Global Externalities and the Future of World Order

Market failure has now become one of the world’s hottest topics, much to the chagrin of neoclassical economists.

One form of market failure is due to what economists call “externalities”. These arise when the rational, profit driven, actions of economic agents have deleterious and uncompensated impacts on third parties. When externalities are present market outcomes are not socially optimal.

Two of the most important global crises today, the financial crisis and the ecological crisis, can be described as market failures where the presence of externalities are pervasive.

As we increasingly move towards a global economy, which includes the development of more globally integrated markets, we would expect externality effects to become increasingly global. Although much has been written about both crises, little attention has been directed towards this broader issue.

Milton Friedman, the noted free market economist, had surmised that externalities are small and not that much of a problem. Boy was he wrong!

Globalisation now means that externalities will become larger than even the wildest imaginations of heterodox economists could conjure, as they correspondingly become global. The bigger markets get the bigger would be any resulting market failures due to externalities, assuming markets are not as efficient as neoclassical economic theory asserts.

If markets are indeed efficient then any anomalies in global markets need not led to global systemic effects. We would expect any anomalies to be still small in scale even should markets develop truly global dimensions.

The repudiation of the efficient market hypothesis, empirically well supported by the great crash of 2008, means global markets can lead to global externalities.

That, in turn, poses a global macroeconomic stability problem that challenges our international political architecture.

The global financial crisis, to a very significant extent, can be seen as a global externality because crucial to its development was the under pricing of risk by financial institutions. That is to say, risk was under priced from the point of view of society. From our perspective consummately rational financial market entities took on far too much risk, enabled by both deregulation and lax regulation, in the pursuit of dazzling short term profits.

It was the under pricing of risk that paved the way for the rise of systemic risk, the crucial impost on society. That the under pricing of risk in financial markets could lead to systemic instability, which then impacts the real economy through liquidity and solvency crises, was in fact an important, though ignored, staple of Post Keynesian economics.

What has made this crisis decidedly global is that the financial system created in the wake of the “Nixon shocks” of the early 1970s, the crucial acts that enabled financial liberalisation, has led to the development of a global financial market characterised by tight coupling between its constituent parts. Even relatively well regulated and sound domestic markets can be impacted by financial shocks originating from elsewhere through global feedback loops.

Recognising the presence of an externaility does not necessarily tell us much about its underlying cause. The best causal explanation that accounts for the global financial crisis is the Post Keynesian Financial Instability Hypothesis of Hyman Minsky.

According to complexity theory small perturbations in highly integrated complex systems can reverberate and lead to systemic collapse. Events such as the Long Term Capital Management collapse, Doha and Greek debt crises and the like can touch off a system wide cascade. The global financial crisis was a “normal accident.” Normal accidents in finance are consistent with Minsky’s theory.

Greater economic integration also means that the impact of financial instability upon the real economy that Post Keynesians warned us about will also become increasingly global. In the wake of the financial crash in 2008 the Baltic Dry Index, which provides an insight into global trade and production trends, went into a downward spiral much like the US real estate market. Perhaps Japan illustrates this point best. The Japanese financial system was relatively insulated from the worst excesses of Wall Street, but Japan’s dependence upon exports to the US to drive economic growth had seen Tokyo take an almighty hit.

When two of the world’s leading economies, at the very least, go down into deep simultaneous recessions a global recession becomes difficult to avoid. It would appear that we were indeed headed for a Great Depression like contraction, but for a coordinated global Keynesian stimulus of great force.

Globalisation now requires that Keynesian demand management needs to shift upwards and become internationalised. This will require greater global economic institutionalisation.

Sir Nicholas Stern, upon handing down his influential report on the economics of climate change, described it as the “greatest market failure the world has ever seen.” This failure is also due to an externality. This is of the familiar type arising from pollution, in this case the emission of greenhouse gases. Here the externality is global, but not because of a global economy. The problem arises as a result of the emission by many individual firms and householders of greenhouse gases into a globally integrated climate system. This integration also results in global feedback loops and other knock on effects; as such the externality becomes global.

It should be stressed that climate change is not the leading global ecological problem. Far more important is the loss of biodiversity, towards which climate change contributes but it is by no means the only factor. Some biologists, such as Edward Wilson, argue that the background rate of extinction might be reaching levels consistent with a sixth mass extinction of life on Earth. The emphasis on climate change has obscured the existence of an integrated global ecological crisis, encompassing biodiversity, desertification, defosterisation and so on.

Economists have identified three main ways of mitigating externalities. The strategy is to internalise the external effects of individual actions upon others either through taxes, market based schemes that try and develop price signals, and regulation. It is the purpose of our political institutions to craft and enforce these remedies.

