5 Downsides to 'Cash for Clunkers'

Eureka! Stimulus works! The first $1 billion allocated to "cash for clunkers" rebates apparently helped boost car sales by more than 250,000 vehicles, bringing some much-needed cheer to depressed auto showrooms. So Congress added $2 billion to the program, which by extrapolation could increase sales by more than 750,000 units overall. Carmakers are gleeful. And the Obama administration finally has some concrete evidence that extravagant government spending occasionally moves the needle.

But the buying spree, fueled by government rebates of up to $4,500, may not be quite the economic boost it appears to be on the surface. And there will probably be some of those pesky unintended consequences. Here are a few reasons that cash for clunkers is likely to look a lot less successful when seen in the rearview mirror:

Some of those car purchases would have happened anyway. Analysis from car-research site Edmunds.com found that at least 100,000 car buyers put off a purchase earlier this year to take advantage of cash for clunkers, once they learned about it. So those sales would have happened even without the government giveaway. And analysis of the steep discounts offered in 2001, after the 9/11 attacks, has shown that most buyers who took advantage of the sales simply moved up their planned purchase by a few months, creating a "payback" effect when sales dipped several months later. That's probably happening now. "We have crammed three to four months of normal activity into just a few days," wrote Edmunds CEO Jeremy Anwyl in a recent Wall Street Journal op-ed. If so, car sales could dip again this fall, slowing any momentum gained over the summer.

[See which cars have been hurt most and helped most by the recession.]

The used-car market might go haywire. Since clunkers that get traded in have to be destroyed, the program could take 750,000 vehicles out of the used-car market. That's about 5 percent of the market, according to kbb.com—enough of a contraction to cause significant price hikes for used vehicles. Kbb.com predicts there will even be a used-car bubble, with a shortage now leading used-car dealers to stock up on inventory. But when the clunker rebates end, dealers could end up with too many cars, causing prices to seesaw the other way. A serpentine sales curve makes it much harder to manage a business and earn profits than a nice steady one.

The program could depress sales of other goods. Most consumers have only so much money to spend, especially in a recession. And while the rebates lower the cost of a new car, buyers are still adding a sizable new payment to their monthly budget. Purdue University retail expert Richard Feinberg estimates that the average clunker-upgrader takes on an extra $400 in monthly car payments, which could divert $1.5 billion from elsewhere in the retail economy. "After suffering from the worst holiday sales season since 1970," he says, "retailers will be facing an even more dismal 2009, in part because of the cash for clunkers program." So the overall effect on the economy could be nothing more than a shift from one kind of retail spending to another.

[See why GM is ready to rebound.]

Drivers could end up burning more gas. That's counterintuitive, since drivers must trade in their old car for one that gets significantly better mileage in order to get the rebate. But with a fresh ride in the driveway, buyers are likely to change their driving habits. Surveys by research firm CNW Marketing Research have found that clunker-upgraders drove their old vehicle about 6,200 miles in 2008, barely half the typical annual mileage of 12,000. But most said they'd drive their new car more and take longer trips. CNW's math shows that if clunker-upgraders drive just 90 percent of the annual average mileage in the first year of ownership, they'll end up burning an extra 61 gallons of gas, even though they get better mileage. Multiply that by 750,000 vehicles, and cash for clunkers would result in an additional 46 million gallons of gas being burned.

As a consolation, the program will unambiguously cut down on greenhouse gas emissions, since today's cleaner engines more than make up for extra miles driven. CNW pegs the greenhouse-gas reduction due to clunker retirement at 92 percent or more.

[See 8 industries that will sit out a recovery.]

Sticker prices could rise. For the past 18 months, there's been an oversupply of cars, since virtually all automakers failed to anticipate the sharp plunge in sales. The excess inventory has made it a buyer's market, with historic deals available on many models. But the automakers have curtailed production and whittled down their inventory, gradually bringing it in line with demand. Now, the sudden spike in demand generated by the clunker program has created unexpected shortages of some models.

That's the kind of problem the automakers don't mind, because it allows them to raise prices. As long as the clunker program is still in place, the government rebate will mask the increase for those who qualify. But buyers who don't qualify for a clunker rebate will be more inclined to notice that prices are up and choice cars are harder to find. And the clunker rebates will end at some point, since the government can't subsidize car purchases forever. Or can it?

[See if you qualify for a Cash for Clunkers rebate.]