When John Paul MacDuffie began studying the auto industry three decades ago, Japanese automakers Toyota and Honda had only just begun to make a small dent in the massive sales numbers of Detroit’s so-called Big Three: Ford, GM and Chrysler.

But even though the Big Three were showing signs of stress, it was difficult to imagine a day when those American industrial flagships wouldn’t be viewed as the world leaders in automotive manufacturing.

Well, that day has come.

The U.S. auto industry is facing a crisis like it’s never faced before. Years of mismanagement, relentless competition from overseas, burdensome obligations to retirees and, most recently, a worldwide economic collapse, have put each of the Detroit Big Three in serious dire straits. Reports surfaced last month that both Ford and GM were in danger of running out of cash, and by late November, Detroit’s top execs were asking the government for a reported $25 billion bailout package.

The proposed bailout sparked widespread criticism from both sides of the aisle and, as of this writing, was still being negotiated. Many say a bailout is the wrong move. MacDuffie, however, disagrees.

A Wharton professor of management and one of the nation’s most respected experts in the auto industry, MacDuffie says he believes the government would be wise to do something to help the Big Three stay afloat. Though Chrysler may not survive for long, and though the Ford and GM of the future may never be the Ford and GM of the past, MacDuffie says these companies have made positive moves in recent years. And he believes they just need some time to start reaping the benefits of their wise strategic shifts.

We recently caught up with MacDuffie to discuss how the U.S. auto industry got here, what must be done now to save it and how it may look in years to come.

Q. The Big Three are obviously in bad shape. How much of this is due to the economic climate, and how much is due to each company’s own missteps?
A. That’s kind of the big question of the week. It’s what everybody is struggling to figure out. To start with, absolutely, the current financial crisis has created an extraordinary situation where, very, very quickly, we’ve seen huge drops in sales. It looks like in the U.S., sales will go from being projected around 15 million cars for 2008—which is already on the low side historically—to about 10 million. That’s a big drop. That hasn’t happened in post-World War II American history. And that drop—that’s because of the financial crisis, because of credit drying up, and a bunch of other things that you can’t really attribute to any one company. And it’s hitting everybody. Toyota just closed its pickup truck plant in Texas. Everybody has inventory sitting around and not getting sold. So then the next part of the question is: What would the situation be if the financial crisis hadn’t happened?

Q. And what’s your answer?
A. Clearly, the Detroit Three—and more and more, ‘Detroit Three’ is feeling like the right term instead of ‘Big Three’ now that Toyota has passed them in total sales—have had 30 years of a sort of decline from a competitive and market share perspective. And there are a lot of different factors for that. A lot of them can very much be laid at the feet of the industry, the management, the labor relations, which therefore includes the unions. That being said, there has been a lot of convergence on a lot of key performance metrics between the Detroit Three and the foreign auto makers, which is a result—although it took a while—of them learning from their foreign competitors. They’ve changed more toward Toyota’s production system and those kinds of things. They’ve improved. They’ve also—and again, maybe much later than they needed to—tackled some of the most really complicated issues such as legacy costs of health care and pensions and labor costs. The 2007 UAW negotiations with all three of the companies were really dramatic. Those were the most radical new contract terms in 50 years, and part of what’s complicated about the present moment is that a lot of the benefits from those negotiations—which the stock market greeted with all sorts of jumps in stock price—haven’t been realized yet. Those plans are still being implemented, and probably won’t show up until 2009 or 2010. That’s going to be billions of dollars taken out of the old arrangement. It just hasn’t shown up yet. And on the product side, clearly the Detroit Three were too hooked on SUVs and truck sales and I see that as them having somewhat addictive properties, where they had this space where they were making a lot of projects and going really well and didn’t face much foreign competition and they couldn’t let go of it. And when oil prices went up, they didn’t have an alternative product ready.

Q. How have they responded to that?
A. They’ve responded pretty quickly and creatively, and the product portfolio that is available now and will be available soon includes not only a lot of fuel-efficient vehicles, but also some genuinely innovative vehicles. And now there is this sense that, man, after all of this decline and trouble, the last five years have really seemed to be in some way exactly the kind of difficult but positive reconstructive steps that needed to happen and the change that everyone has been yelling at them to do. And now, before those changes come to fruition, bam, they get hit by all of this other stuff. But there’s still a worry that these companies haven’t really won back the trust and confidence of the American consumer, and that even under better financial conditions, they wouldn’t have definitely pulled this off and not made other kinds of strategic mistakes.

Q. Do you see any other recent strategic errors from the Detroit Three?
A. Yes, I think there was a very misguided, long use of very heavy rebates and discounts on products that started after Sept. 11 to get sales going. But that continued for a long time and, sure, it pumped up sales, but it also stole sales from the future. It hurt resale values. It kind of devalued the brands. And it trained customers to wait to buy until they were going to get $5,000 or $6,000 back. That’s not a path to health, but a path to short-term sales numbers. I think that’s part of the reason why the appropriate policy now is to do the things that would allow the positive trajectory of these companies to at least come to fruition, as long as it comes along with some conditions. My worry is that bankruptcy, which seems to be the primary alternative that people are talking about, provides the wrong set of conditions for that to happen.

