November 28, 2009


An Economist's Invisible Hand: Arthur Cecil Pigou, overlooked for decades, provides a guide to the financial crisis (JOHN CASSIDY. 11/28/09, WSJ)

Today Mr. Pigou's intellectual legacy is being rediscovered, and, unlike those of Messrs. Keynes and Friedman, it enjoys bipartisan appeal. Leading Republican-leaning economists such as Greg Mankiw and Gary Becker have joined Democrats such as Paul Krugman and Amartya Sen in recommending a Pigovian approach to policy. Much of President Barack Obama's agenda—financial regulation, cap and trade, health care reform—is an application of Mr. Pigou's principles. Whether the president knows it or not, he is a Pigovian.

Mr. Pigou pioneered the study of market failure—the branch of economics that explores why free enterprise sometimes. During the 1930s, Mr. Keynes lampooned him as a reactionary because of his suggestion that the economic slump would eventually recover of its own accord.

But while Mr. Pigou believed capitalism works tolerably most of the time, he also demonstrated how, on occasion, it malfunctions. His key insight was that actions in one part of the economy can have unintended consequences in others.

Thus, for example, a blow-up in a relatively obscure part of the credit markets—the subprime mortgage industry—can undermine the entire banking system, which, in turn, can drag the entire economy into a recession, as banks refuse to lend. "The actual occurrence of business failures will be more or less widespread according (to whether) bankers' loans. . . are more or less readily available," Mr. Pigou wrote in 1929. Today, that might seem obvious. But just two and a half years ago, when the subprime crisis began, most economists, Mr. Bernanke included, believed it would have only modest consequences. [...]

Mr. Pigou drew an important distinction between the private and social value of economic activities, such as the opening of a new railway line. The savings in time and effort that users of the railway enjoy are private benefits, which will be reflected in the prices they are willing to pay for tickets. Similarly, the railroad's expenditures on tracks, rolling stock, employee wages are private costs, which will help to determine the prices it charges. But the opening of the railway may also create costs for "people not directly concerned, through, say, uncompensated damage done to surrounding woods by sparks from railway engines," Mr. Pigou pointed out.

Such social costs—modern economists call them "externalities"—don't enter the calculations of the railroads or its customers, but in tallying up the ultimate worth of any economic activity, "[a]ll such effects must be included," Mr. Pigou insisted. In focusing exclusively on private costs and private benefits, the traditional defense of the free market misses out on a vital element of reality.

To correct the problems that spillovers created, Mr. Pigou advocated government intervention. Where the social value of an activity was lower than its private value, as in the case of a railroad setting ablaze the surrounding woodland, the authorities should introduce "extraordinary restraints" in the form of user taxes, he said. Conversely, some activities have a social value that exceeds their private value. The providers of recreational parks, street lamps, and other "public goods" have difficulty charging people to use them, which means the free market may fail to ensure their adequate supply. To rectify this shortcoming, Mr. Pigou advocated "extraordinary encouragements" in the form of government subsidies. [...]

Global warming presents perhaps the most dramatic example of what can happen if spillovers are ignored. It was the growing public concern over global warming that resurrected Mr. Pigou from obscurity. In 2006, the British government published an official report on climate change by Sir Nicholas Stern, a well-known English economist, which relied extensively on Mr. Pigou's analytical framework. "In common with many other environmental problems, human-induced climate change is at its most basic level an externality," Mr. Stern wrote. And he went on: "It is the greatest and widest-ranging market failure ever seen."

In addition to referencing Mr. Pigou's work directly several times, Mr. Stern recommended the imposition of one of his extraordinary restraints: a substantial carbon tax. This proposal remains controversial, but a number of Republican economists have endorsed it. Harvard's Greg Mankiw has founded an informal Pigou Club for economists and pundits that support a carbon tax.

The fact that oil use doesn't cause climate change doesn't mean it isn't politically destabilizing, both in producing nations and consuming.

Posted by Orrin Judd at November 28, 2009 6:46 AM
blog comments powered by Disqus