Global Economic Forum

Two main proposals. Congress is mooting two competing scrappage proposals. Reps. Steve Israel (D-NY) and Jay Inslee (D-WA) and Sen. Dianne Feinstein (D-CA) support the Accelerated Retirement of Inefficient Vehicles Act of 2009. ARIVA would give consumers vouchers worth $2,000-4,500, which could be used to purchase more fuel-efficient vehicles or spent on public transit.

A competing bill sponsored by Rep. Betty Sutton (D-OH), the Consumer Assistance to Recycle and Save (CARS) Act (H.R. 1550), gives consumers purchase incentives for turning in vehicles that are eight years or older to buy more fuel-efficient vehicles or to obtain a transit voucher. To qualify, fuel efficiency for new car purchases would have to be at least 27 mpg (highway), and for trucks, 24 mpg. The incentives would range between $3000 and $5000 depending on fuel efficiency. A key provision of the Sutton bill would apply incentives to work trucks; without it, the impact would be smaller.

The ‘cash for clunkers’ idea has gotten more traction since President Obama endorsed it on March 30, promising that funding could be drawn from the $787 billion American Recovery and Reinvestment Act (ARRA). At this writing, it appears that the two camps are working to iron out their differences, and the chance that a bill will be enacted is growing. The question now is what will be the impact on sales and the economy.

The bullish view. Some observers, like Morgan Stanley auto analyst Adam Jonas, believe that a cash for clunkers incentive could boost vehicle sales considerably, based on the experience of scrappage incentives in Germany. Following the introduction of those incentives, car sales in Germany jumped by 40%. And many observers, including Larry Summers, head of the White House National Economic Council, believe there is substantial pent-up demand, as 14 million new light vehicle sales per year would be needed just for replacement, far above the March pace of 9.8 million.

A closer look under the hood suggests that cash for clunkers might not provide such a big boost. Eligibility for the incentives is one hurdle for ARIVA: Trade-ins would have to get 18 miles per gallon or less and the purchased vehicle would have to offer a 25% improvement over the average federal fuel efficiency standard (currently 27.5 mpg for passenger cars). The American Council for an Energy Efficient Economy (ACEEE) estimates that only about 12 million vehicles on the road (5%) would qualify. That would substantially limit its potential impact. In addition, the UAW opposes ARIVA because it could boost sales of imports.

In contrast, under the CARS bill, roughly half the light vehicles on the road would be eligible. The UAW favors CARS, because it would be limited to cars and trucks assembled in North America. (NB: This restriction could run afoul of WTO rules and could trigger protectionist measures from abroad. At this writing, it appears that Rep. Sutton may be willing to broaden the bill to include all vehicles.)

But bang for the buck is a hurdle for either proposal. Here are some rough calculations: Under the Sutton bill, roughly half the consumers who own a vehicle could qualify for the incentive. The average incentive of $4000 per vehicle is 16.6% of the average new vehicle price ($24,122), according to Commerce Department data. But to calculate the net incentive, one must deduct the average trade-in value that we estimate at $2600, because the consumer loses the trade-in if they cash in the voucher. (One could also analyze the loss of trade-in by adding it to the price of the vehicle and counting the incentive as a discount off that higher price. That would take account of the value the dealer would realize by selling the parts.) The incentive, net of trade-in, would be roughly 5.5% of the average new vehicle price (we guesstimate that the average trade-in value for sedans eight or more years old is about $1800, and for pickups about $3800, using Kelly Blue Book data). Given that the voucher plan might expire at the end of 2009, consumers could be quite sensitive to such a discount. If the price elasticity is 2, a 5.5% discount might spur an 11% increase in unit sales. Since only half of the vehicles on the road are eligible for the incentive, that would yield a 400,000 increment to sales.

We illustrate the sales increment for a variety of elasticities and eligible vehicles. They are designed to be illustrative: While we include an elasticity of 1, we think that may be too low, given the probable ‘use it or lose it’ nature of the incentives (most would expire at the end of 2009). And the elasticity of 4 is probably a bit too high, given today’s circumstances. Based on these calculations, therefore, we would expect that the CARS plan might increase sales by anywhere from 400,000 to 800,000, depending on the restrictions imposed.

