Paul Krugman’s New York Times Magazine article of September 6th maintains that externalities are the most important factor in market failures, but then never considers whether or not large “externalities” caused the failures of 2007. By ignoring externalities, the usually brilliant Mr. Krugman illustrates why economists didn’t see the market crash and Great Recession. The unintended and unrecognized effects of negative externalities were probably the largest factor that contributed to the summer of 2007crash, yet economists virtually ignore these cultural and sociological phenomena that almost resulted in economic seppuku.
Mr. Krugman wrote a single sentence about externalities when he said “…economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities” – costs that people impose on others without paying the price, like traffic congestion or pollution.”
According to Wikipedia (which has a pretty good article on externalities): “In economics, an externality or spillover of an economic transaction is an impact on a party that is not directly involved in the transaction. In such a case, prices do not reflect the full costs…of production…or a product or services…In a competitive market, the existence of externalities would cause either too much or too little of the good to be produced or consumed…If there exists external costs such as pollution, the good will be overproduced by a competitive market, as the producer does not take into account the external costs when producing the good…economics has shown that the existence of externalities result in outcomes that are not socially optimal.”
A good web site for first year economics students, Tutor2u also has a description of externalities. “Externalities are common in virtually every area of economic activity. They are defined as third party (of spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid…Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption…This leads to the private optimum output being greater than the social optimum level of production. “
A little bit of translation is needed at this point. Bubbles are characterized by an unsustainable “over-production” or “over-consumption” of a good or service. For example, the housing bubble was the over-production of homes to satisfy the over-consumption of housing by consumers. First year economics students are taught that externalities are one way that bubbles are created. The housing bubble is a text book example of production and consumption being greater than is socially optimal. Sooner or later in most large negative externalities the true cost of production catches up with the market. In the case of pollution, the environment becomes so polluted it cannot absorb any more discharge and production that is polluting must change. In the case of housing, society couldn’t keep on subsidizing the cost of homeownership and the value of homes crashed.
Economists almost always cite the same examples of negative externalities that cause over-production of a good or service. The examples that they look to are usually physical phenomena such as pollution, traffic, noise or crime. These are externalities that are easy to measure and easy to quantify. Everyone can understand that if a polluter doesn’t have to pay for the cost of his pollution, production costs will be understated and since the producer isn’t absorbing the full costs of production he will over-produce the item causing pollution above the socially optimal amount.
However, non-tangible externalities are tough to recognize, quantify and analyze. For economists to understand non-tangible externalities, they need to be psychologists, sociologists, lawyers and behavioral experts. These are social science disciplines that economists are notoriously bad at mastering and often considered beneath their position in academia.
Economists stopped worrying about the economics of externalities more than thirty years ago when they mastered the math of physical externalities. Externalities aren’t considered a “sexy” topic for economics PhD candidates. If an economist wants to get a good position in a desirable university or think tank he had better write a complicated paper based upon indecipherable mathematic models and formulas. Focusing on soft topics like the nature and cost of creeping changes to our legal system or changes in the sociology of groups aren’t great topics for an ambitious economist.
Perhaps the biggest new externality of the last fifty years is the expansion of limited liability to almost all corners of our lives and business transactions. Fifty years ago limited liability was a concept that was restricted to shareholders in corporations; i.e., the amount that that passive shareholders can lose from an investment in a corporation was the amount of their investment. For example, if an investor buys stock in “Sunshine Widgets”, a hypothetical NYSE traded company, the maximum amount that the investor can lose is the cost of his stock. The theory behind limited liability corporations is that it would be impossible to fund large corporations if passive shareholders were exposed to unlimited liability for losses incurred by management.
However, over the last fifty years limited liability has been expanded to all sorts of businesses, business owners, consumers and transactions. Today it is culturally acceptable for people to walk away from their mistakes and have someone else pay for their losses. Limited liability is the mother of all externalities and economists almost uniformly missed it.
