The only engine improvements domestic manufacturers were making was for road racing and the drag strip. There were no 500 horse 25 mpg cars in the 60's, but there were 500 horse small blocks and big blocks getting single digit fuel economy numbers. The Japanese manufacturers crippled the domestic car market by creating the exact competition you mentioned, but only after the EPA stepped in. There really wasn't a buyer for small, fuel efficient cars before the EPA, so the Japanese builders could not compete in the USDM.
There are some areas the government has overstepped, but they are generally few and you only think they overstepped because large corporations make you think so. The only person losing money with regulation are businesses, not consumers. I'm so glad I don't have to smell the stench of dirty paper/pulp wood plants, smoggy coal plants, etc. etc.