Four additional factors could alter the sales impact, one positive and three negative. On the plus side, additional manufacturers’ incentives could boost the sales total. OEMs’ average incentives ran at $3848 in March, but there is no reason why they might not put some more money on the hood to be sure that the program caught fire. However, that would not alter our thinking on bang for the buck − only the bucks involved.

Yet there are three negative factors. One is that the Administration might eliminate the sales tax incentive currently in the stimulus package (ARRA) in order to limit the cost. ARRA allows a tax deduction for sales and excise taxes paid on the purchase of a new vehicle; those deductions are worth about $300 to the typical taxpayer. In addition, clunker owners typically buy newer used cars, rather than new ones. So the incentive would have to be extended to include such used cars to have a bigger impact; again that would affect the bucks rather than bang per buck.

Finally, roughly 90% of vehicles sold in the US are financed, and credit is still hard to get. The change in loan-to-value (LTV) ratios from the captive finance companies provides a graphic illustration of the importance of downpayments or collateral. LTVs fell from 95% in 2007 to 86.4% in the latest data (February), representing a near-tripling of downpayments from $1500 to $4000 for the typical vehicle. Sales plummeted in response. Regardless of incentives, buyers still need to have more skin in the game than two years ago. Only a dramatic improvement in asset-backed securities markets and lenders’ appraisal of risk would change that.

GDP impact. If the Sutton plan were to hike US light vehicle sales and production by about 600,000 units at an annual rate, it would only boost GDP by about 0.1%. Concentrated into a short timeframe, of course, the annualized effect on a quarter would be larger. But the impact could be even smaller if, in the current environment, producers simply used it to draw down inventories. In any case, the effect on both sales and the economy would be temporary, as the incentives would likely sunset at the end of 2009, so sales and output gains today would borrow from those in 2010.

Why not mimic the success in Germany? In Germany a similar incentive caused auto sales to spike 21.5% in February and 40% in March. However, the German experience is unlikely to be a template for any US incentive program for several reasons.

The German program offers a cash incentive of €2500 on the purchase of a new, more fuel-efficient vehicle. It was originally limited to €1.5 billion, but its success prompted Chancellor Merkel to increase the size to €5 billion. Although the program has been a roaring success in boosting overall sales, it has only helped one domestic carmaker (VW), as people tend to buy smaller, foreign-assembled cars.

Several factors suggest that the US response will fall short of that in Germany. First, German consumers are in better shape than their US brethren, with higher saving rates (nearly 12%) and stronger balance sheets (household liabilities/disposable income is 98% versus 134% in the US). Second, substantially higher gasoline prices in Germany relative to the US and a CO2 emission tax effective July 1 provide a bigger incentive to replace older cars with more fuel-efficient ones (the current tax is based on engine displacement rather than CO2 emissions).

More important still, OEMs selling in the German market paired significant incentives of their own with those from the government. The OEM incentives often doubled the total package to €5000 per vehicle. Clearly a 20%+ discount can go a long way to boosting demand − but this involves putting more money on the hood rather than more bang per euro. Indeed, while it boosted unit sales, the incentives may have shifted demand from premium OEMs such as Mercedes and BMW to foreign makers of smaller cars such as Toyota. And, of course, there will be ‘payback’ when the incentives expire, as some of the demand borrowed from the future.

The experience in other European countries suggests that scrappage incentives alone won’t significantly boost sales in the US. For example, incentives in Austria, Italy and France are only slightly smaller than those in Germany, but sales are still flat to down year over year.

To be fair, it is early days for some of these foreign schemes. A J.D. Power and Associates survey suggests that two-thirds of UK respondents believe that the just-announced government-backed £2,000 “scrappage” incentive for vehicles nine years of age and older will stimulate the new-vehicle market. “Furthermore”, the report notes, “40 percent of all respondents with qualifying vehicles indicate that they would be either “likely” or “very likely” to purchase a new vehicle within the next six months as a direct result of the incentive”. But the evidence so far is not especially encouraging. Stay tuned.