Externalities

I got The Age of Turbulence for Christmas. Very interesting so far, especially to read with hindsight given recent history. This passage is fascinating:

”…According to objectivist precepts, taxation was immoral because it allowed for government appropriation of private property by force. Yet if taxation was wrong, how could you reliably finance the essential functions of government, including the protection of individuals’ rights through police power? The Randian answer, that those who rationally saw the need for government would contribute voluntarily, was inadequate. People have free will; suppose they refused?

I still found the broader philosophy of unfettered market competition compelling, as I do to this day, but I reluctantly began to realize that if there were qualifications to my intellectual edifice, I couldn’t argue that others should readily accept it.”

Greenspan does not come off as an ideologue throughout most of the book; he seems for the most part rational, thoughtful, and balanced. This makes it all the more fascinating and disturbing to me that, confronted with a flaw in his model of the world, his response would be to accept that other people might not be able to accept it!

The issue here is very simple. In the case of a public good such as individuals’ rights (or a public negative such as pollution), rational individual self-interest implies that one should attempt to shift the cost of the public good onto someone else. Markets are brilliant (most of the time) at optimizing functionals, but here the functional is incorrect. If a theoretical free market system optimizes one functional, it is entirely irrational to believe that it will also magically optimize a very difficult functional at the same time.

Moreover, this flaw isn’t even hard to fix! If one believes that free markets are the best system ignoring externalities, the solution is to make the minimal regulatory change required to replace the externalities with individual self-interest. E.g., criminal penalties for property rights violations, carbon taxes for global warming, etc. To my eyes, at least, the market system preserves all of its theoretical and moral elegance even with this correction, and has the benefit of not having a brutally obvious flaw.

Imagine a physicist who believes in the Newtonian theory of relativity, but discovers that it is inconsistent with the theory of electromagnetics. The analogous response to Greenspan here would be for the physicist to accept that the contradiction meant that other physicists would disagree, but to continue to believe in both theories personally! What actually happened, of course, is that physicists came up with a better theory, one that turned out to be even more elegant and beautiful than the first one. The correction required was quite small; the Newtonian theory is still almost right and is still useful in calculations.

One difference between economics and physics is that economics is often filtered through politics, and having a “pure” theory can be advantageous from a marketing perspective. However, Greenspan does not appear driven by marketing concerns; he frequently admits to trying to convey a nuanced view even when afraid that it will be misinterpreted. Therefore, I am not sure why he resists it.

comments powered by Disqus