Tuesday, January 23, 2007

Drunk on Ethanol

In economics, there is the principle that capital will flow to its highest use. In other words, if you can make a profit doing something, you will find backers for your idea.

That principle is forgotten in what is shaping up to be a monumental boondoggle. I am referring to the government's massive program to promote the production of ethanol as a substitute for gasoline. The motives for this program are several. The stated one is that it will improve our security by reducing our dependence on Middle Eastern oil. That is unlikely. But the less frequently mentioned reason is that it is a sop to farmers. It is seen as yet another in the long, 75-year history of government programs that subsidize farmers: most ethanol is made from corn.

Already, corn farmers are feeling the money-rush of Bush's 2005 expansion of government support for ethanol production. Prior to 2005, ethanol producers benefited from favorable tax treatment, in particular an exemption from the 51 cents-per-gallon federal tax on gasoline. Despite that relative advantage, ethanol production for fuel had grown modestly. The Bush-sponsored Energy Policy Act of 2005 went much further. That Act made the tax break permanent, imposed a tariff on imported ethanol, and called for the first-ever requirement that gasoline producers incorporate a quantitative target of ethanol into a gasoline-ethanol blend to be used by cars.

The effect of the triple-punch of favored tax status, tariffs and production quotas has been huge. In just the past two years, the number of ethanol plants in operation has doubled to 110. Half of these are owned and financed by farmers. In 2006, 5.4 billion gallons of ethanol were produced as producers labored to meet the quota.

Today, President Bush proposed more than quadrupling the bet on ethanol by raising the mandatory production target for gasoline substitutes, primarily ethanol, to 35 billion gallons from the current 7.5 billion target. That represents more than 20% of current gasoline consumption.

Such a massive increase in ethanol production, because it largely depends on corn, will predictably raise the price of corn. It is already happening. Higher corn prices mean higher prices for everything that is made from corn, including livestock feed and high fructose corn syrup. (High fructose corn syrup is itself a market that was largely created by government intervention, in this case the near-prohibition of sugar imports.) This means higher prices for meat and the large number of food products that are sweetened with high fructose corn syrup such as soft drinks. American corn exports will also suffer as they are slowly priced out of the international market.

All of this will have a sad and predictable end. Eventually, the subsidies will be curtailed and/or the price of oil will fall to such a level that ethanol will become unprofitable even with the subsidies. A majority of the plants that produce ethanol will be shut down. Farmers who invested in the ethanol plants will lose their investments. Farmers who plowed under their soybeans and grain fields to plant more corn will get hammered. And, at the end of the day, we will discover that the entire effort did not make a dent in our imports of oil, which will be greater than ever. (The latter acknowledges that production of ethanol may actually consume more energy than it produces. If that is true, increasing ethanol production may result in greater imports of oil. Even if it is not true, it is unlikely that ethanol production will result in any significant energy savings. See the first link above.)

A lot of investment, both direct investment through venture capital and government subsidies, and indirect investment through the diversion of resources from other uses, will be wiped out.

All of this is easy to predict because the government's sponsorship of an ethanol program violates a basic principle of capitalism. That principle is that capital flows to its highest and best uses, if it is left free. If ethanol were practical, no subsidies would be necessary. Because subsidies are necessary, it is not practical. Once the impracticality of ethanol is revealed in the marketplace and the subsidies end, the entire pseudo-industry crashes down.

Government management of the economy never works. There are no examples of legitimate industries requiring subsidies, and no examples of subsidized industries that are legitimate, to the extent they are subsidized. All subsidies destroy wealth. Today, everyone -- farmers, politicians and international security "experts" -- is drunk on ethanol. Tomorrow, all of them -- and all of us who were forced to pay for this boondoggle through higher taxes and prices for corn -- will wake up with a hell of a hangover.

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UPDATE 1/25/07: The good times at the ethanol punch bowl may end sooner than a lot of soon-to-be-unhappy investors and farmers may realize. The Dow Jones Newswire reports:

"Speaking... at the World Economic Forum, [U.S. Energy Secretary] Bodman also said he does not see a 51-cent-a-gallon subsidy to U.S. farmers remaining in place beyond 2010 or an import tariff of 54 cents a gallon on ethanol beyond 2008. 'The idea is that at some point in the future all these technologies need to stand the test of the free market,' Bodman said."

Perhaps Bodman has been reading up a little on how ethanol may consume more energy than it saves, corrodes automobile engines, raises the price of corn products... Well, you know the story. All subsidies end. But before they do, they cause a lot of damage. That is why Bodman is wrong on one key point. All technologies should stand the test of the free market all of the time, not just at some point in the future.


AHWest said...

Excellent points. This ethanol frenzy is insanely distortive. Now investment trends in Brazil are also getting skewed by the ethanol subsidies and regulations.

Galileo Blogs said...

Thank you. It is an interesting "real-time" economics experiment. Some people say economics is not as scientific as other disciplines because hypotheses cannot be experimentally tested. That is not true. The ethanol boondoggle is unfolding real-time, and it is providing us with lessons about such economic principles as:
* Supply and demand, and how price controls violate this law, causing shortages
* How subsidies distort the natural flow of capital to its highest and best uses, and thereby destroy wealth
* The law of unintended consequences
* The problem of a mixed economy, whereby controls tend to breed more controls (and how governments can always choose to remove the controls, and thereby avoid the bad consequences).

And many other ideas. Of course, the philosophical ideas are also interesting, such as in my Mexican tortilla post, where the Mexican government acts on the altruistic premise that it must provide enough reasonably priced tortillas to poor people!