Ian Birrell: The economist who got it right

It is astonishing how much Pigou's ideas impact on our lives and debates today

As we stand on the cusp of this new decade, shivering in the snow and contemplating a general election in a world wrecked by the banking crisis, a battle is raging in the dismal science. Although few economists predicted the cataclysm that engulfed the globe, they are now fighting hard for the legacies of their heroes.

Having endured 30 years in the doldrums, disciples of John Maynard Keynes, the guru of government intervention, are convinced their time has come once again. Politicians have dusted off his textbooks and poured billions into stimulus programmes, so his supporters argue that he is rehabilitated as the foremost modern economist. Meanwhile the followers of unfettered free markets, as championed by Milton Friedman and his school of Chicago economists, are fighting back in the face of increasing regulation to preserve the ideals that lay behind our recent period of unrivalled prosperity.

But as the chaos begins to clear, a forgotten figure is emerging from the mists of time who can lay claim as the most prescient economist of our age. It is astonishing how much his ideas affect our lives today. He is credited with originating the theory of market failure, but his work also offers answers to many of the most important questions of our age, from climate change to health care, from population growth to pollution, from bankers' bonuses to binge drinking. He could even be said to provide a third way in economics.

So who is this enigmatic figure? Step forward Arthur Pigou, a colossus who dominated the study of economics before falling out with his friend Keynes and ending his life something of a recluse. Tall, moustachioed and handsome, he was brought up on the Isle of Wight before going to Harrow, where he excelled at sport, then on to Cambridge, where he won armfuls of academic prizes. A conscientious objector, he refused to fight in the First World War but insisted on being sent to the front as an ambulance driver.

At the tender age of 30 he was appointed to the Cambridge Chair of Political Economy, which was then the world's most prestigious post in economics. And two years later, this polymath published The Economics of Welfare, which his champions, such as John Cassidy, author of the brilliant How Markets Fail, have hailed as pioneering the study of market failure.

Pigou's book, which came out 90 years ago, saw that "even in the most advanced states there are failures and imperfections" and underlined the need for state intervention to right such failures. He saw how the actions in one part of the economy could have drastic unintended consequences elsewhere – as witnessed by the current economic mess, which originated with bankers encouraged to take risks by a flawed bonus system and handing out mortgages to impoverished Americans who could not afford them.

Pigou was no extremist. He believed in private enterprise, trusted individuals, was sceptical of politicians and understood the need for limited government. But he also accepted – unlike some economists who refuse to let the imperfect reality of human beings intrude into their perfect worlds of total rationality – that the free market could not solve all of society's problems.

His real genius was understanding the complexity of a modern society. Pigou pointed out how the activities of individuals and businesses can impact on each other, and how sometimes the state had a duty to factor in social costs and combat negative side-effects, or "spillovers", that impact on third parties. His most famous example was a new railway line that damages the environment, but he also cited crimes caused by cheap alcohol and the harm caused to unborn babies by pollution. And one solution was the imposition of taxes, now called Pigovian taxes in his honour, along with the provision of public services and proper regulation.

Unfortunately for Pigou, he fell out with his protégé Keynes over the cause of unemployment. As the numbers out of work soared in the early 1930s, he wrote a book blaming high wages, an argument trashed by Keynes in the work that turned him into an international celebrity, The General Theory of Employment, Interest and Money. Pigou attempted to fight back with a damning review, but he was no match for the mercurial Keynes and his star rapidly dimmed. The one-time wonder boy retreated into his work, slaving away quietly in his rooms at Cambridge until his death in 1959.

Today, the name Pigou means nothing to most people. But his work is central to many of our most controversial political debates, from banking to immigration. It is at the heart of key social issues: should we impose higher taxes on tobacco to stop smoking and reduce health costs, or put up the cost of alcohol to deter teenage drunkenness, or charge people to visit their GP? And it is pivotal to the debate over the environment: do we increase taxes on flying to curb emissions, on road use to prevent congestion and even in the sea to prevent over-fishing.

The Stern Report, which four years ago underlined that climate change needs to be seen as an economic issue, played a central role in Pigou's unexpected rehabilitation, referencing his work and calling for the imposition of substantial carbon taxes – a classic Pigovian strategy. At the same time, Greg Mankiw, a former adviser to George Bush, launched a Pigou Club in the United States calling for increased taxes on petrol to reduce global warming. It has since been joined by figures from all sides of the political spectrum, from Alan Greenspan and David Frum to Al Gore and Paul Krugman.

Pigou's solutions are popular for two reasons. Firstly, they are often the least invasive way to correct a market failure and don't require heavy-handed government intervention into decisions made by families and firms. They nudge people in the right direction, rather than dictate to them. And secondly, in less demanding economic climates they can be used to reduce the blunter weapons of taxes such as those on income or property.

As we start the election campaign, the unseen hand of this forgotten figure guides some of the most critical debates facing our nation. And in these tremulous times, it is worth recalling Pigou's most celebrated warning, which is as pertinent as ever. "Prosperity ends in a crisis. The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born, not an infant, but a giant."

i.birrell@independent.co.uk