Unfortunately, mainstream economists of the progressive era became enamoured of making economics a quantitative “science” and forgot the role of institutions, argues Fred Smith in this guest post. Thus environmental issues were relegated to the category of “market failure,” and the role of economists to that of commissars of rules and regulations designed to correct these failures. With lawyers and regulatory law invoked instead, the institutions necessary to allow environmental market transactions to solve the problems were simply not allowed to evolve. And today, instead, we are faced with political stoushes over water aquifers and mongrelised “legal fictions” manufactured giving “personhood” to rivers …
As Joseph Schumpeter noted, free markets had a good first century. That century was the 1750s to 1850s: A market economy produced massive improvements in the quality of life, and that gained it general legitimacy. But, as he also warned, as wealth increased and this wealth generation became increasingly taken for granted, markets and the prerequisite institutions for markets to exist (specifically property rights) came more and more under attack.
Markets were good at producing wealth but, if tweaked by political intervention (it was thought), would achieve even more benefits. Progressives in the United States and socialists in Europe both championed political control of markets and, perhaps more strategically, both blocked efforts to allow markets to expand into new areas of concern, leaving these new areas exposed instead to intervention.
Those policies are now being reconsidered, but the one area where many, perhaps most, still believe only government can operate is that of environmental protection. This essay argues that classical liberals should challenge this view and seek to evolve a free market environmental programme based on the expansion of property rights and associated legal protections. There are indeed environmental concerns, but these reflect failures to allow markets and their prerequisite institutions to evolve, rather than “market failures”.
Market Institutions
Economic liberals have long understood that free markets evolve and are dynamic, and the appropriate price/demand terms for today will continually vary as consumer tastes and producer technologies evolve. But classical liberals also understand (although they devote less attention to) the fact that markets don’t operate in a vacuum, but rather are embedded within a necessary institutional framework. That framework entails a system of extensive private property, a rule of law outlining how contracts and liability issues are to be resolved and, finally, a culture that recognizes that voluntary exchange can increase wealth. Environmental issues arise in a situation where one or more of these requisite institutions don’t exist, where voluntary arrangements for resolving them have been denied.
Ludwig Von Mises summarised this position:
It is true that where a considerable part of the costs incurred are external costs from the point of view of the acting individuals or firms, the economic calculation established by them is manifestly defective and their results deceptive. But this is not the outcome of alleged deficiencies inherent in the system of private ownership of the means of production. It is on the contrary a consequence of loopholes left in the system. It could be removed by a reform of the laws concerning liability for damages inflicted and by rescinding the institutional barriers preventing the full operation of private ownership.
Policy makers have failed to recognise the relevance of such institutions and that time may be required for them to evolve. This neglect stems in part from the fact that these requisite institutions had evolved, in many areas, long before the Industrial Revolution. Those established institutions were stressed by the different challenges arising from the Industrial Revolution.
As the Nobel Laureate Ronald Coase notes, as the Industrial Revolution developed and environmental concerns (sparks from early rail locomotives, river damage from early industrial processes, the need to locate and develop oil resources), institutions did develop. Nuisance law was applied to pollution, and subsurface property rights were established. But then that process was stopped in its tracks.
Legislatures eager to promote economic growth granted railroads and many industrial plants pollution privileges. Subsurface property rights in oil pools and reserves did evolve, but they were not extended to aquifers, groundwater, and other liquid underground resources. And most mainstream environmental resources, such as wildlife, springs and brooks, airsheds and bays, remained as unprotected commons. Normal market processes were blocked from addressing these emerging areas of social concern. Thus, overuse and pollution – not addressed at the margin – were neglected until they grew to critical levels. A similar problem occurred in the failure to recognise the efforts of radio pioneers to homestead the electromagnetic spectrum.
Institutional evolutionary history has received too little attention because for much of history it had happened incrementally, slowly and largely out of view. Some newly discovered resource or some emerging value raised interest in providing or obtaining that resource, but interested parties found the transaction costs of achieving such exchanges excessive. But, viewing the potential of reaching a mutually beneficial wealth-enhancing agreement, the potential buyers and sellers as well as those brokering such transactions, would seek ways to lower these costs – via institutional and/or technological innovations.
