The BMW "Ponzi" scheme, revisited
I’ve been savaged by BMW fans for comparing the company to a Ponzi scheme. There are those who read my recent post as contending the company was defrauding its customers, or at least its investors. (Yes, I actually do read comments.)
But, those readers have missed the point, and it’s one they should get because the future of their cherished marquee depends on it.
And, no, it’s really not my original thought. The idea was first set forth in an economics journal by one Helmut Becker. He used to be the chief economist for BMW, and he wrote a paper predicting future difficulties for the German economy precisely because BMW and other German manufacturers were persisting in a product plan that emphasized increasingly high priced cars.
The comparison to a Ponzi scheme was not in the fraud. It was in the collapse of the scheme when the point arrives that more and more money no longer comes in.
Look at it this way: in 1956, the average Cadillac sold for about $5,000. By 1966, it was about $6,000. In those days, Cadillac was the largest in the luxury car field, the German brands were not even ripples in the American market. Today, however, a BMW 535i stickers, without options, at over $50,000. The 750i, with no options, is over $76,500.
But the inflation rate since 1966 has been about 535%. That means that the $6,000 car of 1966 would cost less than $40,000 today, actually a bit over $38,000. But that kind of money today will get you a 3 Series, or a C Class, which in today’s market is a smaller, mid-priced car.
The reason every economist has been so worried about the subprime mortgage market is that the inflation in home values at a rate much higher than overall inflation has, in effect, created money for many Americans. That has enabled them to spend more money, more than they earned, and has fueled a demand for luxury goods, including high-priced cars. But that money can only be spent once, unless housing prices keep rising so rapidly that the well is renewed. The sluggish markets in California and Florida, which were the hottest housing markets at one time, suggest that the well isn’t an aquifer. It won’t refill itself.
The German manufacturers, which have extravagantly large labor costs, have sustained their profits by raising the price. They simply built more and more expensive cars, which gave them bigger profit margins per unit. They also got lucky because leasing became commonplace and their higher prestige offered higher resale values, which made leasing cheap in comparison to actually buying the car. In this respect, they traded sales for finance, and profited.
But there comes a point at which they can’t keep raising the price of the car.
Sure, there’s a lot more equipment on the current luxury BMW than there was on the 1966 Cadillac. But that’s true of the market in general and has been for decades: considering engineering improvements and equipment enhancements, the price of a typical Ford didn’t rise at all during the sixties. The BMW holds the same relative position in the market today as did the Cadillac in 1966. But, in constant dollar terms, the sticker price is much more.
And the trend keeps going up.
Which is the problem for BMW and other German manufacturers. They have not achieved control of their labor costs, though that is partly a fault of their government and the system that gives labor representatives much more influence in the operation of the company than have unions in the United States. They have paid for those ever-rising costs of production by adding higher profit margin features to their cars and increasing the prices of those cars.
The GM story says that this can’t keep happening forever.
It’s easy to dismiss GM as having bunglers for managers. But, that’s not a way to distinguish the German auto companies. Was it not the brilliant Mr. Piech who bought Rolls-Royce, outbidding BMW, only to find out that he hadn’t bought the rights to the name? And, wasn’t it BMW who bought Land Rover? Daimler-Benz that bought Chrysler? Volkswagen that has done so well that it is now controlled by Porsche?
It should have been perceived as a symptom when auto companies were spending disproportionate amounts of money on ultra-expensive cars appealing to only, at best, a few thousand buyers. Volkswagen recreating Bugatti, Mercedes finding its heritage in Maybach, BMW landing Rolls-Royce. These are cars that cost real money, but they cannot make real money. The automobile business is, by definition, one in which the profit comes from the volume. If it costs $5 billion to engineer and build a new model, it costs that same $5 billion whether you build one of them, ten of them or ten thousand of them. After you build the first one, the second one only costs labor and materials. The key is to sell enough of them to pay off that $5 billion, with some room to spare – called a profit.
At some point, the spiral has to end, of its own weight. At some point, the brand becomes too expensive.
When that happens, the red ink is a gusher. Auto manufacturers have very high fixed costs. Once they’ve spent the $5 billion, they’re better off to sell that next car for about what it costs to build it than they are to lose the sale. That means the company cannot make the $5 billion back, so it hasn’t the money to invest in new product, and it saves by keeping the old cars on the market. As GM has proved, that’s a losing strategy in the long run. But long-term planning is seldom an issue when short-term survival is at stake.
As always, time will tell.