Ethanol Economics
by Warren Coats
Issue 108 - May 28, 2008

It is often useful to bring an economist’s perspective on issues of interest to most of us. In a nutshell that perspective, the lens through which I see and filter events, consists of a very short list of facts and opinions.

The first overriding fact is scarcity. The world has limited resources at any moment. We can talk about how to distribute them, the zero sum game of redistribution Marx wrote about, or how to increase them, creating “The Wealth of Nations” that Adam Smith wrote about.

To an economist, the fact of scarcity raises the issue of how given resources should be allocated to maximize their value. In this one paragraph I will distill most of what economics is ultimately about. We can reduce scarcity (increase goods and services) by consuming less now (investing in equipment, technology, and education to increase our productivity) in order to have more to consume in the future. We can also increase the benefit (utility as we say) from existing resources by allocating them to where they are most valued. Marx thought that central planners could do that best and Adam Smith thought that free markets worked much better. Markets allow individuals to cast their own individual votes for what they want the economy to produce by buying it. Thus existing output goes where it is most wanted (most valued). The market makes room for diversity of tastes (for a price) while central planners generally don’t.

But that is only the consumption half of the picture. Markets also reward producers with profits for investing in the production of what consumers most want, thus encouraging and rewarding them for producing more of it. Market economies have produced and continue to produce wealth and income for the masses that Marx never would have thought possible.

Behind these broad general propositions lies the belief, supported by overwhelming evidence, that people respond to incentives. Market prices profoundly influence where and how hard people work and what is produced. People value and respond to other things as well. The moral values that we and our neighbors hold and live by also profoundly influences the quality of our lives. Our desire for freedom is tempered and balanced by our desire for security (from physical attack and hunger). The interplay among these sometimes conflicting factors gives rise to the major themes of political debate. The major filter through which I view all public and private policy issues whether something passes a cost/benefit test (is it likely to result in benefits greater than it costs) and whether it creates or contains incentives that encourage desirable behavior. The other is fairness.

Here is a quick example of my economists perspective on a topical problem—food (especially grain) prices. The Washington Post recently ran an outstanding series on its causes and consequences. A major factor is President George Bush’s very wrong headed subsidies for the production of corn for ethanol. If the government provides financial incentives (contrary to the market’s pricing of corn) to grow more corn, farmers will grow more corn. But what are the consequences? Where does the extra corn come from? It comes from providing less corn for the other things it is used for, reducing other grain crops to make the land available for corn and cutting down trees to create additional land for growing corn. Added to other factors increasing the demand for grains, the government’s corn for ethanol program has had catastrophic consequences for the prices of corn and other grain crops and of chickens, eggs, beef, and other animals up the food chain that eat corn.

Why did Bush do this? He wanted to reduce greenhouse gas emissions from gasoline by increasing the use of ethanol. But he relied on bad science. “Although ethanol was once promoted as a way to slow climate change, a study published in Science magazine February 29 concluded that greenhouse-gas emissions from corn and even cellulosic ethanol ‘exceed or match those from fossil fuels and therefore produce no greenhouse benefits.’” By encouraging an expansion of acreage, the study added, the “use of U.S. cropland for ethanol could make climate conditions dramatically worse. And the runoff from increased use of fertilizers on expanded acreage would compound damage to waterways all the way to the Gulf of Mexico.” [ Washington Post, April 30, 2008, page A01]

But this is not all. The administration rejected Brazil’s offers to provide the environmentally superior ethanol from sugar cane. Why? Because Brazilian farmers don’t vote in American elections. Along with contributing to a world wide food crisis, Bush’s ethanol policy is creating a new constituency of government supplicants whose livelihood is enriched by the existence and continuation of this costly and harmful program. It reminds me of our costly and wrong headed sugar beet subsidies introduced to replace Cuba’s long-ago Castro-boycotted sugar--and still with us.

Farmers are responding to price incentives but they are not the market prices reflecting public demand but rather government distorted prices that are producing benefits much below what they cost.

Warren Coats of Bethesda MD is an international banking consultant and former associate at the International Monetary Fund