Next Steps For Detroit - Fix, Close, Or Sell

The Innovator’s Dilemma strikes again, this time with the news that the city of Detroit has filed for bankruptcy protection.  As a business term, ConvergEx's Nick Colas reminds us that the “Dilemma” describes how successful companies fall from grace because they ignore new competition with disruptive technologies at the low end of their markets.  In a world that increasingly revolves around intellectual capital (a.k.a. people), government at all levels needs to think about how they do not fall prey to the same error.  As for Detroit, any lasting solution likely needs far more government intervention than is currently possible. And so to where Detroit goes from here, we’ll borrow from another business paradigm that parses all solutions to troubled operations into three buckets: "Fix, Close or Sell."


Via ConvergEx's Nick Colas,


In 1971 Sam Wagstaff, then the curator of the Detroit Institute of Arts, invited the artist Michael Heizer to create a piece for the museum’s collection.  Heizer’s didn’t only work on canvas or marble; he is primarily known as a landscape artist.  Think trenches in the ground or blocks of concrete placed in the earth.  Heizer decided on a bit of performance art – dragging a 24-ton block of cement with farm tractors across the green space in front of the DIA, with the idea of having the mass dig itself quickly into the ground.


The idea failed spectacularly.  All Heizer succeeded in doing was tearing up the museum’s immaculate lawn.  Wagstaff was dismissed shortly thereafter.  He returned to New York, his hometown, and took up collecting photography.  Here he met with substantially more success, eventually selling his collection to the Getty for a reported $5 million in the 1980s.


Comparisons to the recent news that Detroit has declared bankruptcy run in several directions.









To the positive, consider that the city was once very wealthy and even cutting-edge in its leadership – both artistic and industrial.  In the same year the trustees of the DIA had to replant their lawn, General Motors had a 50% market share of a still-growing domestic auto industry.  The city represented an employment mecca, where millions of workers enjoyed a solid middle class life along with the promise of a secure retirement.  Detroit had a population of over 1.7 million people in 1970, and with that a large tax base to support local services and government.


 


Now, the Detroit Institute of Art sits in the middle of a city where 36% of its population of 700,000 or so live below the poverty line.  The announcement that it will pursue protection under bankruptcy laws is hardly a surprise.  As an auto analyst through the 1990s I travelled to Detroit dozens of times, and even then the decline of the city was as obvious as it was sad.



There’s plenty of finger pointing going on related to the filing, aimed everywhere from a deeply corrupt local government to the power of municipal unions, but they are more symptom than illness; the real cause of Detroit’s failure is something called “The Innovator’s Dilemma”.  It is originally a business term, coined by Harvard professor Clayton Christensen, so we’ll explain it first in along those lines:









Great firms fail because they do the right things, at least to the letter of received business wisdom.


 


New competition, with what Christensen dubs a “Disruptive technology” enters a market, generally at the low end of the product offering.  The classic example is steel.  In the 1970s minimills, which recycle old metal rather than make it new from iron ore, entered the market for the steel bars that reinforce concrete to make buildings.  At first,  “Big Steel”, which operated fully integrated and costly mills to make the stuff from raw iron, barely noticed the new entrant.  “Re-bar” was a low margin product and they were happy to cede this market to the upstarts.


 


Over time, the new entrant learns how to improve their products and compete in more product lines.  The established competitors then give up on those markets, since they are still making plenty of money at the high end of the product spectrum.  Think of how the Japanese car companies entered the U.S. market with small cars, only to work their way to larger cars, minivans, and even pickup trucks and luxury sedans.


 


Eventually, the upstart is able to compete across the entire product line for their industry.  The disruptive technology which gave them their original toe hold becomes their competitive advantage throughout the business.



This was groundbreaking stuff when Christensen first proposed it in 1997; it is now essentially the law of the land.  The entire world of technology-based venture capital is based on finding “Disruptive technologies”, hoping to walk the footsteps of Amazon or Google or anything Elon Musk doodles on a cocktail napkin.  Kodak died because of cell phone cameras.  The domestic auto industry succumbed to first Japanese and then Korean competition.  Tablet computers are challenging the historic dominance of companies such as Microsoft.  The list goes on and on…


Open the philosophical umbrella of “The Innovator’s Dilemma” just a little wider, however, and you can comfortably cover much of what went wrong in Detroit over the last fifty years or so.  A few points here:









While Detroit may be “Motor City”, the growing popularity of the automobile after World War II hurt cities across America from the 1950s to the 1990s.  Greater societal mobility meant suburban living and commuting to a city for work was both feasible and financially attractive.  Taxes tended to be lower outside metro areas, and demographic shifts in urban areas spurred many middle class families to leave cities in the 1960s and 1970s.


 


In short, the automobile was a “Disruptive technology” in its own right.


