CAFE standards, and you don't even need a law

In a low-price environment, which began in the mid-1980's and only ended a few years ago, CAFE standards become a clumsy attempt to marry a policy of reducing fuel consumption through mandates with a low-tax policy on gasoline. CAFE is a tacit admission that the low-gasoline tax policy will boost consumption. To look like it has a policy designed to restrain consumption and promote demand destruction, while keeping gasoline taxes low, the federal government orders up some changes underneath the hood.

This flies smack into the face of Jevons Paradox. Named after the English economist who first formulated it, William Stanley Jevons, Jevons Paradox holds that increased efficiency in the consumption of a desired good will ultimately lead to more consumption of that same good, as the price of it declines and the ability to satisfy that desire becomes cheaper. Jevons made his observations in connection with James Watt's coal-fired steam engine. It burned coal more efficiently than its predecessor models, and the result was that coal consumption actually increased, not decreased, after its introduction.

That's the problem with CAFE standards. As CAFE-regulated cars become more efficient, and the resulting drop in demand leads to a decline in the price of gasoline, demand for the fuel will increase. Yes, there's a short-term decline in the early years of tighter standards, as more fuel-efficient cars take a growing share of the fleet. But even if the mileage traveled doesn't change -- and it always does with increases in fuel efficiency -- the lower resulting price of gasoline will lead many people to switch to larger cars and the creature comforts that come with them. Sound familiar? That's the US car market, beginning in the second half of the 1980's.

But a new round of CAFE standards is contained in the recent US energy bill. It calls for the full fleet of US cars, including minivans and SUVs, to achieve an average fuel economy rate of 35 mpg by 2020. Jevons Paradox is ignored. It is just baffling: otherwise intelligent people who know that the key determinant of demand for a commodity is price, yet they actively support policies designed to ignore that inconvenient truth.

But markets here in 2008 have decided to impose their own CAFE standards, starting now. They aren't waiting until 2020. GM just reported a 37% decline in light truck sales for May. Ford's number was at 26%. (It's sort of amazing, given $4 retail gasoline, that the decline in that category isn't closer to 100%.) Official Department of Energy numbers showing gasoline consumption year-on-year down between 1% and 2% are mocked by gasoline station owners, who see their sales down 5% to 6%.

What should be dawning on the high church of CAFE is that it could have realized its goals of lower consumption a long time ago had its followers advocated for higher gasoline taxes back in the 80's, or better yet, 10 years ago, when the real price of crude was at its lowest point ever. A cut in Social Security payroll taxes could have been implemented at the same time as the federal gasoline tax was raised, seeking a goal of revenue neutrality. That payroll tax cut would have shown up in paychecks immediately, and would have extended down to lower-income wage earners, for whom an income tax cut means almost nothing.

The American public, which is now spitting in the face of conventional wisdom that gasoline consumption would never decrease regardless of price, would have made the same sort of market-driven adjustments then that they are making now. Hummers would have remained something driven in the Army, and government micromanaging of the auto industry -- what should the standard be? when does it go into effect? should there be exemptions? -- would have been utterly unnecessary.

The market would have answered all those questions; the overall fuel efficiency of the auto fleet would have been significantly higher without a government mandate, because people would have reacted to the signals sent by the higher gasoline price and chosen more fuel-efficient vehicles. But the high tax on gasoline, largely offsetting declines in the price of crude as a result of a more fuel efficient fleet, would have kept Jevons Paradox from kicking in. Better fuel efficiency would not lead to higher demand, because the cost of gasoline would be stopped from falling significantly even as crude prices fell. The high tax level on gasoline would have prevented that from happening.

Other benefits would have included a full range of environmental improvements as demand is restrained. Economically, the cost of creating a new job would be lower, because Social Security payroll taxes paid by the employer would have been reduced. The increased money in wage earners' pockets would have gone for other purchases than gasoline, as buyers react to the price signals set by the higher price and other steps toward efficiency are taken.

But no, the US wanted cheap gasoline. OK, that's the choice. But policy makers need to acknowledge that you can not have a price decline for a good that people want and a concurrent decline in consumption simply by using complex legislation to get there. It's not possible.

That's why we say CAFE standards have flaws at high prices. They're unnecessary. The market is going to take the average mileage of the fleet to where policy wants it to go. It could have happened years ago, with a shift in the tax burden from payroll taxes -- which is a tax on work, and a tax on job creation -- and a shift toward taxind energy consumption.

William Jevons could have told you that a long time ago.

A final note: This entry was first drafted on June 4, and lo and behold, columnist Charles Krauthammer wrote something very similar a day later. You can see it here, though it may require a login to view it. But he doesn't quote dead English economists!