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Indiana University

Obama's Auto Pitfalls

August 28, 2009

Media fascination with the government's new "cash for clunkers" program is diverting public attention from President Obama's extraordinary long-term intervention into the automotive sector of the U.S. economy. Since the impact of "cash for clunkers" will be modest and temporary, the more consequential reforms are the massive subsidies to a limited number of vehicle manufacturers and suppliers organized by the United Auto Workers; the new subsidy programs that favor electric cars and plug-in hybrids over ordinary hybrids, clean diesel technology, and other fuel-saving innovations; and the revamped federal mileage standards that supersede-or at least delay-the practical impact of California's complex program to reduce greenhouse gas emissions from cars, a program that was replicated by legislatures in at least a dozen other states.

The U.S. "cash for clunkers" program offers a discount of $3,500 to $4,500 to a motorist who trades in an old, low-mileage vehicle for a new vehicle that achieves significantly better fuel economy (e.g., four to ten extra miles per gallon for a car, two to five miles per gallon for a new small truck, and one to two miles per gallon for a new large truck). At a cost of $3 billion, the program will facilitate about 750,000 trade-ins by the end of the current model year. Dealers and auto makers have found that the program stimulates showroom traffic even among owners who are not sure whether their vehicle qualifies them for a discount. Unfortunately, the stimulus impact will be less than the 40 percent surge in car sales experienced in Germany's discount program because U.S. policy makers, with laudable green motivations, restricted eligibility to old cars and trucks that achieve less than 18 miles per gallon.  

In reality, the U.S. program does little to improve environmental quality. Old vehicles are driven relatively few miles compared to the aggressive use that American consumers make of new cars and trucks. More importantly, the discounts do not cause manufacturers to increase the average mileage of their new vehicles. Under federal mileage standards, which constrain-or will soon constrain-the average fuel economy at each manufacturer, more near-term sales of the Toyota Prius and Ford Focus will permit Toyota and Ford to sell more low-mileage performance cars in future model years (because compliance credits earned in one year can be used to compensate for compliance deficits in future years).

Some economists question whether the discounts have any stimulus impact. They argue that the discounts affect only the timing of vehicle sales, not the actual number of vehicles sold. And taxpayers who foot the bill for the discounts can be expected to lower their spending in the economy, which is the opposite of a stimulus. But there is no doubt that more vehicle sales stimulate production and employment throughout the entire auto supply chain, from parts and tires to final vehicle assembly. (Fears that the discounts will cripple sales of used cars have not materialized.) Financing the discounts with deficit spending will eventually lead to higher taxes or higher interest rates and inflation, but these anti-stimulus effects will occur years in the future and will not eliminate the immediate stimulus effects of the discounts.

A good case can be made that Obama should have chosen a broader stimulus measure (e.g., income tax cuts rather than discounts on car purchases), but it is an exaggeration to say that the "cash for clunkers" program will exert no near-term stimulus on the U.S. economy. If Obama and Congress had simply followed the lead of Germany by enacting an unconstrained incentive to trade in old vehicles for new ones, the near-term stimulus effects would have been even more pronounced than those that are now occurring.

The key long-term issues relate to whether Obama's extraordinary interventions into the U.S. automotive sector will help consumers, industry, and environmental quality in the long run. If an auto manufacturer is to survive and prosper from 2010 to 2020, it must do three things well: offer vehicles that consumers want to buy, produce those vehicles at a lower cost than in the past, and make them "greener" than they have ever been before. Even with hard work and creativity, there are no guarantees. A company's fate may be determined by the uncertain future of world oil prices or the future decisions of politicians. And responding to the president's auto policies will be no easy task.

If these policies are to succeed, Obama and Congress must, sooner or later, resolve a key contradiction. It does not make sense for government to force automakers to build green vehicles unless government is willing to provide consumers an incentive to purchase them without favoring one fuel-saving technology over another.

With U.S. vehicle sales slumping from a peak of 17 million per year to fewer than 10 million per year, all of the automakers-including Toyota, Daimler, and Honda-are suffering. Rather than let market forces take their harsh toll, the Bush and Obama administrations chose to subsidize a future for a downsized GM and a Fiat-led Chrysler. The subsidies are massive: tens of billions of dollars have already been loaned, with no end in sight. Accompanying the huge subsidies and the complex schemes that enabled these firms to emerge from bankruptcy is a revamped federal regulatory scheme: the entire industry must boost the average mileage of new vehicles from 25 to 36 miles per gallon by 2016-the largest push for greener vehicles in America's history.

For GM, Chrysler, and Ford, the immediate challenge is to avoid complete liquidation. A downsized GM needs to focus on building pickup trucks, cross-over SUVs, and sedans-each at lower cost-while continuing to expand its growing Chinese partnerships in the thriving Asian car market. The Fiat-Chrysler challenge is more daunting. Fiat specializes in small cars but the U.S. market is already flooded with low-margin small cars from Toyota, Honda, Nissan, and Volkswagen. Chrysler has developed a niche in minivans and trucks, which Fiat would be wise to retain and nurture. Fiat, though facing its own debt problems, can help Chrysler develop greener engines while exploiting Chrysler's downsized dealer network. But Chrysler will need lots of luck to survive the next ten years. Ford is well positioned in the huge American market for pickup trucks and is carving out a new niche in fuel-efficient sedans. Even if the hoped-for economic recovery occurs, Ford is the only sure survivor among the old Big Three, though even Ford has won some federal financial support to help pay for the development of new green vehicles.  

