The Best-Sounding Bad Idea To Come Along In A Long Time

Reading at Left Coast Rebel about a month ago, I was dismayed to learn last month that the Cash for Clunkers program was gaining political purchase. I can see the logic behind the initiative -- subsidize the ability of people who are driving around old gas guzzlers for newer, more fuel-efficient vehicles -- and I can see that there would be some environmental good done by realizing the objective of updating our fleet of personal vehicles.

But this is definitely a thing to do when times are prosperous, when there is excess money to be spent on this sort of thing. Right now, we're only seeing subtle macroeconomic hints that the recession may be receding, but that doesn't mean times are getting better and it certainly doesn't mean times are good. We're deficit-spending ourselves into fiscal anemia and paying people between $3,000 and $4,000 for what Congressional sponsors hope will be 625,000 vehicles is $2.5 billion that we simply don't have right now.

But even under the best of theoretical circumstances, it is also not clear that the policy would work, or that its benefits would not be swamped by unintended adverse consequences. As I wrote at LCR, if we were in a budget surplus condition, I could call this policy proposal defensible, at least in the abstract; but still a luxury we can't presently afford.

Now, the bill that the House of Representatives just passed has been so compromised that it seems unlikely that it would effect so little advancement towards its policy goal that it seems like a waste of time. In its current form, "cash for clunkers" will benefit almost no one. There are simply not a lot of people who own crappy old cars and who are looking to buy brand-new cars to replace them. So who would be cashing in on this program? As Prof. Steven Levitt writes in today's Gray Lady:

If any vehicles are going to qualify under this program, I suspect it will be because enterprising people who already plan to buy new cars will go out and buy old junkers on the used-car market and then trade them in under the program. But those transactions won’t represent incremental new car sales; it will just be a way for people who were already going to buy a car to rip off the government.

Prof. Levitt points out that, although about ten percent of the total fleet in the United States get low enough mileage to meet the initial threshold for subsidy eligibility status, the bulk of those vehicles are light-duty pickup trucks. Now, light-duty pickup truck owners tend to hang on to those vehicles longer than car owners do because light-duty pickup trucks have utility as cargo carriers in addition to their ability to move passengers around. They therefore become auxiliary rather than primary vehicles, part of the reason why there are more vehicles than drivers registered in nearly every state. The incentive to get rid of a high-utility auxiliary vehicle is much lower than the incentive to upgrade a personal-transportation-only primary vehicle.

Additionally, the person asking for a subsidy on the clunker trade-in will need to prove that the vehicle was registered and insured for the previous year. Well, here's a couple of facts for you coming from a guy who sometimes serves as a traffic judge -- between 20% to 25% of the vehicles on the road are not insured and about one in thirty don't have current registration. They aren't insured and they aren't registered because the people who own and drive them are poor and cannot afford to pay the money to insure and register their vehicles. The vehicles that are uninsured and unregistered tend to be old-model vehicles, the ones that this subsidy is aimed at, because those low-quality vehicles are the only ones that poor people can afford to buy in the first place to meet their transportation needs.

In other words, I would predict that the insurance and registration requirement would substantially narrow the number vehicles that will qualify for the subsidy in the first place. And of those vehicles, the true economic incentives to part with them may be lower than the cash price for such vehicles available on the open market and indeed may be lower than the subsidy offered by this program.

When it's the only car you've got, even if it's a clunker, and you probably can't scrape together enough money to buy a replacement, the utility value of that crappy old car is very high. Higher than the marginal value of $500 to $1,000 in cash that you could get on the open market for it, and probably higher than the $3,500 to $4,500 subsidy you could get for trading it in to be crushed into a small, heavy metal cube. And since you can't scrape together enough cash to replace your junker-with-a-market-value-of-$1,000, you're not in the market for a new car anyway, so the $3,500 to $4,500 subsidy is a non-issue.

In other words, the transactions Congress intends to incentivize are simply never going to happen. Let's consider what would really happen.

