Washington’s Turnaround Artists

Think government can’t fix the auto industry? Then how did it manage to fix the railroad industry—twice?

By Phillip Longman

Bookmark and Share
 
Time & Life Pictures/Getty Images

The massive corporate bailouts that Washington is undertaking as a result of the economic crisis have left most of us feeling deeply nervous. It’s not just the price tag, measured in incomprehensible trillions. It’s also the fear that the problems of the financial and auto industries may be so deep and so tangled that no one can fix them—and certainly not a bunch of politicians and bureaucrats in Washington.

But here’s the funny thing: any honest reading of history suggests that the federal government has quite an impressive record of rescuing institutions considered too big to fail. In addition to almost routine workouts of failed banks conducted in good and bad times by the Federal Deposit Insurance Corporation and other regulators, the list includes many large industrial companies as well. In 1971, for example, Congress extended emergency loans to failing aircraft builder Lockheed and wound up not only saving a company vital to America’s national defense and export manufacturing base, but earning a net income for the Treasury of $5.4 million in loan fees.

In 1980 it did the same for Chrysler, this time extending loan guarantees in exchange for stock warrants that, after the company returned to health and paid back its loans, yielded the government a cool $311 million in capital gains. More recently, in the aftermath of 9/11, Congress granted airlines $5 billion in direct compensation for lost business and up to $10 billion in loan guarantees, again in exchange for stock warrants. That wasn’t enough to save many individual airlines from having to undergo restructuring plans imposed by bankruptcy judges, but when Americans took to the air again they found the industry intact and offering plenty of flights. Moreover, by February 2007, airline stocks had recovered enough that the Treasury was able to sell its warrants for a net profit of $119 million, with no loans left outstanding.

Now, however, comes the prospect of something much larger. Government has already thrown billions at the gigantic mess that is the American auto industry. With Detroit continuing to hemorrhage jobs and cash in a deeply troubled economy, it looks as if government will have to take a much more hands-on approach to reengineering the industry, if not through the bankruptcy courts then through direct executive supervision. Should we be worried that government will make a hash of it? Of course. But there is a bright shining example from not so long ago of government bureaucrats engineering the revival of an industry easily as troubled as today’s automakers and, if anything, more central to the economy. And it all turned out better than anyone dared hope, with a dazzling return to profitability. It is the story of the railroad industry, and while the parallels with today’s auto industry are not exact, they are close enough to provide many useful lessons. Its example suggests that, as the automakers return to Washington for a second round of assistance, the greatest danger may well be not that government will intervene too much, but that it won’t intervene enough.

The Wreck of Penn Central

If you think General Motors has a big problem with ineffective management, truculent unions, and declining market share, consider the Penn Central Company of the late 1960s. Formed by the merger of three ailing railroads in 1968, Penn Central was a colossus, controlling most of the rail network throughout what was becoming America’s Rust Bowl, from Boston and New York to Chicago and St. Louis. It was also a colossal mess from day one. Though the merger had been planned for years, for example, the computer systems of the combined companies couldn’t talk to one another, so Penn Central started life by losing track of thousands of freight cars with no idea where they were supposed to go or how to find out.

Penn Central’s feuding top managers disagreed on just about everything except one point: they wanted in the worst way to get out of the railroad business. So they neglected maintenance of track and equipment, cooked the company’s books, and used what capital they could raise trying to become a modish, 1970s-style conglomerate. Just as General Motors once tried to branch into aerospace, Penn Central bought Executive Jet Aviation. It also diversified into theme parks, pipelines, real estate, and what we would today call a hedge fund, through which Penn Central executives engineered lucrative stock deals for themselves. According to a congressional investigation, Penn Central’s top executives also spent plenty of company dough securing the companionship of comely young women. Congressman Wright Patman fumed that this was "one of the most sordid pictures of the American business Community that has ever been revealed in official documents." Among the names named was a buxom model named Linda Vaughn, who was well known in auto-racing circles for riding around the racetrack clinging to a giant gearshift replica before the starting flag.

