Auto-bailout: Will Americans Demand the Cars Congress Wants the Big Three to Build?

If they build them, will they sell? Having humiliated the CEOs of the big three auto companies to confess their sins and forced them to offer detailed proposals for their rescue, Congress is reportedly ready to support their plans. But it should not do so until it agrees on the steps it will take to ensure that if the big three do supply more attractive small cars, there will be sufficient demand for their products. The centerpiece should be a plan that gradually increases duties on imported oil to ensure a minimum price of gas in five years' time.

The basic problem is that Americans like to drive SUVs, minivans, and small trucks when gasoline costs $1.50 a gallon. As a result, the big three are really truck companies. Concerned about the political fallout from effectively changing this behavior, US politicians have either done nothing or tried to appear to be doing something by passing weak and loophole-ridden fuel economy standards that were barely higher in 2007 than they were in 1984. Under these circumstances, it made sense for the auto companies to produce the products Americans wanted, particularly since doing so was far more profitable than making small cars.

Consumers may have regretted their behavior when gasoline prices soared above $4 a gallon, but as gas prices descend, there is no reason to believe that left unchecked they will not return to their gas-guzzling ways. Indeed, there is a distinct possibility that if they really do increase their small car production, in a few years the big three will be back asking for more help, on the grounds that they are losing money by doing exactly what Congress asked. Concerns about dependence on foreign oil and global warming and wariness about future gas price hikes may lead some Americans to voluntarily reduce their oil consumption, but most need stronger incentives. After all we know that previous oil price hikes did little to change their behavior.

Incentives are also needed for firms developing alternative technologies. As oil prices plummet and equity markets freeze up, many alternative energy firms are canceling their investment plans. There is a consensus supporting government subsidies to develop new technologies, but these will only work if there are strong market forces moving in a similar direction.

The answer is a strategy aimed at domestic oil prices in the medium run. In the short run, given the slumping US economy, low oil prices are beneficial, since they free up income that can be spent on other goods and services. But the key to changing consumer behavior and providing incentives for alternative fuels is a guarantee that in the not too distant future-say in five years' time, and for some time after that-gas will cost no less than five dollars a gallon (in today's dollars). This will lead buyers of cars and trucks to make different choices. It will also provide the incentives for firms to develop domestic energy supplies of both oil and its substitutes.

The United States does not control the world price of oil, but it can guarantee a minimum domestic price by imposing a duty on oil imported at less than that price. The Congress could schedule increases that would gradually rise to achieve the desired price path over the medium run. Variable import duties are easy to administer and the United States has retained the flexibility to raise them under WTO rules. They can be used to peg domestic prices as world prices fluctuate. They simultaneously provide incentives for conservation and for domestic production of both oil and alternative energy and are the right tool to deal with the security and strategic concerns that arise from our dependence on imported oil.

Alternative approaches would use variable domestic gas taxes or gasoline consumption permits, but these would be much more complicated to administer when world oil prices fluctuate and neither would encourage domestic oil production.

Our policies should be precisely aimed at their objectives. If the problem is oil imports, the right instrument is import duties. If the problem is carbon emissions, the right instrument is taxing carbon. Since they are both problems, we need to apply two sets of policies. While they would both have beneficial environmental impacts, either import duties or gas taxes would need to be supplemented by additional measures that targeted carbon emissions to deal with global warming.

Many will reject this proposal as politically naive. The Hippocratic Oath of many policymakers is to avoid being seen to do any harm. Fuel economy standards are regarded as a more pragmatic alternative because they avoid blame for higher oil prices and hide the costs they impose through higher auto prices. But they are an inferior approach. Historically, major users such as large trucks have been exempted. By reducing gas consumption but keeping gas prices low they encourage more driving, and by raising the cost of new cars they keep old cars on the road longer. Unless they are combined with a system of tradable permits, once automakers meet the standards, there is no further incentive to conserve.

Congress should put their mouths where their money is. They should make binding commitments to ensure higher US oil prices and thereby sufficient demand for fuel-efficient cars and trucks in the future.