How do you make car companies innovate? Regulate them

It's a given of modern free market analysis: The best help a government can offer business is to keep its hands off.

Minimal regulation, low interest rates, low taxes are the only exceptions. Maybe occasional transfers of your money into the hands of large corporations to "incentivize" them.

• Ford wheeling and dealing over your tax money: Don Pittis

If the recent mismanagement of everyone's money by deregulated banks didn't make you suspicious of the argument, a new tidbit out this week clinches it.

Remember how all the carmakers complained about the CAFE Standards? Those were the rules set in California, but adopted by the U.S. and Canadian governments, requiring cars to use less fuel. The rules set firm targets, demanding that fleets hit 4.3 litres per hundred kilometres by 2025. (That's about 65 miles per Canadian gallon and 54 per U.S. gallon for those who never learned to convert.)

"Impossible!" said the carmakers. "It places an unfair burden on passenger cars," said Volkswagen executive Tony Cervonein 2011.

Well, now the credible business adviser Boston Consulting has issued a report showing that not only have the car companies accepted the challenge, but that the rules have driven arenaissancein automotive R&D.Even the most staid car companies are bringing out hybrid vehicles and toying with all-electrics.According to the report, about half of the most innovative companies in the world are now automakers.

True, the tech giants Apple, Google and Samsung top the list, but with nine of the top 20 positions, carmakers outnumber those in the technology company category overall.

Finding the right problems to solve

This supports an argument I have made before, which is that while markets are brilliant at solving problems, they are not always the best at choosing the right problem to solve.

Miners, for instance, do tremendous work getting gold out of the ground, moving tonnes of rock and ore for a few ounces of the yellow metal and processing it using complex chemistry and technology. But unless its a requirement, spending on environmental clean-up is seen as a waste of money, even if it will poison future generations.

The advantage of government regulation is that it creates a challenge that companies must face and solve. It releases the power of the market, as successful innovators succeed and the laggards fall behind.

Not all regulation is equally successful. Companies facing regulation invariably declare that the rules will make it impossible to do business, that government interference will kill jobs.

Certainly red tape can give power to arbitrary bureaucrats, adding absurd costs and creating delays. In a world with differing national standards, companies can move their businesses to the places with the most lax and thus cheapest rules.

The great success of the car fuel economy regulation was that it did not try to micromanage. It was simple and explicit. It did not try to measure intangibles like the carbon cost of manufacturing. It set a specific target at a single point in the industrial process consumer fuel efficiency and made the rules the same for everyone, no matter where the car was manufactured.

And most important, it had two clear simultaneous goals. It lessened U.S. demand for imported oil, and it reduced carbon released into the atmosphere.The cost to the taxpayer was small.

Now that we and our governments have seen that this is a tool that works, it is time to use it more broadly. The place to start? How about with the biggest criticism of the new CAFE standard by that VW executive, who complained that the rules hurt cars in favour of trucks, which face much more lenient efficiency rules.

"The largest trucks carry almost no burden for the 2017-2020 timeframe, and are granted numerous ways to mathematically meet targets in the outlying years without significant real-world gains," said Tony Cervone.

"The proposal encourages manufacturers and customers to shift toward larger, less efficient vehicles, defeating the goal of reduced greenhouse gas emissions."

It is time to crack down and make trucks and SUVs a lot more efficient.Let's use regulation to stimulate innovation and release the enormous power of capitalism.