon be prompted by the president's tax commission to consider ending the tax shelter for company health premiums, but the people's representatives will no doubt brush that idea aside. Politically unthinkable, we will be told -- and never mind the fact that it may be good policy.

mallabys@washpost.com


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