Capitalism could still get a stem to stern overhaul. To keep score in the Revolution track something economists call "externalities."

10/06/2009 8:30 am EST


Jim Jubak

Founder and Editor,

“A crisis is a terrible thing to waste,” said Stanford economist Paul Romer way back in 2007 near the start of the recent (or should that be “current”?) global fiscal and economic crisis.

You certainly understand why if you take a look at U.S. economic history. Most of the time the structure of our economy seems ruled by inertia. It takes a crisis to change anything significant. It took the repeated financial crises of the late nineteenth century to produce the Federal Reserve, antitrust rules, and the Income Tax. The Great Depression to produce Social Security, the Securities & Exchange Commission, and the National Labor Relation, and more. (Hey, it was a BIG crisis.)

And what do we have to show for the crisis that has bankrupted the next generation?

Bubkis is the common conclusion. A tweak of CEO compensation here. A little cosmetic gussying up of bank balance sheets. Maybe, just maybe, some feeble protection against rapacious credit card lenders. Oh, and health care reform that is either “The path to socialism” or “Gee, I wish it went further” depending on your politics.

But compared to the bar set by the Great Depression, the Great Recession seems to have produced remarkably little change.

Well, I say it ain’t so. We’re engaged, final score isn’t in yet folks, in the most far-reaching effort to change the way that capitalism works since Bismarck invented the old age pension.

The battle ground is something economists call  “externalities.” And reforms there could reshape the economic playing field for generations to come. And not just in the United States. We’re talking GLOBAL change. Nothing that came out of the Great Depression played out on a stage this big.

Of course, the chances are that you don’t even know that this great battle is going on. That’s because “externalities” are the dirty little secret of capitalism. Nobody ever talks about them outside the pages of economics journals. But I’m here to blow the lid off and show you the importance of the changes that could still emerge from this crisis.

So what’s an externality?

Here’s a pretty standard definition. An externality is a cost or benefit that impacts society but that is not included in the market price of a good or service. The cost or benefit accrues to a party who is external to the transaction between parties in the marketplace.

Exciting as dishwater, huh?

So let’s take a concrete example recently reported in the Financial Times. The village of Hengjiang in China is home to a manganese smelter that, according to the 1,800 people who live in Hengjiang, releases vast amounts of lead into the air and water. The villagers claim that their children are suffering from led poisoning and the reporting from the village by Patti Waldmeir of the Financial Times sure argues that they’ve got a point. She cites the case of a toddler Xiao Wang who is listless, weak, and unable to control his limbs.

After three protests by the villagers the Beijing government agreed to test the children—none of the 17 tested showed elevated levels of lead, the officials declared—and to pay families $22 a month for three months in compensation. (By the way, all the evidence shows that this manganese smelter was illegal. It had never been licensed by the Beijing government even though it was owned by a Communist Party official.)

Hengjiang is an externality at work. The manganese factory sells its product to customers that may be dozens or hundreds or thousands of miles away. The factory and those consumers bargain for the best price. And that best price depends on global conditions of supply and demand.

And the villagers of Hengjiang aren’t at any time a party to any of that bargaining. Which, of course, is the way that externalities work by definition.

Capitalist markets, and China’s got many of the parts of one and globally the country certainly competes in one, are very good at keeping supply and demand in balance. Well, most of the time. (I know some home buyers and owners who would argue the point.) Well, at least in comparison to alternatives such as Soviet-style command economies, which on the record were very good at producing goods that nobody wanted.

You can even argue that we’re getting faster at cleaning up the mess created when the markets get supply and demand wrong. This is the Great Recession and not the Great Depression, after all. And the Great Depression wasn’t as great as the depression of 1837. In that crisis 40% of U.S. banks failed.

But capitalism and the markets aren’t very good at allocating costs some costs. There is, in fact, no market mechanism to take account of the cost of polluting the air and water in Hengjiang, or poisoning the children of the village, or turning the soil into a toxic material, or …

No more than there was a market mechanism for allocating the costs of externalities in the U.S. at what was the community of Love Canal but that became a toxic waste site or at the Third World garbage dumps that get paid to take First World garbage or across the globe when mercury from coal-burning power plants poisons people and animals and soils thousands of miles away.

In fact, the market is constantly at work rewarding producers and consumers who make as many of their costs into externalities as possible. That manganese producer could take the cost of taking the lead out of the smoke from its plant onto its books by buying pollution control equipment. But that would raise the price that it had to charge for its manganese in the market in order to make a profit. If it externalizes that cost—essentially by pushing it onto the villagers—it can sell for less (which makes its customers happy) and make a bigger profit (which makes its owners happy.)