But mismanagement at the top was hardly the only cause of the company’s problems. Beset by mounting competition from trucks, Penn Central was prevented by federal regulation from raising rates high enough to cover costs. Government mandates also forced it to run money-losing passenger trains for the public’s convenience. In addition, the company was stymied by politically entrenched unions that extracted two days’ pay for half a day’s work.

It all came crashing down in May 1970. Because of Penn Central’s creative bookkeeping, few on Wall Street saw it coming. The exposure to the company’s revolving loans was so great that it required a dramatic intervention by the Federal Reserve to prevent a meltdown of Wall Street’s commercial paper market. President Richard Nixon, after refusing to take a call from his panicked transportation secretary, allowed the company to go into bankruptcy. Eventually, however, he determined that it was too big to fail; hundreds of thousands of jobs, as well as key industries like steel and auto manufacturing, were at stake. And so Penn Central received bundles of emergency loans.

But as with today’s loans to General Motors and Chrysler, more money didn’t fix the problems. Instead, new ones developed. Unions went on strike. A key bridge over the Hudson River caught fire, cutting off much of New England from rail service. The company was so disorganized that a connecting short-line railroad stole and relettered 352 of its boxcars and Penn Central didn’t notice. Due to its dilapidated infrastructure, Penn Central suffered an average of twenty derailments a day, and on many lines trains were forced to crawl along at just a few miles per hour. Then Hurricane Agnes deluged the Northeast, wiping out bridges and washing out track. Between natural disasters, mismanagement, and a tanking economy, five other railroads in the region also fell into bankruptcy. On June 29, 1972, Penn Central’s trustees threw up their hands and called for liquidation.

This, however, could not be allowed to happen. Because railroads operate as a network, scrapping the Penn Central would have threatened the viability of the nation’s entire rail system. And while railroads had begun to lose their luster, they were still carrying more tonnage than ever before in their history, making their survival essential to the country’s manufacturing base, including truck and automakers. In the bowels of a U.S. Department of Transportation facility at Buzzard Point in southeast Washington, D.C., a handful of bureaucrats had been trying to figure a way out of this bind for years. Edward Jordan, Jim McClellan, Jim Hagen, Gerald Davies, and others had pored over railroad maps and financial statements in search of a plan for restructuring Penn Central and other failed railroads. It was a thankless task. No private railroad was interested in buying more than a few pieces of Penn Central and the other failed roads. Members of Congress opposed any curtailments of service in their districts, but railed against any additional use of public money to cover the cost. Somehow, the bureaucrats would have to figure out not only how to make the weed-choked rail infrastructure of America’s Rust Bowl work again, but also how to convince Congress and the White House that they could earn a profit doing it.

Under other circumstances, the plan they eventually brought to fruition in 1976 might never have seen the light of day. But this was a hard time for America, and the nation’s political leadership was variously distracted and desperate. The twin hangovers from Vietnam and Watergate throbbed, the energy crisis worsened, and inflation mounted. Don McLean’s number one hit, "American Pie," caught the mood of the moment with its lyric "Father, Son, and Holy Ghost / They caught the last train for the coast." With bad news on the doorstep day after day, a vote to have government seize moribund railroads would barely make the papers. By contrast, as super-lobbyist Charlie Walker, then employed by alarmed shippers, explained in an early-morning call to a young Dick Cheney, then President Gerald Ford’s chief of staff, it sure would be sad if all the trains in the Northeast stopped just before the upcoming New Hampshire primary. And thus was set in motion the creation of a new government entity called the Consolidated Rail Corporation, or Conrail for short.

Born on April Fools’ Day

Conrail started operation on April 1, 1976, and at the outset it looked as if it were all going to end very badly. During its first few years of existence, Conrail blew through $7 billion in direct federal spending while piling up losses as high as $1 million a day. Meanwhile, Penn Central and its large institutional investors deployed a swarm of well-connected lawyers and lobbyists to make the best of the buyout, and wound up getting the government to pay them handsomely for taking the money-losing railroad off their hands.

