Ed. note: This is an excerpt from Chapter 13 of Ricardo’s Dream: How Economists Forgot the Real World and Led Us Astray, written by Nat Dyer and published by Bristol University Press.
Life: An Externality
How climate economics helped mislead elite opinion on the issue of our time
It is more than 30 years since delegations from around the world came to Rio de Janeiro—the port city that rose to prominence with the gold rush of the 1700s—for a historic meeting about the living world. Rio’s 1992 Earth Summit created new international conventions on climate change and biodiversity to halt the destruction of ‘the Earth, our home’. The convention on climate change—known by the acronym UNFCCC—agreed to stabilize ‘greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system’. In hindsight, world governments produced a radical document. They collectively recognized the need for fairness between current and future generations (intergenerational equity) and the importance of acting cautiously even when the science is not certain (the precautionary principle). What the new global climate organization lacked, however, was any enforcement mechanisms. Contrast that with the WTO created in the same decade, which has binding rules backed by a supranational court able to impose billion-dollar fines. And, rules without consequences are just good advice.
The world’s response to environmental crisis has been profoundly shaped by the vision of orthodox economists. This may be surprising as the living world has been one of the profession’s most obvious blind spots. David Ricardo included land in his core model of the economy, but it was seen as a stable backdrop to the action. In 1890, Alfred Marshall celebrated Western ‘man’s’ ability ‘to subdue Nature and force her to satisfy our wants’. New, radical voices only gained prominence in the 1960s and 1970s. E.F. Schumacher—who was both an ecological economist and a former coal executive— for example, argued in Small is Beautiful that ‘It is inherent in the methodology of economics to ignore [hu]mans’ dependence on the natural world.’ Economists in the mainstream have typically looked down on the heretical ideas of these ecological economists and promoted a solution that leaves their core theories as little changed as possible: externalities.
A negative externality is a damaging impact a market exchange has on someone not directly involved. Atmospheric pollution is a classic example of an unintended side-effect. Abundant energy from the burning of fossil fuels benefits industry and consumers but results in a cost, in ecological damage, not included in the market price. Large parts of the green movement have come to see a focus on externalities as a way of recognizing a host of important things businesses and economics exclude from consideration and responsibility. It aims to put a cost on these excluded elements so people value them and, therefore, create markets that are compatible with a healthy environment. At least, that’s the promise.
The economic theory of externalities goes back to Alfred Marshall’s protégé Arthur Pigou. Writing in the 1920s, he argued that the social harms of market transactions can be reduced by putting a price on external costs. When set at the right level, the price on carbon emissions should close a loop and send a signal back to producers and users of fossil fuels, making them reduce their use to an optimal level. And here’s the clever bit, according to the theory, the ‘invisible hand’ of the market will seek out the cheapest ways of reducing emissions. That is because if everyone is guided by a calculating, self-interested, and knowledgeable internal stockbroker, they will search out and exploit to the maximum every difference in price.
This is the origin of the theory behind fixing the climate crisis by putting a price on carbon. These schemes come in two main forms: cap-and-trade (in which governments set a limit or cap of total emissions and companies can buy and sell permits to emit greenhouse gases) or a carbon tax (in which governments raise the cost of emitting carbon and hence discourage emissions). Many environmentalists in the US have been attempting, unsuccessfully, to make variations of these schemes law since the early 1990s. Economists see putting a price on external harms as the most rational and efficient—in their special technical sense—way to solve the climate crisis. An externality, for an economist, means a missing market. Therefore, we need to build more markets. This vision has been incredibly influential. American economist and former Treasury Secretary Larry Summers suggested in 2021: ‘Economists have had a much larger influence on thinking about what we’re going to do about pollution than atmospheric scientists.’