Perhaps the biggest of all the limited liability externalities, is the limited liability of consumers when they finance homes. Notwithstanding what the contracts say, homeowner liability is almost always limited to the amount of the down payment. If the value of a homeowner’s house is less than the amount owed on the mortgage note, the homeowner can default his mortgage and walk away without paying the deficiency.
Lenders’ being financially responsible for bad homeowner decisions isn’t the way things used to be done in America. When I was a child my parents taught me that our family had to pay to the bank the entire amount of our mortgage loan, no matter what. American culture didn’t have exceptions to the rule that families had to pay back the bank. Today, this is a quaint idea from a different time and place.
Limited liability for homeowners changed consumer behavior and encouraged over consumption of homes. After all, if homeowners don’t have to live forever with a bad purchase decision or a failure to maintain their home, why rent. Buying is a much better option in the age of limited liability. This became especially true when required down payments shrank for many homeowners to about the same size as the amount that they would have to give to a landlord for first and last month’s rent and security deposits. Economists missed this essential change and didn’t warn policy makers that modifications to public policy were needed to avoid a housing bubble.
But, our limited liability society doesn’t stop with mortgage debt. Limited liability in commercial transactions has extended far beyond large corporations. As a practical matter all sorts of non-corporate businesses and transactions have limited liability; even when business owners provide personal guarantees. It doesn’t take long for commercial lenders to learn that personal guarantees are largely unenforceable in America. Only the grossest frauds result in recourse being enforced. As a result, the cost of business credit is higher, and the availability of business credit is more limited, than optimal. In part because of shifting the cost of business failure from owners to lenders it shouldn’t shock anyone that most small business lending moved from banks to higher cost non-bank finance companies and now non-bank lenders are having trouble getting funded. The unintended side effect of shrinking credit is contributing to the declining U.S. manufacturing sector and job losses.
The culture of limited liability has changed the financial services and banking industry. The issues of too big to fail and moral hazard are nothing new. But, in the bank and thrift crisis of the late 1980s bank managers, executives and board members were often held personally responsible for bank failures and FDIC losses. The regulators looked at regulatory filings and reports to see if there were reporting errors or a failure to follow safe and sound banking principals. Inevitably there were problems and the executives were held responsible for their mistakes. Back in the 1980s and 1990s there were scores of criminal and civil prosecutions of banking executives and, not surprisingly, bank executives worked hard to avoid unsafe and unsound procedures that would cause failure. This time around, there are almost no enforcement actions against officers and directors of failed banks. The penalty for bank executives messing up is limited to losing their current job but does not include being banned from the industry, paying back past compensation or, in some cases, serving jail time. Again, if economists were doing a good job they would have anticipated that the cost non-enforcement of bad employee behavior would result in more risky banks.
Unfortunately, economists are good at measuring physical things but not emotions, human nature or behavior. When the economy blew a big housing bubble, economists assumed away the observed anomalies by concluding either that by definition bubbles can’t exists in a market economy or that the economy wasn’t operating in a logical or efficient manner. When limited liability was expanded to small business it never occurred to economists to look at the secondary unintended effects of changed behavior and distribution of economic costs. And, when the rules for bank officers and directors changed to limit their liability, economists failed to recognize that higher risk banks would result.
Even worse, it has never really occurred to economists that while their theories about efficient markets and logical behavior are pretty good, the fundamental application of these theories stinks because they do not understand American society and how it changes over time.
There are scores of externalities in the U.S. economy yet precious little work is being done to anticipate their costs and ramifications. Inadvertently, Mr. Krugman accurately depicted the problem – he was correct when he stated that the biggest reason that markets fail to optimize behavior is externalities and then showed how economists blew it by ignoring the obvious problem of identifying current externalities. Instead, he gave readers a history lesson in how economists assumed away observed behavior that they couldn’t explain instead of challenging the most basic of their underlying assumptions. Of course, since most economists missed the existence of externalities, their analysis was irrelevant to actual events.
Economists that continue to assume away externalities do so at their peril. While much of the time it will seem like they know what they are talking about, they will miss the most important trends, bubbles and movements of the U.S. economy.