If you had maybe $6,000 in available cash, you could buy up a dozen junkers at $500 each, and trade them all in at once, getting a $3,500 subsidy for each trade-in. You'd use that money to get new car worth $42,000. You could then re-sell the new car to a third party without ever putting the key in the ignition, realizing a profit of $36,000.

Given an infinite number of $500 cars eligibile for the subsidy available to purchase, your $36,000 in profit from the first turn-around would buy you 72 more junkers, which for your next cycle of purchases and trade-ins, would be worth $252,000 in new car purchase subsidies. Even after paying sales tax, re-registration fees, and rental on property large enough (and zone appropriately) to store 72 crappy old cars at a time, you could theoretically wind up with something like $200,000 in profit.

What makes this worth doing is the government subsidizing the junkers to seven times their open-market value -- paying $3,500 for a car that would sell for $500 on the open market. In real life, you'd be shelling out cash for more than eighty crappy old cars to make this work. Also in real life, the universe of people who are actually selling $500 vehicles that get mileage below eighteen miles per gallon and who have been able to keep their cars registered and insured for an entire year is not infinite; indeed, it is relatively small.

These owners would respond to your market activities by demanding higher prices for the suddenly-desirable subsidy-eligible cars they had to sell -- I'll go so far as to predict that the supply side portion of this market is small enough that even a single entrepreneur behaving this way would, in short order, move the demand curve of that market and drive up the market cost of these vehicles.

This assumes, moreover, that you're the only person in the area clever enough to have figured this out and exploit it -- which wouldn't be the case; this is a pretty easy business model for pretty much anyone to puzzle out. That would also create upward pressure on the demand curve. So it wouldn't take long before sellers began demanding $1,000 or more for the same cars they had previously willing to sell for $500; eventually, the market price would rise to something very close to the subsidy and now all of these middle-men would be out of business.

What's amazing is not that this happens, but rather how fast it happens. Frankly, I doubt that you'd be able to make it through the first cycle of purchases and re-sales before the market price rose to a point that made the business model unworthwhile. You'd never get to the point that you could pocket $200,000 in after-tax profits because you'd have run out of subsidy-eligible cars to buy at any price.

What's more, all of these owners of subsidy-eligible cars would be out of customers. So they would hang on to, and drive, their old junkers until they were in a position to buy new cars for themselves and exploit their own subsidies. That's what the new equilibrium would look like -- people holding on to old, crappy, inefficient cars for longer, creating an even older, less-efficient fleet of cars than we have now. I don't think this is what Congress intends.

Ah, the pernicious and perverse effects of government intervention in the economy!

The only people who would find practical value to this program, as Prof. Levitt suggests, are entrepreneurial sorts who would look to exploit both the government and the economically-disadvantaged owners of the junkers who are intended to be the beneficiaries of the program. I'll go a step further than him and predict that these entrepreneurial sorts will wind up being the auto dealers themselves. They'll "sell" the junkers to their customers who are buying new cars anyway. Then, their customers will "trade them in" and use the voucher to underwrite new car purchases. The dealers will keep a portion of the subsidy for themselves as an "administrative fee," or build that fee into the ultimate purchase price of the new car.

I don't think this is what Congress intends to happen with this program, either. But I could be wrong about that.

Finally, bear in mind that each and every transaction under this program would be a piece of the $2.5 billion line-item of deficit spending, which will also incur transaction costs, paying for clerks and administrators to make the subsidy happen, and of course the cost of creating a new branch of the Department of Transportation and training the people who will work there to do the job. All of that will also be paid for out of deficit spending.

Could the idea be made better? Yes. Remove the insurance and registration requirement for subsidy eligibility. Expand the scope of the subsidy to allow for the purchase of a previousy-owned vehicle with improved mileage instead of only to brand-new cars. Render vehicles sold to the subsidy claimant in the previous six months ineligible for the subsidy to deter exploitation by middlemen and the economic drag that would produce. These things would steer the subsidy back towards the intent of the bill, which is to help people upgrade crappy old cars to more fuel-efficient ones.

But even then, it's still spending billions of dollars that our government just plain doesn't have in the first place. Cash for clunkers -- a creative idea, to be sure, but not one that I can endorse.