The more successful of these innovations would be integrated into the established institutional framework. In effect, over time this would civilise these novel frontier exchanges, extending the market so that it could make “sweet” commerce available there also. The growth of the institutions of liberty would permit the expansion of the market.
Why didn’t this process occur as environmental values moved into prominence? Why were markets blocked from playing a creative role in nurturing and advancing economic values as they had long done in more traditional economic areas? Why are environmental resources rarely available as ownable private property?
Although the history of early environmental concerns has received little attention, Coase among others has examined how environmental concerns were addressed at the dawn of the Industrial Revolution. Early forms of pollution – primitive charcoal production that produced noxious smoke, say, or sewerage that dirtied water – would likely irritate downwind or downstream parties. Communal norms would discipline to some degree such “pollution activities” as they threatened the communities’ “proper enjoyment of their property”. But such low levels of pollution, especially in small cultural enclaves, could readily be handled: community pressures could encourage charcoal operations to relocate to more remote woodlands. Homeowners could be shamed into building clay-lined privies.
"Excuse Our Dust, But Grow We Must"
But with the dawn of the Industrial Revolution, the quantity and nature of materials processed and the quantity of residuals increased. The power of communities to address external and large enterprises weakened; moreover such enterprises brought benefits as well as nuisances.
Yet weak property rights and a liability system dealing with water and air did exist, building blocks for a more robust market in these areas. And efforts were made to adapt them to these new challenges. Coase notes that farmers filed suits against railroads when the sparks from these first-generation locomotives set fire to their crops. Fishing clubs moved to enjoin corporate disposal practices that harmed the fishing in areas where they held rights. And these early “free market environmental actions” had impact – firms did respond and, it appeared, that the Industrial Revolution would consider all values (addressing the challenge posed by Mises).
But, while there were some concerned about environmental values (initially mostly those enjoying those resources or harmed by a firm’s negligence) many, especially socialists in Europe and progressives in America, championed “Progress” – a policy of “Excuse our Dust but Grow We Must!”
Politicians in Britain responded by granting licences to pollute to industries and firms seen as especially important to such growth. Rather than integrating environmental resources into the market economy, they were locked out.
And, perhaps more importantly, the concept of private property as a valuable institution to disperse power, encourage a variety of experiments, allow diversity in use, Progressives viewed resources as better protected by politics – vast tracts of Australia, North America and New Zealand have been transferred to governments over the last century. Moreover, the process by which newly valued resources slowly gained the status of private property, allowing them to become managed by the market, stopped totally in the late 19th Century. No resource that was not in private hands in 1890 is today.
The shift was sometimes abrupt. The electromagnetic spectrum which became a valuable resource at the turn of that century was initially being homesteaded with rules to separate one bandwidth user from another. Then Congress created the precursor of the Federal Communication Commission to own and manage this valuable resource. Subsurface resources such as minerals, oil and water all gained protection in America in the 19th Century by the innovation and legitimisation of the concept of subsurface mineral rights. Yet aquifers (the most abundant source of potable water) remain common property resources, lacking the institutional benefits of ownership.
Environmental Politics
To reiterate: free market environmentalism argues that current environmental policy took an unfortunate path. Rather than realising that the more worrisome forms of external impacts happened incrementally, that we should encourage a vast array of experiments about how best to reconcile (indeed integrate) environmental concerns with economic ones, the “market failure” model presumes that all environmental issues are inherently political.
Such environmental events happen somewhere and at some time before they happen everywhere and persistently. Thus, some individuals will be affected initially and will seek redress while the impacts are still small. Coase finds that the common law was often receptive to such requests, leading firms to reduce the nuisance: relocation, changing time of operations, acquiring buffer zones or even negotiating with the harmed party to permit future emissions. Firms and impacted parties might well innovate – impacted parties “fencing” themselves off from the nuisance, firms adding settling and treatment ponds, and so forth.