 


Making cars and trucks – and the myriad of parts that go in them - provides an excellent wage to the people that do this work.  This fact is not lost on local governments around the country, whether they be in urban, suburban or rural areas.  When Honda, the first Japanese company to open an assembly plant in the U.S., went looking for a location to build cars in the early 1980s, it chose Marysville Ohio.  Not Detroit.  The success of that plant – it has expanded numerous times since it was built – encouraged municipalities across the country to compete for new automotive plants.  The bottom line is that BMW, Mercedes-Benz, Toyota, Honda, Nissan, and Hyundai have all opened plants in the U.S., and none of them are in Detroit. The same holds true for most of the “Technology centers” these companies operate for R&D and design, many of which tend to be (surprise, surprise) in California.


 


In the 1970s, it would have been difficult to imagine that the southern U.S, where all these non-U.S. companies actually have opened assembly facilities, would be a source of “Disruptive technology”.  And yes, it would have been difficult for Detroit to garner much interest from foreign automakers that wanted non-union workforces.  Not to mention the awkwardness of inviting new competitors into the neighborhood.  But if you are going to be “Motor City” you may not have the luxury of playing favorites.


 


Cities and businesses share the same “Innovator’s Dilemma” when it comes to competing for intellectual capital.  If you were tops in your class at MIT, or Cal Tech, or Harvard, where would you rather work: Detroit, New York City or San Francisco?  Unless you happen to hail from the Detroit area, it’s hard to imagine passing on NYC or the west coast.  Employers know that, and choose their home bases accordingly.


 


In a world where a handful of bedraggled but genius programmers and their VC funding sources can upturn an industry in a few years, cities need to offer that group of people an attractive lifestyle.  That means essentially creating a critical mass of other bedraggled geniuses, since what this group values more than anything is the “Network effect” of associating with like-minded individuals.  Yes, most will fail at their dream of changing the world.  But the few that make it have a lot of money to spend. And pay in taxes.



As for where Detroit goes from here, we’ll borrow from another business paradigm that parses all solutions to troubled operations into three buckets: “Fix, Close or Sell.”    We’ll take them in turn:









Fix.  In private enterprise, bankruptcy can often be a useful operational reset.  Good businesses can take on too much debt at the wrong point of a business cycle and end up filing Chapter 11 when the economy turns south.  Bankruptcy there is an indictment of the balance sheet, not the business.  Clean up the debt, reallocate the ownership, streamline the operation, and off you go as a new going concern.


 


This is the path Detroit will likely travel in the coming years, but it is hard to be optimistic about the future of the city.  Bondholders and pensioners will squabble over who gets what, of course.  Bankruptcy lawyers and valuation consultants will make a mint; this is, after all, the largest municipal default in U.S. history.  But what will be the strategy to repair the city’s shattered infrastructure and provide basic security for its citizens?  There isn’t one.  And I don’t expect we’ll hear one any time soon.  For the city whose nickname in World War II was “The Arsenal of Democracy”, that is a societal betrayal of the first order.


 


Close.  No, you cannot close a city, but you can downsize it to match the tax base.  Detroit used to have 2 million people a few decades ago.  Now it has about 700,000.  Visit an enclave like Highland Park, which used to house Chrysler’s world headquarters, and you see the effect of that diaspora.  Only about 10,000 people live there now, most of the street lights do not work, and it is better known as one of the most dangerous areas in Detroit.


 


Any reasonable person with limited financial means would take a modest financial payment and an affordable place to relocate in return for leaving an area like Highland Park.  Chrysler itself moved out years ago, relocating to the suburb of Auburn Hills.  Such a program would have to be closely monitored by professionals from outside Detroit – local government seems too compromised to leave it in their hands.  But until such a plan comes to fruition, Detroit will continue with too few people spread out over too much space to provide basic security and essential services.  It’s pretty much as simple as that.


 


Sell.  The world of technology likes to boast about how it changes the world. If you are a young urban college-educated professional, this is true. You can hail a cab from your smartphone, or order dinner.  Your resume is online, and you keep up with your friends as they take vacations and go out on the town.


 


Compare tech heavyweights like Google or Amazon or Apple, however, with the companies that gave Detroit its original luster and the newer industry’s contributions to society fall very far short indeed.  Ford, GM, Chrysler and their suppliers lifted millions of people out of poverty and into the middle class for the better part of a century.  Their products encouraged the construction of the interstate highway system, bringing tourism and commerce to poorer states. 


 


If the tech industry were serious about its role as a positive force in American society, Detroit would be a great place to put that stake in the ground.  Amazon – how about a distribution center smack in the middle of Highland Park?  Google – maybe wire the whole city with world class Wi-fi?  Apple – iPads made in Detroit?  The tech industry can’t “Buy” Detroit, but they certainly have the cash and know-how to help it turn the corner.  The hipsters in San Francisco have enough of their focus.  How about “Paying it forward” for a change?



In summary, Detroit’s failures are certainly of its own making.  The city, and the industry which dominates it, ignored the lessons of “The Innovator’s Dilemma” for decades.  The way forward will need leadership that is unavailable locally.  It will have to come from private industry and government if the city is to have any chance for recovery.  Detroit’s motto, which dates back to 1804, translates from the Latin as this: “We hope for better things; it will arise from the ashes.”  A Catholic priest originally penned it after the school he founded in Detroit was burned to the ground.  Hopefully the phoenix will rise again. 

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