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September 19, 2005

The Problem of Externalities

"Externalities" is a key word to remember. It means the negative side of economic activity — pollution, etc. — that is not factored into the costs and profits of companies. A commons-based approach to capitalism could remedy this growing problem.

The biggest defect of modern capitalism can be expressed in a single word: externalities (or illth, if you prefer John Ruskin’s prose). Either term refers to the harmful side-effects that accompany current economic activity: pollution, congestion, noise, cancer, stress, extreme inequality, loss of biologic and cultural diversity, and so on.

One way to evaluate the performance of an economic system is to look at the ratio of well-being to illth it produces. This is akin to the way engineers measure the efficiency of an engine: for every unit of energy an engine consumes, it performs some useful work and wastes some heat. The higher the ratio of work to wasted heat, the greater the engine’s efficiency.

Mainstream economists, alas, don’t measure the performance of our economy this way; their excuse is that externalities are difficult to quantify. They assume — because it’s convenient rather than because it’s true — that externalities are extremely low and can therefore be ignored. They imagine, in other words, an economic engine that runs near 100 percent efficiency in generating positive benefits.

While this assumption may have once been acceptable, it withstands no scrutiny today. Suffice it to say that, nowadays, harmful externalities are enormous; it’s even possible they exceed the benefits of economic activity (i.e., that our economic engine is less than 50 percent efficient). This represents such a dramatic decline in marginal utility that it demands not only explanation, but correction.

The former, of course, is easier than the latter. Growth of negative externalities is a result of several factors, the most obvious of which are changes in human population and technology. We are no longer small bands of hunters, gatherers, farmers and artisans; we are industrialists, chemists, shoppers and SUV drivers — and there are 6.5 billion of us. Our aggregate activities heavily affect our neighbors and our planet. In fact, we’ve pushed many vital ecosystems to the point where unpredictable, non-linear changes are occurring.

A less obvious but equally potent cause of illth is the behavior of modern corporations. Their profit-maximizing algorithm makes them shift as many costs as possible to workers, taxpayers, nature and future generations, all of whom are off their balance sheets. As investment manager Robert Monks has noted, “The corporation is an externalizing machine in the same way a shark is a killing machine. There isn’t any question of malevolence or of will. The enterprise has within it, as the shark has within it, those characteristics that enable it to do that for which it is designed.”

How might illth creation be diminished? For decades, economists have agreed we’d be better off if businesses “internalized” their externalities — that is, paid in real time the costs they now shift to others. The problem is, there’s no one in the market to set prices and collect them.

In 1920, British economist Arthur Pigou suggested that government might play this role: it could tax unwanted activities such as pollution, thereby raising their prices and discouraging them. The trouble is, this has turned out to be politically impractical.

Think of a real example here: carbon taxes. A tax on carbon emissions could, in theory, reduce global warming. But in order to make a difference, the tax would have to get extremely high. This means Congress would have to raise the prices of gas and electricity year after year, hitting every business and consumer in the pocketbook. That’s an improbable scenario.

In 1960, University of Chicago economist Ronald Coase came up with another idea: use property rights to set prices for externalities. For example, if pollutees had a right not to be polluted, they could cut deals with aspiring polluters: for such-and-such a price, we’ll accept so much of your pollution. Government’s job would be to create the appropriate property rights, then let markets set pollution levels and prices.

In my view, Coase’s approach is the way to go; the trick is getting the property rights right. Individual pollutees are in no position to negotiate with corporate polluters. The right not to be polluted needs to be a collective right, and pollutees — both present and future — need to be represented by competent agents.

Those agents, as I suggested earlier, ought to be trusts accountable to future generations and living citizens equally; what are now unstoppable externalities would become property rights owned and managed by such trusts. The trusts would set steadily lower pollution levels and collect the fees paid by polluters. They’d then divide that revenue among pollutees and/or invest it in public goods.

Prices of pollution-laden goods would rise, but so would the incomes of consumers. Those who avoid pollution-laden goods would come out ahead; those who indulge in such goods would pick up the tab. What better or fairer set of incentives could we devise?

Illth, of course, will never completely go away; it’s inherent in the nature of all things. But a properly designed economic system, with the right kinds of feedback mechanisms, would go a long way toward reducing it. We don’t have much time to lose.