The lies of Laissez Faire: Externalities

This article is first in a of series of articles I will publish over time where I try to point out the inconsistencies and intellectual dishonesty found within laissez faire philosophies.  As much of the anti-government rhetoric we hear today is phrased in terms of being economic science, it is important to scrutinize the supposed scientific facts on which it is based.  Today I will be focusing on the topic of negative externalities.

Externalities create a special problem for laissez faire economics, because if voluntary economic activity between two parties adversely affects an unrelated 3^rd party, it constitutes an encroachment or trespass on that 3^rd party.  And since encroachment on the person is a cardinal sin in libertarian ethics, the existence of such would justify some sort of action to correct it.

Free market economists often try to minimize the importance of externalities or create the impression that most externalities are only caused by the state.  Friedman and Hayek went as far as to label them “the neighborhood effect” as if to imply that they really aren’t a major deal.  Dismissing externalities as the neighborhood effect is convenient for Hayek and Friedman because it implies: 1) most externalities are local in scope and confined to a small area; 2) limited to a single activity or transaction at a time; and 3) can be dealt with by individual action, for example, the residents of a street can bring an action in equity against a local business that is creating loud noises in the middle of the night and preventing them from sleeping.  Thus, state action is not needed because citizens can take care of it themselves.

This conception of externalities is however horribly short sighted.  Certainly a nightclub or paint factory is going to be creating conditions which local citizens can address on their own using the court.  But what about externalities which affect more than just a few people?  What about externalities which affect entire populations or society in general?

Perhaps the greatest examples of these kinds of externalities can be seen in pollution and ecological problems.  There is no doubt that human activity can affect these, and that things like smog or water pollution can cause adverse effects on others with real economic costs.  For example, exhaust from cars causes much pollution in cities, and smog can affect people’s respiratory health.  Can an individual deal with these externalities in the ways that free market economists expect people to (i.e. courts of equity and individual action)? 

This would be a difficult thing to do, for one, while no one would argue that car exhaust in cities can cause real costs to individuals, chances are that on an individual basis, the costs may not be large.  I may only lose around $70 a year from car exhaust living in a city from costs incurred in buying allergy medicine and a few lost opportunity costs in dealing with or remedying respiratory irritation.  That is hardly enough to justify bringing an action in Court, where attorney’s fees, court costs and the costs involved in expert evidence and data (to prove my losses were caused by car exhaust) would greatly outweigh my costs in simply buying some Claritin and dealing with it.  This seems to negate the argument by thinkers like Mises and Coase that externalities can be corrected simply by having better defined property and individual rights.  Even if this were the case, many externalities are so miniscule on the individual that the opportunity costs of bringing court action simply isn’t worth it. In fact, many individuals may not even be aware of what is causing their problem and know who to sue to get relief.  And when the class of “victims” of such externalities are so large as to encompass an entire population, there is really no reasonable way for such an issue to be dealt with by individual actors alone.  Yet, this is still no small matter, for even if my costs are only $70 a year, in a city of millions people that amounts to hundreds of millions of dollars being imposed on the city in its aggregate.   Hundreds of millions of dollars of costs which are unable to be dealt with in the individual equity-like way that free market advocates hope for.

Now to get around this problem I could perhaps try to bring a class action suit representing all the citizens of the city, but then again, who will I sue?  Should I sue every car owner?  That would include the people I am representing, even myself, would we be suing ourselves?  That would go into the realm of legal impossibility.  Obviously if an externality can be traced to one source you know who the defendant will be, but when the externality is created by multiple players (such as a polluted river with dozens of factories on its shore) it becomes much trickier.  After all, if a river is polluted it doesn’t mean that all factories are guilty, some may actually be extra attentive and go out of their way not to pollute, while others don’t care.  Would it be fair to sue those factories who were not actually causing the harm?  And many drivers too may go out of their way to have vehicles which don’t emit harmful emissions.  Should I sue only those who don’t have clean cars?  It would be nearly impossible to identify and find all those people, and the notion of enforcing an action in equity on an entire city from court decree alone is rather insane, you would merely be replacing government regulatory activity with a court, but in a much more contrived and dangerous manner.

Perhaps I should sue the city council itself for not having adequate emissions standards.  And indeed in most common law countries this would be the most reasonable course of action.  But of course, by doing that I am assuming that the government entity I am suing would or should have the power to create and enforce regulations in the first place, and this is something free market enthusiasts don’t want.  If the government were to be set up so that it had no power to make such regulations over people, I could not sue it.  And given the practical impossibilities of suing all drivers I may not have anyone to sue at all.

Of course if I am creative I may sue the car manufacturer’s themselves for not making cleaner vehicles, this could perhaps work, but it would not give me any immediate relief.  I could perhaps get all new models to be made cleaner, but that doesn’t get the dirty cars off the road anytime soon.  The cars which are causing my respiratory distress are privately owned and beyond the control of car manufacturers.  Furthermore, the problem of car exhaust may only be an issue in cities themselves, by attacking the auto industry as a whole I could be putting unneeded costs on people in rural areas where car exhaust is not a major problem.

