Our Curious CAFE Culture

Tuesday, July 12, 2011

This column is coming to Defining Ideas from the Regina Palace, located in Stresa, Italy, a small town outside Milan, on Lake Maggiore. The ride from Milan to Stresa has its fair share of wonderful lake views, a topic which few people would care to hear me opine. But inside the Volkswagen of our Italian hostess, which took us on that stunning ride, was a small gas gizmo. To my surprise, that small-freestanding device relates to the policy error du jour of the Obama administration—its proposed stiffening of the long standing CAFE, or corporate average fuel economy, regulations.

Illustration by Barbara Kelley

The gizmo, I am told, was a direct and widespread private response to the high price of gasoline in the European Union, brought on by a combination of scarcity and high taxation. Essentially, that device contains an opening that is smaller than the ordinary nozzle that goes into the standard gas tank. It is inserted into the gas tank where it then hooks up with a natural gas container that is now built into more and more European cars. In the hinterlands, natural gas is a bestseller because it is about one-third of the cost of gasoline. But in the city, where its flammability is judged to create too large a risk, natural gas is not sold, so people have to shell out significant Euros, roughly eight dollars per gallon, to fill the tank. The moral of the story is that private firms and drivers find ways to reduce gasoline consumption as the price of the commodity moves upward.

The use of this fancy little device in Italy parallels the rise of hybrid cars in America. Hybrid cars can shift back and forth from gasoline to electricity as circumstances warrant. The combined system is perfect for cooling heels on Los Angeles freeways because of how it optimally powers down electricity when the zip of gasoline is not needed.

The question here is: what policy implications should be drawn from these (and doubtless other) examples of how private individuals adopt devices to reduce the consumption of gasoline in the face of high prices? To my mind, the lesson ought to be clearly beyond dispute: markets work in dealing with relative scarcity of competing goods. As price goes up in the short run, people reduce the amount of the scarce commodity that they use. In the long run, they make technical adaptations that increase the gains from forsaking the high price commodity.

Yes, we should eliminate CAFE standards, but we should not eliminate all regulation on automobile emissions.

Therefore, as long as high gasoline prices spur specialized gas conservation devices, we should conclude that the market is sufficient to meet the challenge of curbing excess gasoline consumption, without any boost from some misguided form of government regulation. High prices reduce quantities consumed, and do so faster and by more unanticipated pathways than even the standard static accounts of competitive markets predict.

This simple insight has been lost, however, on American policy makers for at least the last 30 years. Under the banner of savings in energy consumption, they have opted to impose a set of objective, nationwide fuel efficiency standards that fleets of automobiles must meet. These CAFE standards have long been prized as a way to induce more efficient use of energy in American automobiles. The idea behind the CAFE standards is to speed up fuel efficiency technology via regulation instead of relying on market forces. The regulator puts up a target in miles per gallon (mpg) that is just out of reach and which the industry must meet over a designated period of time. The industry then finds the resources to reach the appropriate target sooner than it would have otherwise done.

In previous years, CAFE standards were often ambitious but the consequences for noncompliance were softened somewhat by the relatively low fines that were placed on luxury car-makers whose fleets did not meet the appropriate standards. But leave it to the Obama administration, with its faulty economic intuitions, to turn a bad idea into a horrible one, and to do so in two related ways. First, the administration has proposed to raise the CAFE standards far higher than they once were—from about 29 mpg in 2010 to about 56 mpg by 2025. The second part of its strategy is to increase the level of fines for noncompliance so that they really start to bite on firms whose fleets do not meet the appropriate standard.

The best way to grasp the social harm caused by CAFE standards is to think of them as a minimum wage law. When the market wage is $10.00 per hour, a minimum wage law of $9.00 per hour will affect only a few employees. But if the market wage goes down (as it has tended to do in the last two years or so) to $8.00 per hour, then the minimum wage standard of $9.00 per hour will impose real dislocations on labor markets.

The high CAFE standards, with the high fines, not only crimp the operation of overall markets but they also impose a differential impact on firms, depending on the firms’ specialized market niches. A firm that sells chiefly light (and all else equal, more dangerous) automobiles needs to make few adjustments to meet the standards. A firm that makes chiefly, or even exclusively, heavier (and all else equal, safer) cars will learn to its sorrow that heavy fines will raise its prices relative to the competition’s prices.

