Keynes or Friedman? nahhh...Pigou!

From John Cassidy in the WSJ (hat tip: Linda Christiansen)...

At the Heavenly Models home for deceased economists, an award is being presented to the resident whose work best explains financial crises, global warming, and other pressing issues of today. The favored candidates include John Maynard Keynes...and Milton Friedman...The winner's name, however, turns out to be much less familiar: Arthur Cecil Pigou...

A contemporary of Mr. Keynes at Cambridge University, Mr. Pigou was, for a long time, the forgotten man of economics....Today Mr. Pigou's intellectual legacy is being rediscovered, and, unlike those of Messrs. Keynes and Friedman, it enjoys bipartisan appeal....a Pigovian approach to policy...

Mr. Pigou pioneered the study of market failure—the branch of economics that explores why free enterprise sometimes. During the 1930s, Mr. Keynes lampooned him as a reactionary because of his suggestion that the economic slump would eventually recover of its own accord.

But while Mr. Pigou believed capitalism works tolerably most of the time, he also demonstrated how, on occasion, it malfunctions. His key insight was that actions in one part of the economy can have unintended consequences in others.

Thus, for example, a blow-up in a relatively obscure part of the credit markets—the subprime mortgage industry—can undermine the entire banking system, which, in turn, can drag the entire economy into a recession, as banks refuse to lend....

Like many contemporary economic commentators, Mr. Pigou was reacting against laissez faire—the hands-off approach to policy that free market economists, from Adam Smith onwards, had recommended. Such thinkers had tended to view the market economy as a perfectly balanced, self-regulating machine....

Such social costs—modern economists call them "externalities"—don't enter the calculations of the railroads or its customers, but in tallying up the ultimate worth of any economic activity, "[a]ll such effects must be included," Mr. Pigou insisted....

Economics textbooks have long contained sections on how free markets fail to deal with negative spillovers such as pollution, traffic congestion and the like. Since August 2007, however, we have learned that negative spillovers occur in other sectors of the economy, especially banking....

The mere existence of negative spillovers doesn't necessarily justify government intervention, Mr. Pigou conceded....