With all these options exhausted (pun intended), I would most likely be left to my fate and stuck with putting up with the encroachment on my person that is car exhaust.  And free market advocates would probably agree that I should just do nothing, after all its only $70 a year it’s costing me.  But if I live in a city of a million people that means that the total costs of the externality is actually $70, in which case we are talking about some pretty significant costs.  Environmental externalities are some of the most insidious ones because of this, their effects on any individual may be small, but as a whole they can be enormous, and given their nature, they are nearly impossible to correct by traditional legal means.  Climate Change is perhaps the mother of all externalities, slowly building up emissions which could cause catastrophe in the future.

Even $70 million may not seem like a whole lot to many advanced cities, but these kinds of costs from externalities exist all over the place, and can cause death by 1000 paper cuts if they grow too weighty.  Indeed, one of the major causes of the business cycle in my opinion is that in a monetized economy many people have the impression that all costs and benefits can be expressed in pure monetary terms, however, at the peripheries we find many costs which are not being reflected in monetary terms.  And although they are not being figured into monetary calculations, those costs are still present, and in the right set of circumstances the weight can be enough to have those costs come crashing in and bring the market’s monetary value back down to its real value.

In dealing with these smaller peripheral externalities like environmental pollution, state action is the most logical choice.  By enforcing regulations which force actors to conform their behavior, we are actually sending a signal which does reflect the real costs and value of this activity.  It is simple and easy for a city council to simply pass a law which requires emissions standards in vehicles, and in fact humanity has set up government for purposes such as these.  Government regulation is merely a natural process used to identify and correct certain costs from things like externalities which are not being expressed in monetary calculations.  By creating a regulation which imposes a duty on a private actor, the government is actually monetizing those costs so that the real costs are now being reflected in markets.  And the more our monetized economy reflects reality, the better it will function.

Now this concept I am conveying is essentially that of external costs (which one can read about more in depth on the Wikipedia link I provided at the top of the page).  As the argument goes, a free market is actually inefficient by allowing business entities to externalize the costs of certain economic activities onto the public which incur costs on society which are not reflected in prices and thus are not creating benefits to the same extent that they are creating harm.  Thus while free market advocates claim that their system is one which adequately balances costs and benefits, it in fact does the opposite and creates extra, unnecessary costs which not only hurt individuals but hurt markets as well. 

Pundits complain that regulations create costs for businesses, but that is exactly what they are supposed to do!  A good regulation is supposed to take these real costs and make so that they are expressed in monetary terms and taken seriously by firms, this reduces externalities and actually improves the sovereignty of the individual because now they do not have externalities imposed on them.  Libertarians should be embracing regulation if they truly care about the individual.  Markets like regulations because ultimately externalities are bad for markets by imposing costs on it, governments with regulatory powers and markets go hand in hand and always have.  The laissez faire characterization of collective action as emotion stirred mobocracy is pure nonsense, there is a real reason for its existence, it serves a vital role in helping to guide markets and reflect true costs.  The libertarian characterization of government action often described by the Austrian School or Public Choice Theory is nothing more than a conspiracy theory designed to cast it in a negative light rather than an actual objective view of collective action and what its role is in human society.

Now it is true that some regulations may be done in a poor fashion, and some may not be needed at all.  But then again, many business actions are done in poor fashion and are not needed.  Humanity is an imperfect species and individuals, firms and governments are imperfect actors.  As long as corrective measures as in place (for businesses the market can decide if an idea is bad and deserves to fail, for governments democracy, public opinion and successive administrations can correct bad policies), in the long run society should be fine, and the existence of regulatory institutions like governments are a good thing.

Thus externalities are downplayed and minimized by free market advocates for a good reason.  A thorough evaluation of them reveals a fundamental flaw in free market logic which should actually create a case for government action.  However since laissez faire economists have already made up their mind from the start that government is bad (as opposed to true scholarly open mindedness), they try to find a way to conveniently brush over this phenomenon and minimize it to the greatest extent possible.  But any logical and comprehensive review of externalities indicates that these are real costs which can have real effects on society, and can not only hurt the individual, but can actually hurt society as a whole and have negative effects on markets.  The most rational and reasonable way of dealing with many externalities is not simply to leave it up to courts and individual actions in equity, but to have a governing authority with the power to regulate and address these costs.  And of course, by addressing these costs, government is sending signals and inducing behavior which makes these real costs actually reflected in the monetized market, which makes markets healthier and more reflective of a reality, a win-win for collectivist and capitalist alike.  The attempts at downplaying this phenomenon are little more than intellectual dishonesty on the part of laissez faire advocates, who are more interested in enforcing a social ideology than they are on creating a prosperous and stable economic and social atmosphere.   

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