In the modern market, high CAFE standards and fines now operate as a covert tariff on luxury car importers that specialize in selling big and heavy vehicles to the top half of the market. The net effect is to give an undeserved boost to domestic producers of light cars—and to their union workers. Their small cars count against the CAFE quotas even if they are sold at a loss or languish unsold in the lots.

The Obama administration has proposed to raise the CAFE standards from about 29 mpg in 2010 to about 56 mpg by 2025.

The removal of the CAFE standards does not of course give free rein to luxury car-makers. To the extent that weight is a nice proxy for gasoline consumption, the higher cost of gasoline will drive consumers to buy lighter cars. But there is this key difference. Major reductions in the cost of gasoline or its substitutes will once again induce consumers to return to those heavier vehicles.

It is at this point that the long-term targets of the CAFE standards are on a collision course with the new emerging realities in the automotive market. One development very much in the news today is fracking, a low cost technology that now allows for the release of natural gas in sufficient quantities to substantially lower its price. If that price drops while the price of gasoline remains high, we should expect in short order—at least in the absence of any regulatory restraint—a shift toward something like the dual energy system seen in Europe to power cars.

Indeed, the technological shifts could prove even more seismic if fracking turns out, as seems quite likely, to add large new supplies of gasoline to world markets. At that point the price of both gasoline and natural gas should fall, so that the costs of a dual system may well not be worth it anymore, at least in the absence of the CAFE standards. Once that happens, the true folly of the CAFE system takes place. Its regulatory rigidities are not relaxed even when the shortages that it was intended to counteract have been largely obviated by technology.

Let this scenario come to pass, and the high cost of the CAFE system’s unnecessary regulatory compliance scheme will result in serious waste. The adoption of an expensive new technology, for instance, could easily place sharp strains in other products, including those precious metals or other materials now needed in large quantities to meet the CAFE standards. In the end, therefore, the CAFE regulations are likely to induce the same types of distortions that the ethanol subsidies have done in worldwide agricultural markets.

There are two important lessons to be drawn from the Obama administration’s major policy mistake of increasing fuel efficiency standards. The first is that increasing the number of available instruments to handle any type of social planning often makes matters worse. The CAFE standards are like a one-way ratchet that operates fitfully at best in complex markets subject to technological change. The price system works alone far better than it does in combination with the CAFE standards, and it does so at a far lower administrative cost.

Taxing standards should be set to incentivize new, lower-polluting cars to enter the market.

The second point is that while we should eliminate CAFE standards, we should not eliminate all regulation on automobile emissions. In particular, two types of regulation seem appropriate. The first is a set of user fees that are based on a combination of congestion and wear and tear on public highways. The second item to regulate is the emission risk from tailpipes.

The congestion risk is sensitive to the time at which the car is driven, and ideally should be metered to reflect that highways are a scarce resource. Thinning out traffic on a price sensitive basis produces large gains by reducing the travel time for high demand travelers and increasing overall safety in the bargain.

In contrast, wear and tear levels are correlated with weight rather than time. On this front, the level of harm more than doubles for any doubling of automobile weight. Heavier luxury cars should, on this theory, be taxed at higher rates. But the tax would be related strictly to weight, and not to luxury, so that less expensive cars in the same weight class are subject to the same treatment.

The pollution risks present an entirely different problem, for now neither the weight nor the cost of the vehicle is a strong proxy for its level of emissions. Instead, emission rates are highly correlated with the age and upkeep of the vehicle. At this point, the newer luxury vehicles of the rich may well be a better bargain than the smelly clunkers driven in larger numbers by less wealthy drivers, whose tax levels should be set to correlate with emissions risk. Taxing standards should be set to induce new, lower-polluting cars to enter the market, thereby increasing the incentive to substitute in clean for dirty cars.

In the end, it’s best to decompose the cost of driving into an energy component, a congestion component, a wear and tear component, and an emissions component. Let any one of these costs go down, and the total cost of driving should fall with it. The opposite will happen when those costs increase. The correct social policy therefore is to price each component independently and then sum them up to get the total cost. In this scheme, the CAFE regulations have no useful role to play and thus should be scrapped as other regulations are adopted. A fierce opposition to CAFE standards is thus consistent with any theory of optimal regulation.