Monday, May 25, 2009

Anticipating Unintended Consequences or The Impact of MPG Efficiency
on Inflation and Taxation

When well-meaning policies override the laws of supply and demand, the shifting of the American economy towards a command economy is likely to have unintended consequences with serious investment implications. The mandated increase in the miles per gallon (MPG) average for US manufactured automobiles is an example of policy which could be more harmful to us than the supposed benefits of reducing man’s impact on global warming.

The unproved supposition is that if Americans get more gas mileage per gallon the environment will be better and perhaps healthier, thus the results will be worth the expected cost increase of $1,600 per car. There is a belief that the cost of fuel savings will amortize the increased cost. One might say that could happen if the price of gasoline rises sharply to the $4.00 or higher level. While at this point I do not argue with the possibility of a sharp increase in the price of oil due to its own supply and demand imbalance, I wonder whether the policy-makers understand their induced inflationary impact. Unless wages go up substantially, not only is inflation the cruelest form of taxation, but is highly retrogressive. The percentage of a poor family’s weekly spending on transportation will rise dramatically at the expense of healthier food, medical attention and education. Because the good people in Washington are smart and caring for people, I assume that they had already thought this out. As Brutus might say under these conditions “They are all honorable men (and women).”

I wonder whether the inhabitants of the Beltway understand the other implications of this mandated mileage efficiency edict. Since the last mandated increase in gas mileage, some “experts” believe the number of incremental deaths occurring in lighter cars is on the order of 2,000 lives per year. If one values these lives, not in human terms, but economic terms at a $100,000 per life (which is very low in terms of lifetime earnings and expenditures), the aggregate cost would be $200 million per year. One of the likely ways to increase mileage efficiency is to produce lighter cars. Since there appears to be a close relation between vehicle weight and auto fatalities, we can assume this trend will produce a larger number of deaths at a larger economic impact. Luckily for all of us, the frequency of collisions is considerably greater than auto fatalities. However, the human and financial impact of collisions is a multiple of whatever turns out to be the costs of death by auto. The lighter the weight of the vehicles, the greater the structural damage to the driver’s cabin in a collision, and therefore more likely will be declared “totaled” for insurance purposes. I suspect the scrap value of these light vehicles will be significantly less than the metal-laden older vehicles. On an underwriting basis, I believe most American auto insurance companies lose money and only stay in business through successful investing of the “float,” (holding the premiums until they need to be paid out in claims).

There are other consequences from the industry -wide mandate, already there are clear lessons from the auto manufacturers’ current dilemma. While the auto industry can probably challenge the motion picture industry for the title of “Most Opaque Accounting,” many believe one of the reasons for a significant portion of the reported losses is due to selling cars below cost. Why would a company sell anything below cost? I would submit to bring the calculation of the company’s average miles per gallon statistic up. In this way they do not have to skinny down their more profitable heavy vehicles. A further consequence is likely to be met with the same strategy: car companies (that will eventually be owned by the American tax payers) could generate even larger losses than those of 2008 and 2009.

There may be more insidious consequences from the mandate. First, there will be increased substitution of plastic for steel and aluminum. Clearly this substitution will hurt the mines, mills, and workers who produce these metals. There are other consequences for this growing level of substitution, e.g. the USA will produce less scrap metal, a key ingredient in steel manufacturing around the world (including the USA). Ironically, one of our major export earners is scrap metal, often sold to companies to lower their cost of the production of steel that they then re-export back to us at lower prices than what we can produce.

The light weight of plastics and the fact that they do not have to be produced close to the auto companies’ plants have led to many forms of plastic becoming favored materials. While I do not know for certain, I believe that the environmental impact of some plastic producers could be worse than metal producers. I am reasonably certain that the lighter materials take substantially less human labor to produce, and my guess is the labor force is far less unionized.

There are undoubtedly other consequences of the government mandate, not the least of which is traveling on the slippery slope to a command economy. I am quite sure I have not identified all of them by any means. The purpose of this blog is not to attack the government policies, but to explore how unintended consequences, some of which can be anticipated, might materially shape the impact of any major change. Astute investors should give themselves a heads-up by listing the identifiable consequences of impending changes. To quote a modern classic song, “The Times They Are a Changin.”

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