However in international relations governance is weak. The international political order has been characterised, it is easy to overstate this, by the “Westphalian” system that places state sovereignty at its core. This means that the amelioration of global externalities becomes decidedly problematical, as the international negotiations over both financial market regulation and a global emissions trading regime demonstrate.

In the case of financial markets we have the added problem that financial instability is endogenous to capitalism. An implication of the Financial Instability Hypothesis in the context of globalisation would be the need for a global financial authority to enforce systemic stability at the international level.

So, what are the prospects for reform?

Two developments in the evolution of world order are of first importance here. Firstly, the global economic order, from 1945 to the early 1970s, had gradually moved from unipolarity, based on the US, to tripolarity, based on the US, Europe and Japan. The development of tripolarity was a key motivating factor behind the Nixon shocks. Now we are slowly starting to see the emergence of a classically multipolar economic order, where the major poles are not allied states moreover, given the rise of the BRIC economies. Multipolar orders are the most difficult to manage if the major powers within that order are not allied. The US, Europe and Japan were and are allied powers.

Secondly, there exists an important fissure within this emergent multipolar economic order, namely between developed and developing economies which makes matters worse. Some see this cleavage as constituting an “international division of labour”. This division means that the polar powers of the economic system have structurally divergent interests, one of the reasons for the lack of progress in the Doha round of world trade talks.

The world’s polar economies are not all strategic allies and they are not all structurally of the same class. That’s a double whammy. An added spice is the relative decline of Washington’s ability to coerce economically. The system of world order constructed after the end of World War Two greatly depended upon US hegemony. In the study of international relations this is called “hegemonic stability theory.” According to this theory we are now in for a rocky ride.

The G20 summit on the global financial crisis and the significant differences between the developed and the developing states post Copenhagen can be invoked as evidence supporting the case for pessimism.

Regulatory reforms to the financial system have not gone far enough (barely even started), another financial shock is still possible, whilst China and India have been digging their heels on climate change. The developed states, for their part, do not show much interest in helping either India or China adequately overcome the very large opportunity costs that retooling their energy systems poses. This cleavage was a very important factor accounting for the failure of the Copenhagen summit.

The global political economy can be described as a type of state enabled corporate mercantilism, which poses another important barrier against international coordination in response to global market failure. Globalisation has been hitherto concerned with dismantling state based regulations over corporations. We now see, however, that global market failure will require extending global regulations over corporations. The economists John Eatwell and Lance Taylor have called for a world financial authority to regulate the global financial system and the head of the UK Financial Services Authority has made a case for the introduction of a global Tobin tax.

It is doubtful that such measures will be enacted through elite coordination at the international level.

The banks are furiously lobbying governments to water down reforms. Kevin Rudd placed great store on Australia’s involvement in the G20, but it appears that he is falling in line with the big four banks’ campaign, supported by the Reserve Bank, for Australia to reject any stringent G20 coordinated reforms. This will lead to regulatory arbitrage. When it comes to border protection regulatory arbitrage is to be avoided, but welcomed when the interests of the big banks are concerned.

For the Liberal Party a “giant big tax” is to be avoided when it hits polluters, but welcomed, the GST, when it slugs the poor. Tony Abbott actually likes a “giant big tax” that “redistributes income” so long as the direction of redistribution goes from poor to rich.

It is interesting to reflect that states and markets, both based on rational utility maximisation, can so badly reinforce each other at the global level. On the one hand rational self regarding actions within markets may not be socially optimal. On the other rational amoral states that tend to be geared toward relative gains are not terribly well disposed towards achieving socially optimal outcomes internationally.

The reforms required to remedy this reinforcing contradiction will not be easy to achieve. If we want to deal with global externalities properly the reform of the current system of international relations will be required. The same applies to the current corporate dominated form of globalisation. The role of social movements within and across states will be critical.

Democratic theory has not properly addressed the challenges that global governance poses to our notions of democracy. Global governance, as with any type of governance, is not exempt from democracy’s moral scope. The ethical argument for democracy does not stop at state borders, at least not for those who adhere to moral rationalism (a small group).

Externalities are not just features of market based economies. For instance the Soviet Union, a command economy, was a polluter paradise. During the Soviet era externalities were a function of dictatorial political processes. Globalisation has led to the development of a “democratic deficit.” The mitigation of global externalities will also require the development of more democratic forms of global governance. How this is to be achieved is a major task for both democratic theory and practice.

There appears to be a profound link between global justice and the major challenges facing mankind.