External Damnation


3.6 million jobs into this recession,[i] insult has been added to injury. The Peanut Corporation of America, nut supplier to Kellogg and the lower-rent peanut butters, deliberately sold peanuts contaminated with the salmonella bacterium. Twelve times in the last two years. The current headline-grabbing salmonella outbreak is the most recent result of these knowingly-tainted shipments.[ii] Now, the FDA could have been on top of this, but companies aren’t obliged to inform the food regulator of the results of their own tests. And then, even after the contaminated plant was found by the FDA, the full recall couldn’t be announced for almost three more weeks because the FDA has to obtain corporate approval of the wording of product recall announcements.[iii] While a few hundred more people enjoy nausea, vomiting, and diarrhea.
 
Pretty cold, I know, but this is just another example of what economists call "externalities." An externality is an impact of an economic transaction that falls on someone outside the transaction. The nice smell of your neighbor’s barbecue is an example of a positive externality, and your insomnia when he buys new sub-woofers would be a negative one. These externalities are treated as rare occurrences in economic theory, but the reality is that external effects of our actions are everywhere. As the Harvard Business Review puts it, "Virtually every activity in a company’s value chain touches on the communities in which the firm operates, creating either positive or negative social consequences."[iv] And for the business world, negative social consequences can mean big corporate savings.
 
Take the energy industry, where gas prices increased in recent years as demand grew. BusinessWeek reports "Even though it seems like the market is working in this regard, it really isn’t. There’s widespread agreement that the current price of oil doesn’t reflect its true cost to the economy," such as "the more than $100 billion cost of having troops and fighting wars in the Persian Gulf."[v] It turns  out that the market can’t make a price for everything: "The tricky part is pricing these externalities…More dollars come from adding in numbers for the costs of air pollution, oil spills, and global warming." The magazine also invites us to "imagine" that "in an ideal world, we could settle on the size of the externalities." This is one reason why economists prefer to sweep externalities under the rug—they make the economy much more complicated.
 
And speaking of complicated things, externalities are also a crucial element of the credit crisis. The immediate cause of the banks’ dire straights is their overinvestment in risky credit derivatives—financial products representing pieces of loans, often "subprime" ones. Banks spend millions on executives and staff who are expert at risk-management, yet clearly the risk of these assets was underestimated by the banks, as our billions or trillions of bailout dollars prove.
 
The Financial Times says the paradox "echoes a fundamental problem about banking…the social cost of a systemic disaster is greater than the private cost to the individual bank. In the end, it is the task of regulators, not investors, to address this externality."[vi] So a bank will view its assets as representing a certain risk to the company, and cannot afford to think of the broader "external" risk created for the system if the bank collapses from holding excessively risky assets. In other words, the stability of the system is someone else’s problem, and while investors may not want to see the system collapse, "their fiduciary obligations prevent them from taking a broader, systemic view." The result is that risk is chronically underpriced in the financial markets.
 
Beside external costs, other related developments lie behind the crisis, like the bipartisan consensus to bail out big companies. As the business press reports, "Private-sector companies and individual bankers have been making huge profits in the bubble. Their risk appetite has been enhanced by previous bailouts and…by the government’s implicit guarantee. Yet their market pricing does not reflect the potential cost to the system of their own collapse."[vii] The business world recognizes that "This inability to handle externalities" has worsened the financial crisis at every stage, such as when hedge funds further weakened the banks and insurers by short-selling their stock.
 
In fact, the market’s failure to value external costs and benefits helped lead the banks to hold so much subprime debt in the first place. Law professor and corporate governance expert Janis Sarra explains that before debt was packaged into derivatives, the banks created a "positive externality" for investors: "corporate stakeholders…could be confident that the bank was engaged in a measure of monitoring and oversight of the firm’s solvency," so bank loans created a standard of trust for investors[viii]. But since banks now package and sell off loans, "The exponential growth in use of credit derivatives has shifted the externalities in a way that may contribute to market destabilization…originating lenders may be less willing to expend the time and resources to undertake due diligence in undertaking credit arrangements, as risk is laid off through derivatives under the originate and distribute model…previous positive externalities are lost and new negative externalities are created, creating more systemic risks across the market."
 
The foreclosure crisis also owes something to externalies: "credit derivatives impede the normal negotiations between creditors and debtors in that borrowers can less easily renegotiate terms and conditions with lenders…Spread across the economy, the freezing of such relationships may increase systemic financial risk." Again, bad for everyone, but highly profitable in the short term.
 
So it comes out that corporations don’t pollute because they’re evil villains, but because the very real costs of pollution can be made to fall on others, or "externalized." Likewise banks load up on unregulated, risky assets because they don’t consider the risks to the whole financial system, beyond themselves. In general, companies have compelling reason to externalize any costs they can—lowered costs improve profitability. So global climate change, air pollution, contaminated food, an unstable financial system—all are external impacts that firms are obliged to ignore.
 
Regulation has been the traditional way of limiting the external impacts of corporate activity, as the business press recognizes. But firms will always resist regulatory restraints on their income, and historically companies have worked together to cajole the government to relax regulations. Besides, in the end it’s not good enough to just put a leash on institutions that can’t sustain their own financial system, let alone value long-term ecological health. As long as our economy is run by companies that see the world as an externality, then your health, the environment, and the overall economy will be things the market has an "inability to handle."
 
True, more regulation would lower profitability, so America’s executives and equity holders may have to cut back on the caviar and foie gras. Let them eat peanuts.
Rob Larson is sharing the external benefits of his cigar smoke with everyone else on the elevator. He’s Assistant Professor of Economics at Ivy Tech Community College in Bloomington, Indiana, and blogs at http://theprofitmargin.blogspot.com. 
 



[i] Wall Street Journal, Soaring Job Losses Drive Stimulus Deal, February 7, 2009.
[ii] Washington Post, Peanut Processor Knowingly Sold Tainted Products, January 28, 2009.
[iii] New York Times, Peanut Product Recall Took Company Approval, February 3, 2009.
[iv] Harvard Business Review, Strategy & Society: The Link Between Competitive Advantage and Corporate Social Responsibility, December 2006.
[v] BusinessWeek, Taming the Oil Beast, February 24, 2003.
[vi] Financial Times, Watchdogs Must Not Kick Banks When They Are Down, February 4, 2009.
[vii] Financial Times, Capitalism In Convulsion, September 20, 2008.
[viii] Sarra, Janis. "Credit Derivatives, Market Design, Creating Fairness and Stability," Network for Sustainable Financial Markets, January 2009.

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