Beyond the Big Three and Wall Street: The Other Massive Market Failure

In light of all the recent failures from Detroit, the Big Three and Wall Street, can we really trust the invisible hand to allocate financial or natural resources rationally?

December 23, 2008

In light of all the recent failures from Detroit, the Big Three and Wall Street, can we really trust the invisible hand to allocate financial or natural resources rationally?

When Nicholas Stern, former chief economist at the World Bank, released his ground-breaking study in late 2006 on the future costs of climate change, he talked about a massive market failure.

He was referring to the failure of the market to incorporate the climate change costs of burning fossil fuels. The costs, he said, would be measured in the trillions of dollars.

The difference between the market prices for fossil fuels and the prices that also incorporate their environmental costs to society are huge.

The roots of our current dilemma lie in the enormous growth of the human enterprise over the last century. Since 1900, the world economy has expanded 20-fold and world population has increased fourfold.

Although there were places in 1900 where local demand exceeded the capacity of natural systems, this was not a global issue.

There was some deforestation, but overpumping of water was virtually unheard of, overfishing was rare, and carbon emissions were so low that there was no serious effect on climate. The indirect costs of these early excesses were negligible.

Now with the economy as large as it is, the indirect costs of burning coal — the costs of air pollution, acid rain, devastated ecosystems, and climate change — can exceed the direct costs, those of mining the coal and transporting it to the power plant.

As a result of neglecting to account for these indirect costs, the market is undervaluing many goods and services, creating economic distortions.

As economic decision makers — whether consumers, corporate planners, government policymakers or investment bankers — we all depend on the market for information to guide us.

In order for markets to work and economic actors to make sound decisions, the markets must give us good information, including the full cost of the products we buy. But the market is giving us bad information, and as a result we are making bad decisions — so bad that they are threatening civilization.

The market is in many ways an incredible institution. It allocates resources with an efficiency that no central planning body can match and it easily balances supply and demand.

The market has some fundamental weaknesses, however. It does not incorporate into prices the indirect costs of producing goods.

It does not value nature's services properly. And it does not respect the sustainable yield thresholds of natural systems. It also favors the near-term over the long-term, showing little concern for future generations.

One of the best examples of this massive market failure can be seen in the United States, where the gasoline pump price in mid-2007 was $3 per gallon.

But this price reflects only the cost of discovering the oil, pumping it to the surface, refining it into gasoline and delivering the gas to service stations.

It overlooks the costs of climate change as well as the costs of tax subsidies to the oil industry (such as the oil depletion allowance), the burgeoning military costs of protecting access to oil in the politically unstable Middle East, and the health care costs for treating respiratory illnesses from breathing polluted air.

Based on a study by the International Center for Technology Assessment , these costs now total nearly $12 per gallon ($3.17 per liter) of gasoline burned in the United States.

If these were added to the $3 cost of the gasoline itself, motorists would pay $15 a gallon for gas at the pump. In reality, burning gasoline is very costly, but the market tells us it is cheap, thus grossly distorting the structure of the economy.

The challenge facing governments is to restructure tax systems by systematically incorporating indirect costs as a tax to make sure the price of products reflects their full costs to society and by offsetting this with a reduction in income taxes.

We are doing today exactly what Enron did. In the late 1990s Enron, a Texas-based energy trading corporation, may have appeared on the cover of more business magazines than any other U.S. company.

It was spectacularly successful. The darling of Wall Street, it was the seventh-most valuable corporation in the United States in early 2001.

Unfortunately, when independent auditors began looking closely at Enron in late 2001 they discovered that the company had been leaving certain costs off the books. When these were included, Enron was worthless.

Its stock, which had traded as high as $90 a share, was suddenly trading for pennies a share. Enron was bankrupt. The collapse was complete. It no longer exists.

Then, as now, we are leaving costs off the books, but on a far larger scale. We focus on key economic indicators like economic growth and the increase in international trade and investment, and the situation looks good.

But if we incorporate all the indirect costs that the market omits when setting prices, a very different picture emerges. If we persist in leaving these costs off the books, we will face the same fate as Enron.

Today, more than ever before, we need political leaders who can see the big picture, who understand the relationship between the economy and its environmental support systems.

And since the principle advisors to government are economists, we need economists who can think like ecologists. Unfortunately they are rare.

Ray Anderson, founder and chairman of Atlanta-based Interface, a leading world manufacturer of industrial carpet, is especially critical of economics as it is taught in many universities.

“We continue to teach economics students to trust the ‘invisible hand’ of the market,” he says, “when the invisible hand is clearly blind to the externalities and treats massive subsidies, such as a war to protect oil for the oil companies, as if the subsidies were deserved. Can we really trust a blind invisible hand to allocate resources rationally?”

Adapted from Chapter 1, “Entering a New World,” in Lester R. Brown, Plan B 3.0: Mobilizing to Save Civilization (New York: W.W. Norton & Company, 2008). Available for free downloading and purchase here.

Takeaways

Since the principle advisors to government are economists, we need economists who can think like ecologists. Unfortunately they are rare.

Burning gasoline is very costly, but the market tells us it is cheap, thus grossly distorting the structure of the economy.

The roots of our current dilemma lie in the enormous growth of the human enterprise over the last century.

Now with the economy as large as it is, the indirect costs of burning coal — the costs of air pollution, acid rain, devastated ecosystems, and climate change — can exceed the direct costs.