In brief, classical liberals would expect a period of confusion and adaptation as the parties encountering such-extra market costs and benefits evolved means of integrating those costs and benefits into the market structure. These would include extending property rights to the new resource (clarifying the right of owners to prevent this new form of trespass), legitimising new contract instruments that would permit the parties to agree to a risk-sharing arrangement (the plant agrees to hold its effluents below some harmful level and agrees to compensate the property owner if those protections fail), cultural change (recognising that air and water transgressions – transferring one’s residuals on to the properties of others without their permission – is a trespass, a “pollution”).
Since environmental issues will happen in many areas over time, classical liberals would expect the discovery process to provide a number of competing environmental response strategies and for those which proved most effective to gain dominance in the courts and in practice. Moreover, given the dispersed nature of these initial events, we would expect the initial respondents to be those most adversely affect or those most sensitive to nuisances, or those who value aesthetic more (modern environmentalists). If the culture viewed polluting activities as “necessary”, such individuals might well use their own resources within the restricted institutional framework to protect those environmental resources they valued.
Moreover, since those early events would affect relatively few people there would be less urgency to solve such problems immediately, politically. Over time, as the legal rules and property rights evolved, the nuisance would integrate into the standard market framework.
Endangered Animals
There is much to say about this process but an illustrative example can be drawn by concern over endangered species (and more broadly biodiversity). Efforts to protect such species politically – making such species a ward of the state – have not fared well. Too often the reaction of property owners faced with laws banning them from encroaching (on their own land) on the habitat of such species is: “Shoot, shovel, and shut up.”
That’s a description of how many American landowners have reacted to the burdens of the Endangered Species Act. Those burdens are substantial – finding that an endangered species is using your land as its habitat will preclude any further development or use of the land. The result has been that landowners have an incentive to kill any endangered species they find on their land, remove all traces of it, and keep quiet about it. Can there be a better way?
Classical liberal economics suggests that the answer is yes. The reason why the landowner disposes of the endangered species is not simply because the species imposes a cost, but also because the species has no economic value to him. If we can find a way of providing value to the landowner in having the species on his land, then the incentives towards destructive behaviour will be removed (or at least lessened).
One way to do this would be through ownership of the animal(s). Having a property right in the members of the species inhabiting his land would give the landowner an incentive to protect his property and its habitat. Moreover, the landowner could realise that value by selling his property right to someone else, thereby allowing the landowner to “cash in” his ownership stake.
The new owner might then pay the landowner to maintain the habitat, thereby providing an income stream associated with the species. Moreover, ownership in wildlife – like ownership in commercial and pet species – encourages the developing of a wide array of supporting institutions: pet stores, veterinary science, licenses, and pet adoption agencies.
To initiate this process one might leave in place the current government ownership of wildlife but create a process that would allow individuals or groups (those having a special interest in that species) to petition to acquire ownership of a suitable population of that species. As in the case of human adoption, the petitioners might have to demonstrate their ability to manage the species and be monitored until that was proven. Different petitioners might experiment with different approaches and, over time, one would expect a wide array of management practices. All this would open the market to Green experiments and innovation just as has long happened in conventional areas.
Every party would benefit from such a market arrangement. The landowner would get a continuing income from land that would otherwise have been worthless, the new owner would get a property right in something he regards as valuable, and the endangered animal gets a chance to live in a maintained habitat. Such a market arrangement of winners is clearly preferable to the current regulatory arrangement, which produces losers.
Even a market arrangement short of outright ownership would be better. For instance, crowdfunding could be used to compensate the landowner for his foregone income from his land. People who value the endangered species could pool their resources to provide this benefit. Again, this would be a market transaction.
‘Externalities’ and the Market Process
The problem is that market solutions like these are currently made very difficult by the nature of environmental regulation. Environmental regulation generally depends on bans, caps, and mandates that restrict the possibility of market transactions. Why should people who value the spotted owl send money to a landowner to protect it when the landowner is theoretically banned from doing anything to harm it or its habitat? They get far more “bang per buck” from funding environmental groups that lobby for more bans, caps, and mandates.
