Sunday, August 23, 2009

Revisiting Cash for Clunkers: The Law of Unintended Consequences

A short while ago, I wrote about the Cash for Clunkers program and why I wouldn't be participating. Now that the program has blown through $3 billion, it is time to start looking at the unintended consequences. Actually, the unintended consequences should have been looked at before, but I don't really expect Congress to do that.

The program's goal is to get gas guzzling vehicles off of the road and replace them with high MPG vehicles. Sadly, the car market (like any other market) is a complex system. Complex systems are highly dependent on their initial conditions, and slight variations in those conditions can cause vastly divergent results. So let's look at some of the initial conditions that affect the car market:

Bailout, layoffs, and bankruptcy of two of the largest automobile manufacturers
New government mandates of MPG that manufacturers need to meet over the next 20 years
Increasing unemployment in the country
Government spending that has increased the deficit 400%
Forecasts of peak oil imminent with no widespread replacement technology
People spending less and saving more
Dealerships closed down by pseudo-government
Control of hiring/firing and pay by czars
Recent gas prices at all time highs
Recovering stock market
Population that is growing at a slower rate than in the 60-90s
Population that is living longer than ever before

This list is not meant to be exhaustive. There are thousands of initial conditions that affect the car market. Only one or two of these were considered when this program was conceived without regard to how they would affect the rest of the market. Let me go through some numbers.

The program (with the extra $2 billion) is going to help put 750,000 new cars on the road. The major negative with this program is that all 750,000 of those vehicles are going to be destroyed. That means the used car market (about 41 million vehicles a year) will have 750,000 less used cars, or about 2%. Unfortunately, this is going to be magnified because the 2% of $2000 cars are not going to be traded in for $4000 cars, and 2% of $1000 cars are not going to be traded in for $2000 cars, and 2% of people that were going to buy the $1000 cars are not going to be able to because of availability.

Except that the scenario above would only happen if cars of all values are traded in. So let's do a little mental exercise. First, we know that the used car market is roughly 41 million. Second, we can probably safely assume that 95% of the cars turned in were worth less than $4500. Any car that was worth more, we can just chalk up to the Stupid Tax. So that is 712,500 cars worth less than $4500 are now off of the market.

Next, I needed to figure out how much of the 41 million cars are part of the under $4500 market. So I went to my friendly neighborhood car dealer and checked out his used car inventory. It would only allow a lower limit of $7000 so I used this. Two. A total of 2 used cars under $7000. How many in his inventory overall? 63. 3% of his inventory is under $7000.

Now in all fairness, this was a dealer attached to several big name companies. There are plenty of mom and pop shops and lots of people sell their cars themselves whenever a dealer isn't going to buy it. I looked in my local newspaper. The ratio here was much better, 6 out of 10 were under $4500. And there were 118 listed. So if I assume that there 75% of the used cars are sold by dealers (there are at least 5 big dealers in my area with 60+ used cars a piece, at 3% under $4500 rate) and 25% are sold through newpaper, mom & pops, etc (with a 60% under $4500 rate), then roughly 17% of used cars sold are under $4500. Or 7 million.

The dilemma then becomes that we are taking 712,500 of the 7 million away in one year. A 10% drop. So what was on the surface 2% of the entire market (all used cars), is actually 10% of the focused market (sub $4500). To take away 10% of the supply (in basically a month's time) is definitely going to put price pressure on the market. Used cars that sell for less than $4500 will now be more expensive. Unfortunately, the laws of supply and demand are not linear. Some economists have proposed that the ratio is as high as 10:1 (for each 1% decrease in supply, there is a 10% increase in price).

While this may be a bit of a stretch, I feel confident that we will see used car prices increase for the near future. All car prices. Because if sub $4500 increase say 50%, then cars above $4500 will also increase due to relational value (if the $4500 car is now worth $6000, then the $6000 car must be worth $7500, et al). This is going to squeeze the people at the bottom (the poor) the most, by pricing them out of a better car (or any car for some).

The program is a huge waste of resources. All of the new cars will will lose value to depreciation in the first month which will more than offset the $4500. All of the cars turned in will be scrapped making them worth only a fraction of their value. Since 10% of the sub $4500 fleet is removed, there will be a decrease in the used/rebuilt parts for these cars since they aren't being recovered.

The lost energy cost is most troubling. In all 750,000 cases the cars were already manufactured, and while their mpg might not live up to some government ideal, the energy cost of replacing them with a new more fuel efficient vehicle (i.e. the amount of CO2 pumped into the atmosphere by the manufacturing process) far outweighs what little CO2 is pumped out from burning the extra gasoline. In other words, we just pumped more CO2 into the atmosphere than we saved. And destroyed $1-2 billion dollars of wealth to boot.

Whenever the government tries to mess with the free market they always screw it up. Doesn't matter if it is Republicans or Democrats, both think they are good at playing God. They aren't. And they hurt the poor more than anyone. Cash for Clunkers is a perfect example (or imperfect example to be precise).

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