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How Did Economists Blow It (Part 2)? – They Missed The Negative Externalities of America’s Limited Liability Society

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. 

Posted in: economy, Finance, New York Times, Paul Krugman, Politics, Public Policy

1 Comment

  1. knapp

    Great post!

    It makes per­fect sense to me that Krug­man would avoid the issue of lim­ited lia­bil­ity exter­nal­i­ties. Lim­ited lia­bil­ity is a “crea­ture of the law” not a “crea­ture of the mar­ket”. It is thus a govt fail­ure not a mar­ket fail­ure. To point a fin­ger at lim­ited lia­bil­ity would work against Krugman’s entire the­sis of blam­ing the free mar­ket and weaken his case for a Key­ne­sian solution.

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