Limitations of the Free Market and the Value of Natural Capital Maintenance

By: Maggie Winslow

The financial crisis has made abundantly clear what many economists have been arguing for decades: the free market can not be depended on to maximize social welfare. Free markets can be very efficient for allocating resources in certain types of markets. The promise of free-markets holds when certain conditions are met. However, free markets have proven to be poorly adapted to protecting the natural world, the basis of our collective wealth. Obviously now, they are also unable to successfully work in the financial economy, where most of the ‘goods’ have no actual value, only a perceived value. But, more on that later.

Rather than relying on disposable consumer goods to prop up our economy and maintain employment, we need a new economic sector – natural capital maintenance. This sector would include economic activity related to increasing energy efficiency and renewable energy development, preserving water resources, and preventing further environmental degradation such as soil run-off. This sector could create millions of jobs, make our society richer and stronger in the future.

Real vs. Perceived Value
One of the challenges the government experienced with the bail-out plan was determining the price to value credit default swaps. Their value is derived from other values and also depends on perception and expectations.

Adam Smith differentiated between real value and perceived value. Goods with real value can be more easily priced through the forces of supply and demand.
Goods with perceived value are likely to experience bubbles and crashes and wreak havoc on markets. This is one reason why the head of the central bank of Mexico called the marketing of ‘derivatives” – those financial instruments that derive their value from other goods – unethical. The financial economy is supposed to lubricate the real economy, allowing for savings to be efficiently transformed into investments and to provide for insurance to mitigate swings of fortune in the real economy. Allowing the financial economy to become a market in its own right, and lightly regulated at that, was and is an invitation to disaster.

The financial crisis has highlighted the need for a reconsideration of how our economy works and part of this rethinking must entail consideration of how the natural world links to our economy. It is not simply a source of resources and a dumping ground for waste. It is the foundation of wealth.

The financial crisis is relatively easily solvable because it just related to money. An environmental crisis will be much more intractable and profound. It is harder to solve sea levels rising, massive species die-offs, water tables dropping, and changing weather patterns which make large areas of agricultural land more tenuous.

Maggie Winslow, Ph.D.  Professor of Economics, Presidio Graduate School