January 26, 2012

Economic Externalities

In my last entry, I mentioned that a focus on financial metrics, such as ROI (Return on Investment) and ROE (Return on Equity), can result in a reduction in the quality of our lives.  While transactions that achieve targeted returns lead to the enriching of shareholders, the same transactions can also have a range of impacts on the wellbeing of others.  These impacts can be beneficial, but are often costly. 

This transaction spillover is often called an economic externality.  Some economists define an externality as the result of undefined property rights.  For example, no one owns the air we breathe and so no one bears the burden of its cleanup.  As a result, we pollute it without regard to the costs of our actions.  If we were somehow able to assign ownership rights—legally and otherwise—in a way that requires the owners of the sky to bear the costs of dirty air, they would be far more interested in keeping it clean.  To do so, they would exact a toll on others who use the resource.  In other words, if the sky’s owners were made to cover the costs of pollution (such as medical expenses associated with emphysema, or the costs of restoring coral reefs damaged by acidity) they would, in turn, charge users of the air in a way that would provide a return over incurred costs. 

While air pollution is certainly an example of a negative externality, the issue goes deeper than a lack of ownership rights as we traditionally recognize them.  When a private equity company purchases a plant, for example, it legally acquires the right to do a number of things to the assets it now owns.  The new shareholders can downsize the plant’s operations, move contracted production to offshore facilities, sell off some of its component pieces, and siphon away excess pension assets.  These actions can ring up huge transactional returns, in part, because the shareholders are not made to own the external costs they cause others to bear.  Since the private equity firm doesn’t bear the long-term costs of a worker’s unemployment, for instance, it doesn’t care about the resulting layoffs.  However, someone has to bear such costs.  Who?  Let me mention one: taxpayers who are the eventual payers of unemployment benefits.  In other words, you and I pay for a portion of the return shareholders achieve.    

When investors are allowed to look solely at ROI or ROE in making transactional decisions, they evaluate the potential for personal returns, without considering impacts to society.  This is a mistake.  The costs of transactions can be far-ranging and well in excess of the gains made by a small number of people.  Think, for example, about the multi-million dollar bonuses paid to the developers of mortgage derivatives.  Think also of how those derivatives sunk our economy and caused us to lose a ton of home equity and 401K value.  This explains, in part, why an economic rising tide doesn’t float all boats and can result in huge wealth disparities, the likes of which our nation has been experiencing. 

In fact, the ROI metric, in connection with Wall Street’s focus on quarterly results, is at the center of our nation’s loss of good manufacturing jobs.  What’s incredibly problematic about this is that when manufacturing jobs leave our country, so does manufacturing technology.  We tell China, or India, to figure out how to make things cheaply.  While today they have the advantage of having low-cost workforces, eventually that won’t be the case, but we’ve handed them the ability to ride a manufacturing learning curve that we may never be able to follow.  In short, if we aren’t making things, we’ll forget how things are made, which is another external cost not embedded in our short-sighted ROI metric. 

Perhaps no cost is as ignored and misunderstood as the cost of a bad education.  During government budget discussions, it seems that our schools and teachers invariably get the short end of the stick.  What’s the effect of this?  As I’ve mentioned before, McKinsey and Company estimates that the cost of the black verse white achievement divide alone was as much as $525 billion in lost GDP in 2008.  When we shortchange our children, we incur external costs that few seem to recognize.  It’s delineated not only in lost productivity, but increased incarceration, unwanted pregnancies, heightened drug use and other social costs.  Some people respond to this assertion by saying money doesn’t produce a good education.  But if that’s true, why do the rich put their kids in private schools?  Warren Buffet has been known to say he’d like to eliminate private schools altogether.  By doing so, he reasons, the rich will become part owners of public education and finally be made to contribute to heightened general achievement.  Embedded in this idea are two important implications: 1) What the well-to-do want from public education doesn’t affect them or their families, because they don’t use it and 2) The fact that education has become bifurcated in this country ensures the continuation of a moneyed class. 

So what does all this have to do with a New Christian Ethic?  After Christ’s crucifixion, His followers lived communally and there were no poor among them.  Don’t take my word for that, but read Acts 4:34-35, which tells how the people sold their belongings and distributed their resources according to need.  The historian, Elaine Pagels, describes a remarkable people, who practiced literally Christ’s admonition to feed the hungry, clothe the naked and minister to the sick.  As I’ve mentioned before, when plagues struck cities, they were the few who remained behind to practice charitable acts of service, even though it put them in harm’s way.  I’d love to encourage us all to be as noble, but I don’t think it’s possible—we’re too far gone—but let’s at least look out for what Jesus called “the least of these”, the people who need our help.  That can’t be done by encouraging the continuation of a system that allows the rich to further enrich themselves at the expense of the less fortunate.  


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