So far, market conservatives and pessimists generally seemed to have their worldview confirmed. Yet within a few short years, the bureaucrats running Conrail evolved into a lean, mean management team that later became the subject of case studies on corporate turnarounds. Edward Jordan, formerly a top bureaucrat at the federally chartered, nonprofit U.S. Railway Association, who had helped craft the plan for Conrail, became its first CEO. He cracked down on suppliers selling faulty equipment, rebuilt half the railroad’s engines and 21,000 freight cars, and refurbished 14,000 miles of track. He also streamlined and reengineered the railroad’s management and marketing efforts, renegotiated its labor contracts, and, most importantly, went to work on politicians who continued to insist that railroads operate money-losing branch lines and passenger trains. In a statement that was shocking in the political atmosphere of the time, Jordan declared, "It is not the responsibility of a railroad to operate social services at a loss."

And with all this public money at stake, politicians started listening hard to what Conrail and other railways were saying about the public policies that were driving their industry toward ruin. This is a key to understanding why the Conrail bailout worked so well. Politicians could grandstand all they wanted about call girls, secret Swiss bank accounts, lost boxcars, and other legacies of Penn Central’s management, but now they had ownership of the problem and had to concentrate on the ways in which public policy had contributed to it. The most dramatic policy change came with the enactment of the Staggers Act, signed into law by President Jimmy Carter in 1980, which, for the first time in nearly a century, allowed railroads to set their own rates according to market conditions—a prohibition that had been hobbling their ability to compete with trucks and barges. In short order, this and other reforms created a policy environment in which both Conrail and the rail industry generally would begin a dramatic comeback after decades of decline and near demise by the end of the 1970s. Indeed, Conrail became so profitable that by the mid-1980s the political process had to contend with another vexing, if happier question: What to do with this coveted public asset?

Ronald Reagan, who had famously said, "Government is not the solution to our problems, government is the problem," naturally wanted to privatize it—never mind that in this case government had provided the solution, and had made a tidy profit doing it. A donnybrook ensued, with the once-failed, now-lucrative railroad as the prize. Transportation Secretary Elizabeth Dole, under intense lobbying pressure, eventually decided that a private railroad, Norfolk Southern, should get the nod. With the help of her husband, then Senator Bob Dole, she got the deal through the Senate. But Conrail’s government managers, seeking to avoid a hostile takeover by Norfolk Southern, teamed up with Wall Street investment firm Morgan Stanley, which was looking to make huge fees on a public offering. Together, they won the support of the all-powerful Democratic Energy and Commerce Committee chairman, Congressman John Dingell, who nixed the deal in the House. Morgan Stanley wound up taking Conrail public in 1987 in what at the time was the largest initial public offering in Wall Street history: $1.65 billion. The Treasury used the money to help defray the deficits the Reagan administration had incurred.

Ten years later, Conrail had gained so much more value that two other railroads put out $115 a share to carve the company up in one of the largest and nastiest takeover fights of the 1990s. To be sure, the route to high profitability for Conrail, particularly after it became a private company, involved abandoning hundreds of branch lines and several strategic mainlines. With the loss of rail service, many regions suffered economic decline and/or had to make much greater use of trucks, which are far less energy efficient and create far more pollution while also contributing mightily to highway congestion, accidents, and disrepair. Many of the routes Conrail abandoned would be highly valuable today; they will be missed even more in the future as the volume of freight traffic grows. So the story of Conrail is not an unblemished one. But this shouldn’t diminish its moral: government, it turns out, can run a railroad.

Progressive Era Redux

Lest you think this story is anomalous or unprecedented, consider this: during World War I, President Woodrow Wilson nationalized the country’s entire rail system, with results that were similarly stunning. Coming into the teens, railroads were in financial and physical shambles—deeply in debt, forced by ruinous competition to give big, under-the-table rebates to large shippers like Standard Oil, threatened by militant labor unions and antitrust legislation, and shackled by a regulatory regime that, under the Interstate Commerce Commission, overwhelmingly favored shippers with low rates. As preparations for war drove up the volume of rail traffic, the nation’s entire rail system at one point became so congested that it simply seized, leaving 180,000 loaded freight cars unable to move.

