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Going Crazy for Ethanol

By Steven Pearlstein
Wednesday, May 24, 2006

You got to hand it to Elmer. When it comes to getting the government to subsidize the same activity not just once, but several times over, nobody can touch the American farm lobby -- not even the Alaskans.

Let's consider the case of ethanol, which thanks to numerous government policies has now overtaken Manhattan real estate, derivatives trading and high-tech start-ups as the investment opportunity du jour for the smart-money set.

For starters, there's the 51-cent rebate on the federal fuel tax for every gallon of ethanol added by refiners to their gasoline products. Or, if they prefer, refiners instead can take a 54-cent credit off their federal income taxes.

And then there is the federal mandate, written into last year's energy bill, that will require refiners to buy a minimum of 7.5 billion gallons of ethanol by the year 2012, nearly double the current production.

To encourage investment in plants to turn corn, sugar or agricultural wastes into ethanol, there's a 10-cent-a-gallon tax credit for "small" producers, which is now defined as anyone producing up to 60 million gallons. At the current market price of $2.90 a gallon, that would be a $175 million-a-year business.

And a full accounting would also include the government's price supports for corn, including that used for ethanol.

Of course, it wouldn't be right for the government to stimulate all that production and then open the border to cheap Brazilian ethanol, so Congress very thoughtfully imposed a 54-cents-a-gallon tariff on imported ethanol.

And let's not forget the myriad state subsidies. They range from direct producer payments (16 states) and tax credits (seven states) and fuel tax reductions (eight states), to grants and subsidized loans and requirements that government car and bus fleets run on ethanol-based fuels.

With all that government-induced demand, and the price of gasoline going through the roof, it should be no surprise that the wholesale price of ethanol (a gasoline substitute) has reached $2.90 a gallon. That's double what it was only a year ago. And with the cost of ethanol production around $1.25 a gallon, that works out to an operating margin of more than 50 percent.

It's no wonder, then, that investment capital is now pouring into renewable fuels. Everyone from Goldman Sachs, Bill Gates, Richard Branson and venture capitalist Vinod Khosla to any corn farmer with a credit line is getting into the game.

"We'll be the Arabs of the Midwest," John Becker, manager of an Iowa farm cooperative, told The Post's Peter Slevin earlier this month. Yeah, right.

You're probably thinking at this point that I'm dead set against government subsidies for ethanol. I'm not. Because of the economic, environmental and national security costs imposed on the country from excessive reliance on imported oil, it's probably a good idea for the government to engineer a shift to renewable fuels. But at this point, we're overdoing it.

From what I can see, the most effective policies are the ones that boost demand for ethanol until the industry has a chance to attract capital, and develop cheaper and more plentiful sources of ethanol than corn, while attaining critical mass for the distribution network. The energy bill took a step in that direction by establishing a guaranteed floor for the market of 7.5 billion gallons a year. We could double that number, as some senators have proposed. Or we could follow Brazil's lead and require that all new cars be able to run on either ethanol or gasoline, which would add about $100 to the price of a car. To overcome the natural reluctance of big oil companies, the government could mandate that each gas station provide at least one ethanol pump by 2015.

There's also an argument for a big increase in federal research spending to speed development of ethanol production based on agricultural waste material. President Bush is for that. So is Hillary Clinton.

Beyond that, however, the government needs to step back and let the markets set prices, allocate capital, choose winning technologies and balance supply and demand. Right now, all the overlapping incentives interact in ways that distort the price of corn and sugar and inflate the cost of farmland. They have created an investment bubble in corn-based ethanol that is almost certain to cause hardship and dislocation when it bursts. And, in the case of the fuel tax rebate, they may also create the perverse effect of subsidizing the already-record profits of independent refiners and major oil companies.

By contrast, a simpler ethanol strategy that boosts demand for a variety of crops for energy production could create just the right political and economic conditions to finally wipe out many agricultural support programs that cost taxpayers $20 billion a year, drive up food prices and stand in the way of trade agreements.

Think of it this way, Elmer. What we have here is a grand bargain, one that will not only wean the United States from its dependency on foreign oil, but also free you from your decades-long dependence on government subsidies while giving your kids a shot at a productive and prosperous future down on the farm. So do we have a deal?

Steven Pearlstein will host a web discussion today at 3 p.m. at washingtonpost.com. He can be reached atpearlsteins@washpost.com.

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