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Internalize This

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Here’s a letter to a regular correspondent of mine who “sees plenty of common sense in Oren Cass’ writings”:

Mr. Dye:

I’m familiar with the concept of externalities. And I agree that looming somewhere in the bowels of Oren Cass’s hostility to financial-market activities is an aching suspicion that these activities give rise to negative externalities – that is, to undesirable effects on third parties that are unaccounted for by persons whose actions create those effects.

Any such ache, however, is psychosomatic. It’s unjustified by reality.

Investors who buy other firms spend their own money and money entrusted to them voluntarily. When their merged firms succeed, these investors profit; when these firms fail, they lose. Likewise, owners who sell their assets gain when their decisions are wise and lose when they aren’t. This prospect of gain and threat of loss ‘internalizes’ on those who make financial-market decisions the benefits and costs of these decisions. And this internalization is at work in financial markets no less than it is at work in what Cass & Co. confusingly call “the real economy,” by which they mean manufacturing and other activities that directly produce tangible outputs. (All parts of the market economy are real; they all really do positively contribute to the production of goods and services that enhance our living standards.)

In short, American Compass’s hostility to financial markets [2] reflects nothing so advanced as a well-worked out and tested theory of externalities. The externality that Cass & Co. seem to have in mind – or, rather, have in their guts – is based on the superstition that value is created only by the actual, physical production of tangible goods, and that all other activities are merely “derivative.” Strong evidence that Cass embraces this absurd superstition is found in the e-mail that he sent out yesterday [3].

Of course it’s true that taxes and regulations themselves often create externalities that enable individuals to profit at the public’s larger expense. Subsidies that would be part of Cass’s industrial policy are a classic example of a negative externality created by government: some producers free-riding on resources seized from other people. But there’s no reason to suppose that such distortions are more numerous or worse in financial markets than in the so-called “real economy.” And it certainly makes no sense to ask the very people who impose these harmful interventions – politicians – to address the problem with additional interventions rather than simply to remove the offending ones.

Donald J. Boudreaux
Professor of Economics
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030