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Pop! Goes the Auto Bubble

By Michael Mandel Last August, I wrote a column about the dangers of a looming "auto bubble" (see BW Online, 8/23/04, "What's Driving the Auto Boom?"). At the time, I pointed out that Americans had been buying more and bigger vehicles at a truly astonishing rate that was unsustainable over the long run. Moreover, I also noted that the popping of the auto bubble could have harsher economic consequences than the end of the widely discussed housing bubble.

I admit, my warnings looked premature for the rest of 2004, as vehicles continued to roll out of the showrooms at roughly the same rate as earlier in the year. Indeed, sales hit an annual rate of 18.3 million in December, the highest level since the pre-bust months of early 2000 (leaving aside October, 2001, the bounce-back month after the terrorist attacks).

DEALS AND MORE DEALS. But that hissing you now hear marks the first sound of the auto bubble losing air. On Mar. 16, General Motors (GM) announced a big loss for the first quarter of 2005, the result of an unanticipated plunge in sales. Beset by high health-care costs, weak car models, too many divisions, and excess capacity, the giant auto maker has plunged into serious trouble (see BW Online, 03/28/05, "Running Out of Gas at GM").

The problems in the auto industry, though, go far beyond GM. In fact, the entire sector has outrun itself, cutting prices and offering big rebates and great financing deals in an effort to keep consumers buying cars and the factories running. But with interest rates rising and the price of oil sky-high, Americans may be nearing satiation, with much less incentive to buy new cars for now. The sales slowdown may result in a stunningly nasty crash.

Let's look at the facts. The real value of motor vehicles owned by American households has risen by more than 50% since 1997, one of the sharpest rises on record. Why did this happen? Not because of the fundamentals of population and income. Over the same stretch, the number of households rose by only 12% or so, and median household income, adjusted for inflation, went up by only 3% or so.

OVER A BARREL. Instead, the car-buying spree was driven by a combination of temporary factors. In particular, low interest rates enabled auto makers to offer very attractive terms on loans and leases, while low gas prices made fuel-guzzling sport-utility vehicles more appealing.

The combination helped make the automotive industry one of the few bright spots in manufacturing. Today it contributes a bigger share of manufacturing employment than it did in the 1990s. Motor vehicles and parts production has risen 33% since 1997, while output in the rest of manufacturing, outside of high-tech, has increased only 3%.

Well, the good times may end soon. On Mar. 16, the same day as GM's announcement, the price of crude oil went past $56 a barrel, a record level that will soon translate into higher gasoline prices. New-car loans at auto-finance companies now carry an average interest rate of 5.6%, vs. 3.2% at the beginning of 2004. A pretty pricey time to be buying an SUV, it seems.

HOMEGROWN "IMPORTS." And did the auto industry get ready for this downdraft by tightening its belt and cutting capacity? Hardly. Since the peak of the last economic boom in early 2000, production capacity of the U.S. motor vehicle industry has actually risen by 20%, according to figures from the Federal Reserve. More capacity and weakening demand make precisely the right conditions for the deflating, or even the popping, of the auto bubble.

Moreover, the domestic auto industry may face an even bigger danger. The overcapacity is global, which is only increasing as countries such as China get into the car-building game in a big way.

So far, auto imports into the U.S. have stayed relatively restrained -- rising by only 19% in real terms over the past three years, vs. a 40% increase for consumer goods and a 38% increase in capital goods. Production in the U.S. has stayed high, as American carmakers have offered good deals to keep their factories running and foreign carmakers have found it worth their while to assemble vehicles in the U.S.

UPHILL SLOG. This ability to maintain a domestic production base makes the auto industry a real anomaly. Recent history has shown that with most manufactured products, once imports get more than a toehold, they end up taking most of the market, leaving American manufacturers to compete by innovating or offering higher-quality products. The U.S. has few market segments in which imports and domestic production compete on equal terms -- and motor vehicles are one of those few exceptions.

But this precarious balance is unlikely to persist. The end of the auto bubble may create the conditions for a new wave of inexpensive imports as domestic manufacturers weaken and consumers get even more price-conscious. GM's bad first quarter may signal a very rocky road ahead. Mandel is BusinessWeek's New York-based chief economist

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