A Revolution in Reckoning Who Pays

10/06/2009 9:41 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

The biggest reforms to emerge from the current crisis will be global changes in the ways companies are held accountable for the huge, hidden costs now foisted on the public.

"A crisis is a terrible thing to waste."
- Stanford economist Paul Romer

Most of the time, the structure of our economy seems ruled by inertia. It takes a crisis to change anything significant. And what do we have to show for the crisis that has bankrupted the next generation?

Bupkis is the common conclusion. A tweak of CEO compensation. A little 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 "useless without a public option," depending on your politics.

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

A Giant, Secret Global Battle

Well, it ain't so. We're now engaged in the most far-reaching effort to change the way that capitalism works since Otto von Bismarck invented the old-age pension. I'm talking about reforms that could reshape the economic playing field for generations to come. Not just in the United States, but globally.

Of course, chances are you don't even know that this great battle is going on. That's because it involves the dirty little secret of capitalism: "Externalities." Nobody talks about externalities 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 affects society but is not included in the market price of a good or service. The cost or benefit accrues to a party external to the transaction between parties in the marketplace.

That's kind of abstract, 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 there, releases vast amounts of lead into the air and water. The villagers say their children are suffering from lead poisoning.

Hengjiang is a classic externality. The manganese factory sells its product to customers that may be 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. The villagers of Hengjiang aren't a party to any of that bargaining, but they get stuck with the cost of treating health problems caused by the factory.

Capitalist markets—and China's got many of the parts of one—are very good at keeping supply and demand in balance. But capitalism and the markets aren't very good at allocating costs when externalities are involved. There is, in fact, no market mechanism to take account of the cost of polluting the air and water in Hengjiang.

On the contrary, the market is constantly at work rewarding producers and consumers who turn as many costs as possible into externalities. The manganese producer could take on the cost of removing the lead from the smoke coming out of its plant by buying pollution-control equipment, but that would raise the price it has to charge for its manganese in order to make a profit. If it externalizes that cost—in this case 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 come out of private pockets, to the public purse, where everybody has to pick up the cost. (The great work on this tendency of the market, in my opinion, is Garrett Hardin's 1968 essay, "The Tragedy of the Commons" (.pdf file).)

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Where to Draw the Line?

Pushing costs from private pockets to the public purse—does that sound familiar? Maybe the financial crisis we're living through right now?

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.

Where that line is drawn 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 (NYSE: KO) or a PepsiCo (NYSE: PEP) becomes less profitable.

Force banks to keep more capital in reserve in order to reduce risks that taxpayers will have to pay for a $700 billion bailout and banking becomes less profitable.

And who decides where that line is? Government.

I'd argue that this function of deciding where the line between private costs and externalities is drawn, between who pays and who profits, is one of the central functions of a government in 21st-century capitalism, whether you're in the United States, France, China, or the Democratic Republic of the Congo.

That issue lies at the heart of the current battles in the US 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, even though the outcome will determine profits and costs for a decade. We've been down this road plenty of times on clean air, on auto safety, and on highway spending.

A Revolutionary Rethinking

The real revolutionary potential lies in the coming debate over global climate change. Costs are going to be massively moved around the world economy. Nothing new there, even though the scale will be huge.

But this will really be the first time 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 externalities. 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 the globe has tackled the question of externalities over a long time period. The carbon dioxide released 30 years ago by a steel plant in Pittsburgh that no longer exists has created an externality for people living today.

The evidence for global climate change based on the increased release of greenhouse gases resulting from human activity is convincing. Maybe you don't agree. 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 effort to think about how to allocate costs in a global economy that's the new big 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.

Too often globalization has turned into a race to the bottom, a contest to see who can make what cheapest by cutting any corners that can be cut—decent wages, pensions, health benefits, child-labor laws. This debate will be our first global effort to see if we can agree that some corners shouldn't be cut—no matter how hard the market pushes.

If the debates over health care reform and financial regulation provide a template for a breakthrough global effort to figure out where to draw the line on externalities, then we won't have wasted this crisis after all.

At the time of publication, Jim Jubak did not own shares of any company mentioned in this story.

More from Jim Jubak:

After the Crisis, What Will Be the New "Normal?"

View the complete Jubak Picks Portfolio here

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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