Vehicles with better mileage ratings can certainly contribute to consumer welfare and environmental quality, although experts do not agree on the precise case for greener vehicles. Some see less oil consumption by vehicles as a strategy to depress world oil prices, enhance energy security, and slow the flow of funds to terrorist organizations and tyrannical regimes. Others see less fuel consumption as a way to slow the pace of global climate change. And some see more fuel-efficient vehicles as a plus for consumers who have a tendency to focus too much on the sticker price of a car and not enough on the operating expenses that accumulate over the life of the vehicle. Yet there are few experts who believe that none of these rationales for better mileage has any validity.   

Contrary to what politicians say, it will not be easy to make a profit offering green vehicles. While fuel prices at the pump have again risen to a summer-time peak, they are projected to decline in the fall and winter. In fact, the global economic recovery is unlikely to push U.S. fuel prices over $3 per gallon for a sustained period of time before 2015. With low fuel prices and politicians unwilling to raise federal and state fuel taxes, most consumers who enter showrooms will want to buy pickup trucks, cross-over or mid-sized SUVs, vans, and mid-sized or large sedans. The small-car market, while thriving in most of the world, will not boom in the United States. American families and businesses need larger vehicles, income growth will spur more demand for them, and our highways and fastest growing cities are designed to accommodate them.

Making large vehicles fuel-efficient is feasible but will also be costly: at least $1,000 to $3,000 for Ford's "EcoBoost" improvements to the gasoline engine, $1,000 to $6,000 for a clean diesel engine, and $2,500 to $7,500 for a hybrid engine. The added cost for plug-in hybrids and electric cars can easily exceed $10,000 to $30,000 per vehicle. If fuel prices stay below $3 per gallon, none of these innovations will find much enthusiasm in the U.S. marketplace.

Obama's mileage plan does contain some excellent features. Automakers may ignore California's complex regulatory requirements if they comply with the single national mileage program that Obama has established through 2016. If the national program had not been favored, automakers would have been forced to calculate compliance separately in each state that chose to enact the California standards. Since auto makers sell different mixes of vehicles in different states, the California approach would have been a paperwork nightmare without any significant environmental benefit. Obama also retained a key innovation in Bush's mileage plan: adjustments to each manufacturer's mileage target based on the size of that manufacturer's vehicle offerings. Size-adjusted mileage rules discourage the unsafe downsizing of vehicles and encourage the diffusion of fuel-saving innovations into all vehicle size classes. And Obama has set mileage targets far into the future, a practice that provides a measure of regulatory certainty for an industry that faces long lead-times in product development.

What is missing is an effective plan to persuade consumers to buy the greener vehicles that the industry will be compelled and subsidized to produce-beyond the expiration of "cash for clunkers" and during the make-or-break years for auto manufacturers. In the near term, Congress needs to renew the federal income tax credits for consumer purchases of clean diesel and hybrid engines that are now expiring. These are the credits that helped spur sales of the Toyota Prius, the Honda Civic Hybrid, and the Ford Escape SUV hybrid.

Over time, the government needs to replace these credits with a system of rebates for high-mileage vehicles and fees for low-mileage vehicles. A well-designed "feebate" system should favor greener vehicles in each size class, rather than simply subsidize the lightest-and least safe-cars. Accordingly, a Ford F-150 with an efficient diesel engine-an option that Ford recently delayed due to low fuel prices-should be favored over pickups that are available only with a thirsty gasoline engine. If "feebates" earn the confidence of industry, consumers, and environmentalists, the system could simply replace the cumbersome federal mileage regulations. To ensure that "feebates" do not turn into another national tax increase, the total amount of rebates should be set equal to the total amount of fees on vehicle purchasers.

Instead of taking these technology-neutral steps, Obama has encouraged Congress to veer off into a speculative adventure: vast subsidies and tax credits for plug-in hybrids and electric vehicles. Billions of dollars in guaranteed loans and subsidies have been invested in the hope that improved lithium ion batteries will make electric vehicles more affordable and cost effective than they are today. A $7,500 tax credit has also been authorized for purchasers of advanced battery-powered vehicles such as GM's highly touted Chevy Volt and Nissan's new electric car. In early August, the president and administration officials traveled the country to announce $2.4 billion in Recovery Act funding for 48 new advanced battery and electric drive projects.

Obama has publicly called for one million plug-in hybrids in the United States by 2015, but no similar goal or subsidies have been established for advanced diesel technology, ordinary hybrid engines, or turbochargers and other refinements to vehicles that save fuel. Even proponents of electric vehicles acknowledge that the Obama plan is overinvested in battery technology and underinvested in the infrastructure (e.g., recharging stations) that is necessary to support electrification of the vehicle fleet. While some federal research and development support of battery technology is defensible, even the most recent, improved lithium ion batteries are too expensive to compete with the modern diesel engine offered by Volkswagen and Daimler or the hybrid engines offered by Toyota, Ford, GM, and Honda. A $7,500 tax credit will not do much good if the vehicle costs more than $40,000 to produce, as GM and Obama's auto task force admit may be the case. Plug-in hybrids and electric cars should not be subsidized in the marketplace until developers-who now have access to plenty of federal research and development as well as venture capital-make a compelling case that battery technology is ready for prime time.

John D. Graham is dean of the Indiana University School of Public and Environmental Affairs. His areas of research include government reform, energy and the environment, and the future of the automobile in both developed and developing countries. From 2001 to 2006, he was administrator of the Office of Information and Regulatory Affairs at the White House Office of Management and Budget.


Reprint courtesy of The American, The Journal of the American Enterprise Institute

Image by Darren Wamboldt/Bergman Group.