In effect, the market encourages producers and consumers to push costs from the private realm—where they have to come out of private pockets—to the public purse where everybody, including people who were external to the transaction pick up all or part of the cost. (The great work on this tendency of in the market in my opinion is Garret Hardin’s 1968 essay “The Tragedy of the Commons.” You can read it here )

Let’s see pushing costs from private pockets to the public purse. Does that sound like any crisis we’re familiar with—like maybe because we’re living through it right now? (Hint: bankers are involved and so are multi-million dollar bonuses and multi-billion dollar tax-payer funded bailouts.)

And as the subprime-prime-commercial mortgage-credit-card-derivative financial crisis tells us, the question of where the line gets drawn between what is treated as a private cost and what can be turned into an externality isn’t fixed. It moves. Governments of all sorts decide where to put it. (In non-market, non-capitalist economies governments often decide where to put it by force.)

Where that line gets put is tremendously important. It decides who pays. And who profits.

 Put a tax on soda because soft drinks raise the cost to society for treating obesity-related diseases like diabetes and being a Coca-Cola (KO) or a PepsiCo (PEP) becomes less profitable.

Force banks to keep more capital in reserve in order to reduce risks lowers the chance that tax payers will have to pay for a $700 billion bailout and an $800 billion stimulus but makes banking less profitable.

And who decides where that line gets put?


I’d argue that this function of organizing where the line between private costs and externalities is draw, between who pays and who profits is one of the central functions of a government in 21st century capitalism as it is practiced in such different economies as the United States, France, China, and the Democratic Republic of the Congo.

Government, rather than wasting away as Marx so fondly hoped, has become ever more important to the creation of private profit.

That, of course, lies at the heart of the current battles in the U.S. and elsewhere about financial regulation and health care reform. Where does the line get drawn on who pays for what costs? If you think of it this way, it’s easier to understand why companies spend so much money hiring lobbyists and contributing to political campaigns. In many cases that spending is the single most important determinant of the level of company profits.

The puzzle isn’t why companies spend as much as they do but why they don’t spend more.

The fights over financial regulation and health care reform don’t blaze new ground in this battle. Although the outcome will determine profits and costs for a decade, I’d estimate. We’ve been down this road plenty of times on clean air, on auto safety, on highway spending. Making sure that another 40 million people have health insurance is a truly important goal--I'd agree with those who call it a moral imperative--but it's also just the long-delayed extension of what we began with Medicare and Medicaid.

The real revolutionary potential lies in the coming debate over global climate change. Costs are going to be massively moved around the economy just as they will be in the battles over health care and financial reform. Nothing new there even though the scale will be huge.

But this will really be the first time that the world has tackled the issue of externalities on a global basis. There’s no way to attack the problem without taking a global look at what we define as an externality. A coal-burning plant in Ohio creates an externality for people in Greenland, Australia, the Sudan, and Ohio.

And it will be the first time that the globe has tackled the question of externalities over a long time period. The carbon dioxide released thirty years ago in Pittsburgh by a steel plant that no longer exists has created an externality for people living today.

I think the evidence for global climate change based on the increased release of greenhouse gases resulting from human activity is convincing. Maybe you don’t. And if you don’t I’m sure I’ll hear from you.

But it isn’t the science, right or wrong, that’s revolutionary here.

It’s the capitalism.

It's the effort to think about how to allocate costs in a global economy that’s the big new thing. We’ve never tried this before and it’s absolutely essential that we learn to think this way if globalization is to result in anything more than the survival of the most connected.

Maybe you remember globalization. Before the financial crisis it was the BIG problem confronting the world. How do you keep jobs from flowing like water to the cheapest labor markets? How do you prevent the countries with the weakest environmental and labor standards from gaining an unfair edge?

Well, the financial crisis sure didn't solve any of those problems. And it didn't make them go away.

Too often globalization has turned into a race to the bottom, a race to see who can make it cheapest by cutting whatever corners can be cut.

The debate about climate change is our first global effort to see if we can agree that some corners shouldn’t be cut—no matter how hard the market pushes us in that direction.

And if the debates over health care reform and over financial regulation provide a dry run that results in a breakthrough global effort to figure out where to draw the line on externalities, then we won’t have wasted this crisis after all.
  By clicking submit, you agree to our privacy policy & terms of service.

Related Articles on STOCKS

Keyword Image
Crude March Madness
03/22/2019 10:48 am EST

Energy markets are experiencing their own March Madness, notes Phil Flynn, senior market analyst at ...

Keyword Image
ET: An MLP to Phone Home About
03/22/2019 5:00 am EST

A couple of weeks ago I had an extended exchange with a friend of mine who is an oil man in Oklahoma...