Q. So in your view, what is the most likely solution here?
A. Right now, it seems like it’s going to come down to two not-so-great alternatives. Nobody is really happy with the choices here. Both of them have a really big government role. That’s unavoidable. You have government-facilitated bankruptcy, or you have government-facilitated loans with a lot of conditions. The reason the government has to be involved in the bankruptcy is again somewhat because of the extraordinary economic conditions we’re in. To do Chapter 11 type of restructuring, where you’re trying to keep operations going, you really need a bunch of financing to keep that going. It’s called debtor-in-possession financing, and generally you raise it from the credit markets and they become the first creditors to get repaid. Those loans gain priority. The problem is, nobody is going to provide that kind of financing right now. So the government would have to do it. … Another thought is that a company like GM has so many complex relationships and so many complex creditor demands on them that bankruptcy would be incredibly complex and long-lasting and expensive, and that there’s also the danger they would never come out, so then they would have to liquidate. And of course all of the economic consequences are far more dramatic and sudden with Chapter 7 liquidation. Nobody wants that, and the question is how great you think the risks are.

Q. You don’t seem really thrilled by the idea of letting these companies go into bankruptcy. Why?
A. My final point on bankruptcy is that it looks like there are going to be several kinds of policy goals [Washington] is going to want to advance at one time. There are energy independence goals. There are economic stimulus goals. And there’s going to be something specifically related to the auto industry. I think the bankruptcy process is not a good way to pursue any kind of policy goals. Bankruptcy serves to protect the creditors and have their claims resolved in an orderly fashion. But if you want these companies to increase or shift their mix of products to more fuel-efficient cars faster, I think it’s hard to get that through the bankruptcy process. It’s easier to get that out of [loans with conditions]. You’re already seeing in the House and Senate bills provisions that say, ‘You’ve got to meet these targets if you want these loans, and if you don’t meet them, we call the loans early.’

Q. There is a worry, though, that if the taxpayers loan these companies $25 billion, that money is as good as gone.
A. The government will end up being first in line to be paid. I know people are worried that we’ll be pouring money down a rat hole and we’ll never get it back. But even in the worst-case scenario of liquidation, I don’t think there’s much doubt that the amount of loans we’re talking about will be paid back. We’d get it back and we’d be at the front of the line. That’s another important issue to understand, I think.

Q. I think maybe the biggest question here is this: Can the Detroit Three ever be what they once were?
A. It’s a great question and it’s another big question mark for them. From a reputation point of view, what’s clear is that the consumer gave them the benefit of the doubt for a long time. I know a lot of people who kept buying American for a long time and they finally hit a tipping point where they got fed up and bought a foreign car and they’ve been happy. So their experience since then has not given them reason to go back. You see some surveys today that show that 30 percent of American consumers won’t even look at Detroit Three products when looking for a car. So how do you build back that reputation? Well, that’s the big question. Just as there was a lag in losing trust, there is also a lag in building it back. I talk to people in these companies, and they really are feeling very proud of the progress they’ve made and maybe a little bit hurt and mystified that nobody seems to notice. But they’ve got to understand that this is where they are, and they have to win trust back one consumer at a time. I don’t think there are any guarantees here. But part of what I think would be very important and healthy for the industry is to have a goal of sustainable size and just accept that this goal is going to be a lot smaller than what it’s been and what they would like it to be. I think even through all of these years of market share decline, part of what has energized and also slightly distorted the way these companies see the world is that they still think in terms of economies of scale and volume. They want to keep going back to more volume. They have over-optimistic projections of how many of each model they’re going to sell. But then the sales don’t materialize, and that hurts the dealers, and the suppliers, and it makes the fixed health care costs higher per car sold because they’re not selling as many. I just think it’s a destructive way of thinking. It’s like the same reason they would do all of those rebates and incentives—to keep the numbers up. Because that’s what their experience for most of the 20th century has taught them, that the path to success is [volume]. Now, what shakes that view, I don’t know. But it seems to me some kind of very stern government oversight is appropriate. These companies should be pursuing healthy profit margins from healthy pricing on products that people want, even at lower volumes. And if they’re lucky and they get a hit product, sure, sell as many as you can. But their goal should not be volume. It should not be just scale for scale’s sake.

Q. There is a lot of talk that if the government is going to prop up the Detroit Three, the government should also push hard for those companies to create more energy-efficient cars. But right now, shouldn’t the companies just focus on making cars that sell?.
A. That’s a tough one. There’s legitimacy to the idea that we should be thinking about public policy objectives if we’re providing public money. In a no-government aid world, maybe a company would rightly say, ‘We make what consumers buy.’ ... But if you go to Europe, you go to Asia, there’s almost a floor under gas prices. They’re never going to drop under a certain level. Everyone adjusts their driving, the way they think about buying products, and the way they design products based on that. So maybe it’s a time here when, from an energy standpoint, something is going to happen. Maybe government energy policy is going to nudge consumer behavior. Maybe government aid to the car companies is going to nudge the product portfolio. And maybe people’s attitudes toward climate change will start to shift, too. Maybe that’s where the whole system gets aligned in a better way.

Originally published Dec. 4, 2008