Wilson faced a simple choice: fix the railroads or lose the war. This was the climax of the Progressive era, and Wilson knew just what to do. Converting many experienced rail managers into modestly paid government bureaucrats, he set them to work in his newly formed U.S. Railroad Administration. After dividing the nation’s rail network into seven regions, they quickly fixed its many choke points and other sources of inefficiency. The USRA designed and commissioned the construction of 2,000 steam locomotives, in six standard sizes with interchangeable parts, which vastly cut repair costs. USRA bureaucrats also added 100,000 new standardized freight cars to the nation’s fleet, placed embargoes on shippers who ordered more cars than they could use, and sped up and rationalized the logistics of train movements in a way that previously competing private railroads could not do.

With no apparent sense of irony, the USRA also reversed many of the government regulations that had contributed to the industry’s failure, by raising shipping rates 25 percent and allowing for more pooling of resources. After reverting to private ownership at the war’s end, railroads generally thrived until the Great Depression, in no small measure because of all the public investment put into them during the war. So it might be said that during a brief period of wartime socialism, the U.S. government bailed out a central industry that had been undone by a combination of capitalist incompetence and inept government regulation—which should give ideologues of all stripes something to think about.

Auto Applications

What do Conrail’s and Woodrow Wilson’s forays into socialism tell us? For one, they contradict the doctrinaire idea that government will always and everywhere mess up if it gets hands-on control of a private industry—even if in both instances other government policies largely contributed to the crisis that government control ultimately solved. The dramatic improvements to rail technology and logistics achieved by the USRA during the Great War also belie the notion that market forces alone will always be a sufficient spur to innovation and maximum efficiency. When government takes responsibility for an ailing industry, it also gets a combination of a hands-on learning experience and a strong incentive to do the job right: with public money at stake in the industry’s success, politicians pay more attention to the ways in which their own past decisions are making its problems worse.

These are vitally important truths to keep in mind as Washington considers how best to help an ailing Detroit avoid catastrophe. The auto industry’s problems, like the railroads’, are not solely the fault of arrogant, out-of-touch executives flying to and from begging sessions on Capitol Hill in private jets; government policies have shaped the environment in which automakers must produce and sell vehicles, often for the worse. Antiquated state laws forbid Detroit from streamlining its distribution networks by closing unneeded dealerships—a hindrance that advantages foreign automakers, who entered the U.S. market later and accordingly built fewer dealerships. Similarly, foreign car companies have an edge in producing smaller, more fuel-efficient cars because they have eager domestic markets for such vehicles thanks to government policies in those countries that keep the price of gasoline high. In America, by contrast, decades of cheap-oil policies out of Washington—many wrangled at the behest of the auto industry—brought it short-term profits from gas-guzzling SUVs, but long-term ruin.

Simply throwing vast sums of money at Detroit, then, is unlikely to save the American auto industry, no matter how many strings are attached to that money. Better for the federal government to take direct, if temporary, control of U.S. automakers, as it did with the railroads. Only at that point will Washington have both the leverage to force needed management reforms as well as the incentive to change its own policies—increasing gas taxes, preempting state dealership laws, and easing Detroit’s high health care costs by, among other things, passing universal health care.

As with Conrail, however, care would have to be taken not to surrender too many public goods to the altar of profitability. It would be wonderful if the government could one day sell its shares in General Motors at the same high price Conrail eventually fetched—but not if the profits came by turning GM into a monopoly or by making Americans still more dependent on cars. When it comes to rescuing deeply troubled industrial companies that the country cannot afford to do without, Conrail’s successful managers have left us with a good checklist to follow: leave your ideology at the door, pay more attention to the engineers and managers on the ground than to the financiers in the corner offices, and remember that social returns, not profits, are the ultimate measure of success.
Bookmark and Share
   

Subscribe & Save! Gift Subscriptions Make a Tax Exempt Donation

- - Advertisers - -


Liberal Blog Advertising Network

buy from Amazon and
support the Monthly

   

Phillip Longman is a senior fellow at the New America Foundation and the author, with Ray Boshara, of the forthcoming book The Next Progressive Era.  
 
Washington Monthly subscribe | donate | mission statement | masthead | contact us | send letters to the editor

This site and all contents within are Copyright © 1969-2011 Washington Monthly
Editorial offices: 1200 18th Street NW, Suite 330, Washington, DC 20036