There is something about this bill that I can’t get my head around. When I first read about the legislation I checked to see if my vehicle was eligible and was happy to learn that I can turn in my 1997 Ford F-150 pickup and get a $4,500 credit towards a new fuel efficient vehicle. Then I started thinking about all the secondary market effects of the bill and my head just couldn’t stop spinning. Below are some potential negative impacts:

• Manufacturing cars is bad for the environment. Some environmental accountants argued that the environmental impact of manufacturing a vehicle outweighs the environmental impact of all the oil consumed and carbon dioxide emitted during a vehicle’s driving lifetime. Following this logic, the best scenario for the environment would be to continue driving our vehicles as long as possible.
• Corporate average fuel economy (CAFE) will not improve. Large trucks and SUVs tend to be the most profitable vehicles for automotive manufactures,  and these companies would sell far more large vehicles if they were not bound by CAFE regulations. To meet these regulations auto companies subsidise the sale of fuel efficient vehicles (often through incentives) to balance out the sale of fuel inefficient vehicles (gas guzzlers). This process has been in place for decades and auto companies have mastered the art of just meeting the CAFE regulations. Thus, with the introduction of cash for clunkers, auto manufactures will either drop their own incentives on fuel efficient vehicles (canceling out the government sponsored incentive), offer incentives on large vehicles (since they can now sell more and still meet CAFE regulations), or both in an effort to maximize profitability. The end result is that the average fuel economy of vehicles sold will not be affected by this program.
• Prices for fuel efficient vehicles could rise. Simple supply and demand curves suggest that an increase in demand for fuel efficient vehicles brought about by government incentives will put upward pressure on prices for fuel efficient cars. The price increase could be implemented by auto manufactures dropping their incentives or dealers raising their margins. Either way, it is reasonable to expect that prices for fuel efficient cars will rise for consumers who are not trading in old gas guzzlers.
• Intended life of legislation is unclear. The current bill is expected to last for at least one year and cost tax payers roughly $4B over that period. So far, $1B of funds have been set aside which should fund the program through September. As someone who personally qualifies for this incentive, the eligibility window is a big deal. My truck is fully paid for, has low insurance premiums, and runs great. Thus, it’s in my best financial interest to drive this truck as long as possible, and only trade it in under the cash for clunkers program at the last possible moment. With an undefined eligibility window it’s not clear how long I can wait to take advantage of this incentive. Furthermore, I expect a large portion of old car owners are in the same boat and would like to hold off on getting a new car as long as possible without missing on on this opportunity.
• Establishes a price floor on used vehicles with low fuel economy. When a vehicle can be traded in for $4,500, there won’t be many people willing to sell their fuel inefficient vehicles for less than $4,500. The good news is that people looking for inexpensive used vehicles will have to settle for a fuel efficient model. The bad news is that by establishing a price floor on gas guzzlers the government has lowered the total cost of ownership for these vehicles (e.g., purchase price minus sale price). In fact, one might expect the legislation to result in lower lease prices for fuel inefficient models.

With many benefits and disadvantages this bill is difficult to judge on the balance. Some have tried to resolve the debate with virtue-based arguments such as ‘this bill will help our auto companies which are in dire need’ and ‘the government is getting too involved in the private sector’. In the end, only time will tell if cash for clunkers brings us closer to meeting our national economic and environmental goals.

Let’s look at the sub-prime mortgage situation that pricked our housing bubble. Using a supply and demand framework, Americans demanded more expensive homes and banks responded with a supply of sub-prime mortgages. In this context it was the common interest (greed) of both parties that created the market. Therefore, it is only logical that both parties should share the blame.

When trouble arises in markets, Americans generally blame the suppliers. In the 1970, when drug use was on the rise in the United States, we engaged in a War on Drugs with drug suppliers (cartels) in Columbia. As tobacco use rose, we fought the Big Tobacco industry. History has taught us that the war on drugs must be fought at home with drug prevention and education. Anti-smoking campaigns have been a huge success and tobacco use has declined accordingly. In both cases, the key to success was focusing on curbing demand with consumer education.

The regulation of credit card lending focused on the suppliers of debt (banks) and has been generally unsuccessful. The most profitable customers for credit card companies are still the individuals who make minimum payments, and generally make these payments after their due date. This market has become somewhat efficient in that several credit card counseling and debt consolidation services are now available. You may have seen some of their advertisements on television.

I think our regulation of the credit card lending is a good indication of what will take place on Wall Street. There will be more paperwork and disclaimers associated with high interest rate mortgages. This will certainly increase costs for consumers while providing some indirect education on the risks associated with high interest rate debt.

A more effective approach is to directly educate consumers on the risks of high interest lending. The US policy is that everyone should have the opportunity to own a home. If the path to home ownership requires financing with ARMS and balloon payments, we have an obligation as a society to offer education on these financial instruments. To the best of my knowledge, there is no large scale program in place to educate our citizens and students on home ownership.