On May 19, President Barack Obama proposed rules requiring higher fuel-economy (and lower carbon dioxide emissions) standards for automobiles. Under the rules, new passenger vehicles and light trucks must average 35.5 miles per gallon by 2016.

The move is a major win for beleaguered California Governor Arnold Schwarzenegger, since the national rules mirror a California proposal. It is a big win for environmentalists, who have been pushing for years for more fuel-efficient cars. It's a win for the Obama Administration's efforts to get once-fractious agencies to work together, since the Environmental Protection Agency's proposed limits on greenhouse gas emissions are tailored to match the Transportation Dept.'s proposed fuel-economy standards. "Moving the two bureaucracies in lockstep is a herculean success," says ClearView Energy Partners analyst Kevin Book.

It's even a partial win for the auto companies, since they get the certainty of a national standard instead of having to meet different state rules, not to mention ending years of costly litigation over the proposed California rules. "Today's announcement on a new, harmonized national fuel economy standard is another example of President Obama's tremendous leadership ability," said Representative John Dingell (D-Mich.) in a prepared statement.

Policy Drawbacks

But what's being missed in most of the headlines is that the proposed rules could have serious negative consequences unless Washington also moves ahead on policies to increase the price of using fossil fuel. Economics professor Lester Lave at Carnegie Mellon University is one of many experts who point out that Americans won't buy higher-mileage cars as long as gasoline remains at $2 per gallon, or lower.

"Forcing automakers to produce cars that people don't want to buy is not good for employment or the environment," Lave says. And, ironically, the more fuel-miserly cars get, the worse the problem becomes.

The reason is the basic law of supply and demand. Think about the implications of raising fuel economy by 10 mpg or more. That would push gasoline demand down by as much as 2 billion gallons a year. Then add in the planned billions of gallons of additional biofuel that the U.S. government will mandate for use, rising to a total of 36 billion gallons by 2022. And if electric cars and plug-in-hybrids, which can go for weeks without using any gasoline at all, really catch on, the drop in demand could be even greater than the new rules mandate.

Gas Prices and Car Sales

Consider that the relatively small 5% drop in gasoline use in the second half of 2008 (compared with the previous year) helped push down the average price at the pump from $4.14 per gallon to $1.74. The new rules, along with biofuels and electric cars, have the potential to cut gasoline use by a staggering 15% or more. Even with global demand picking up after the recession ends, the world could be awash in gasoline. There will be a "significant erosion" in gasoline demand relative to projections, says analyst Book.

In many ways, that's a good thing. As President Obama said during the May 19 ceremony at the White House, it saves consumers money at the gas pump, reduces greenhouse gas emissions, slows the flow of dollars going overseas to buy oil, and reduces America's dependence on foreign oil.

The potential downside, though, is that the price of gas could plunge and high-mileage cars might pile up on dealers' lots. Michael Jackson, chief executive of the AutoNation (AN) chain of auto dealers, has pointed out that Toyota (TM) Priuses are worth $10,000 more per car when gasoline is $4 per gallon than they are at $2 per gallon. If gas prices stay low, consumers may continue to buy trucks and other gas hogs, forcing automakers to pay penalties for not meeting the average fuel-economy standards in the vehicles they sell.

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