Global market failure and the necessity for a new world

As the globe heats up and anger boils at the inequities of wealth and power so market failure becomes one of the world's hottest topics, with good reason for the greenhouse effect and the economic crisis are types of market failure that strike upon us all.

One form of market failure is due to what economists call "externalities". These arise when the profit or benefit driven actions of individual economic agents have uncompensated impacts on third parties.

When externalities are present market outcomes are not socially optimal.

Pollution, for instance, incurs a cost upon others that a polluter need not pay in a free market. Because the cost is not incurred by the polluter, it is in effect externalised, too many products are being produced than is socially optimal. This is an example of a negative externality.

However, in the case of positive externalities it is benefits, rather than costs, that are externalised. Production of goods, most especially public goods such as knowledge, can lead to benefits for users that are not reflected in the recompense received by producers. A producer in effect is providing benefits for others at their own cost, so the benefits of production in this case are externalised. When positive externalities exist free markets produce too few resources than is socially optimal as relatively little profit is derived from doing so.

Markets, far from producing and allocating resources in a goldilocks like fashion, can produce too few resources or far too much from a social point of view. A global externality would be an externality whose causes and/or consequences can be described as being global in scale.

Many of the most important global crises today, for example the financial crisis and climate change, can be described to no small degree as market failures arising from externalities.

As we move toward a global economy, which includes the development of more globally integrated markets, we would expect such externality effects to become increasingly global. Globalisation surely will result in externalities of planetary scale. Furthermore, global externalities challenge our international political architecture, which is based on the particularistic state. 

Milton Friedman, the noted free market economist and ideologue, had always argued that externalities are small and of little significance. Nothing demonstrates better the fallacy of his reasoning than the existence of global externalities.

Let us, briefly, consider our two examples of a global externality; the global financial crisis and global warming.

The global financial crisis, to a very significant extent, can be described as an externality because crucial to its development was the under-pricing of risk by financial institutions. The pursuit of bedazzling short term profits was a risky venture but so long as the costs of a wider systemic breakdown of the entire financial system could be externalised on to society, as it was, then financial institutions had little heed to account for its cost nor possibility when engaging in highly leveraged activities.

The cost to society of systemic breakdown of the financial system can also be measured in the way that the financial crisis has impacted the real economy through unemployment, lower wages, and all the other social effects associated with debt deflation.

That the under-pricing of systemic risk in financial markets could lead to financial instability, which then impacts the real economy through liquidity and solvency crises, had been an important, though ignored, staple of heterodox economics throughout the neoliberal era.

Neoclassical economics itself was an externality; there was too much credence placed upon it, and there was far too much of it in our universities than was socially optimal. Universities, economists, and banks derived the benefits from widespread belief in its verities whilst everybody else paid the costs.

What has made the ongoing financial crisis decidedly global, the European debt crisis represents a continuance of the original, is that the financial system created by neoliberal financial market deregulation following the "Nixon shocks" of the early 1970s has led to the development of internationally integrated financial markets characterised by tight coupling and non linear interactions between its constituent parts.

Systems that are tightly coupled and exhibit unpredictable non linear interactions are subject to what, in the context of technology, Charles Morrow referred to as “normal accidents.” There exists no reason why Morrow's insights and conclusions should not also apply to social systems. Normal accidents are system wide breakdowns that cannot be predicted in advance but whose occurrence are inevitable. So long as we have a highly deregulated, tightly coupled, global financial system normal accidents are inevitable.

Greater economic integration means that the effects of financial instability upon the real economy will also become increasingly global. In the wake of the liquidity and solvency crisis of 2008 the Baltic Dry Index, which provides an insight into global trade and production trends, went into a sharp downward spiral much like the US real estate market. A global recession followed.

What of our second example, global warming?

Sir Nicholas Stern, upon handing down his key report on the economics of climate change, described it as the "greatest market failure the world has ever seen." This failure is also due to an externality. This is of the familiar type arising from pollution, in this case the emission of greenhouse gases.

Here the externality also is global, but not because of a global economy. The problem arises following upon the emission by many individual firms, and to a far more limited extent, householders, of greenhouse gases into a globally integrated ecological system. The externality becomes global for the costs of climate change, which fall upon all of us as we all depend upon the biosphere, are not reflected in the costs of production of greenhouse gases.

The biosphere is a self regulated federation, as it were, of ecosystems upon which the health and vitality of life depends. The climate system is a global one, and when the global climate system changes it too has feedback and knock on effects that affect life on a planetary scale. Ours is a global ecological crisis that is affecting much of the organic world, as evidenced by a creeping sixth mass extinction of life on Earth.

When the biospehere falls under stress all of us fall under stress.

Mainstream economists have identified three main ways of mitigating externalities. The strategy is to internalise the external effects of individual actions upon others either through taxes, market based schemes that try and develop price signals, and regulation.

It is the purpose of our political institutions to craft and enforce these remedies. At the global level that requires cooperation and coordination among states.

States are amoral interest and power maximising entities and to the extent that they are free of popular pressure, either through force or a system of propaganda that controls the public mind, are no less amoral than corporations. Furthermore, they are tightly linked to the economic institutions that dominate the societies of which they are a part.

Although in standard international relations theory the international system is seen as being anarchical it is in reality quite hierarchical.

International relations, pretty much throughout the modern era, has been dominated by a few great powers dedicated to advancing their own peculiar interests and the dominant social sectors within their borders. These great powers have set the contours of world order based on the maxim that the strong do what they can and the weak suffer what they must.

The global political system is best characterised as a form of state-corporate mercantilism where the dominant powers advance the interests of the mutinational corporations that are headquartered within their borders.

So long as the international system is largely structured by states pursuing the mercantile interests of corporations the mitigation, let alone eradication, of global externalities  becomes difficult to envision as the negotiations over both global financial market regulation and a global  mechanism to combat global warming demonstrate.

But hope there is.

The standard account of externalities cannot be described as being a general theory, as it applies to markets only. However, the Soviet system of state directed central planning was a polluters paradise so it thereby also exhibited powerful negative externality effects.

The Western analyst of Soviet economic affairs, Marshall Goldman, characterised the collapse of the Soviet economy as a “supply side depression” as it produced too few consumer goods despite the existence of demand for them. The Soviet collapse, then, was a type of economic failure partly caused by positive externalities for Soviet planners did not receive adequate compensation from the state for the production of consumer goods.

A general theory of externalities would need to account for externalities in both the market and central planning cases.

At the core of externalities lies the issue of participation. Externalities arise when people are being effected by economic dynamics but without fully participating in them. This is where the libertarian left vision of a federation of worker and community owned and managed economic institutions operating on principles of participatory democracy is unique. Such a federal order would encompass the local, regional, national and global levels.

Such an arrangement of economic affairs is highly participatory and so thereby would be characterised by limited externalities. Such an arrangement, in short, contrary to the common refrain, would more closely approximate a socially optimal production of resources than would a capitalist or centrally planned economy.

The development of a global social movement demanding, firstly, the mitigation of global externalities through resistance and direct action, such as of the type that occurred with Occupy Wall Street on finance and with the global mobilisation on climate action, is a necessary first step in the right direction.

Upon this burgeoning movement the prospects for meaningful human survival much depend.

The most pernicious global externalities may well be too much pessimism and precious little hope.