Regulation evolved this way because the economists of the progressive era viewed environmental degradation as a social cost. Landowners, factory owners, utilities, and so on were viewed as imposing costs on the rest of society and had to be prevented from doing so by legislation.
This imposition of regulatory law derailed the process by which market institutions could have evolved to solve the problem. As Coase revealed in his essay The Problem of Social Cost, such “externalities” are actually the manifestation of differing priorities between people that, if the transaction costs are low enough, could be painlessly resolved by market transactions .
Coase therefore did not support government intervention (at least, not initially or permanently) but rather argued that the potential wealth-creating opportunity would engage entrepreneurs to devise ways of reducing such transaction costs, to realise that wealth. The possibility of transactions creating value for both parties would create the “inventive-incentive” necessary for creating a framework for these transactions to happen.
In particular, proper institutions can lower transaction costs. For example, the rule of law makes transactions more likely, as parties to the transaction can be certain that disputes will be resolved fairly. The institution of property rights provides a vehicle for a whole swathe of transactions. These institutions are essential and evolving prerequisites to markets. This is a central insight of classical liberal economics.
Unfortunately, mainstream economists of the progressive era became enamoured of making economics a quantitative “science” and forgot the role of institutions. Thus environmental issues were relegated to the category of “market failure,” and the role of economists to that of commissars of rules and regulations designed to correct these failures. The institutions necessary to allow environmental market transactions to solve the problems were simply not allowed to evolve.
A Path Forward
In many ways, environmental regulation is the last bastion of central planning. It is remarkable that even as Europe has realised the folly of central planning in so many other economic areas, it has actually doubled down on it in environmental regulation, and has indeed sought to export it to other nations. In this, it has found a willing ally in recent years in the United States, whose environmental policy is also largely a product of progressive era thought.
In that framework, the role of government should be to stand ready to facilitate proposals to expand and refine property rights and contracts, to ensure that liability laws encourage rational exchanges.
Perhaps the simplest example of this thinking would be to encourage experimentation with subsurface ownership of suitably isolated aquifers. The history of mineral and oil and gas policy suggests the value of linking ownership and natural resources. Does anyone really think that water availability would be a problem if such a policy were in place?
The term “the environment” has become a synonym for “everything” – but central management of everything is foolish. Allowing private parties to pioneer extending the institutions of liberty to environmental areas would begin the exploration and discovery process that has been suppressed for the last century. It is overdue.
A property rights approach would allow those closest to a polluter the right to enjoin that nuisance. The polluter could bargain and compensate to gain operating rights, with penalty fees for accidental discharges. That would create incentives for an array of ameliorative innovations: settling ponds, treatment diversion to other media (via incineration or land disposal).
Moreover, as such policies became widespread, firms would locate in areas where non-industrial uses were rare or where dilution potentials were high. In effect, externalities would be internalized while they were minor, and readily addressed, rather than waiting till there was a crisis.
Fred L. Smith, Jr. is the founder of the Competitive Enterprise Institute. He served as president from 1984 to 2013 and is currently the Director of CEI’s Center for Advancing Capitalism.
His post first appeared at CEI and FEE.
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According to their public accounts, as of December 31, 2022, Silicon Valley Bank had approximately $209.0 billion in total assets and about $175.4 billion in total deposits. Their top shareholders are Vanguard Group (11.3 percent), BlackRock (8.1 percent), StateStreet (5.2 percent) and the Swedish pension fund Alecta (4.5 percent).
The bank’s assets rose in value. More than 40 percent were long-dated Treasuries and Mortage-Backed Securities. The rest were seemingly world-conquering new tech and venture capital investments.
As the bank manager said in the famous South Park episode: “Aaaaand it’s gone.” Silicon Valley Bank showed how quickly the capital of a bank can dissolve in front of our eyes.
