11/27/11

Discounting the Wealth of Nature

Modern economics is a superstition. Its once-sensible logic is now divorced from actual conditions in which economic activity takes place. So argues John Michael Greer in his  book that details the discipline's blindness to the physical constraints imposed upon economic activity by the limited stock of natural resources and failure of their models to take non-economic factors into account. Another problem is what Greer calls premature mathematization, which finds economists using numbers and formulas to make economics seem like a 'hard' science. These are all common (but still valid) criticisms of economics.

Greer cites David Ricardo's idea that land retains its "original and indestructible value" after use as a possible origin of the bias in economic thinking that discounts the wealth of nature. (The better-known Ricardian vice is the tendency of economists toward abstraction into numbers and models that are logically sound but offer no meaningful insight into actual economic realities.) This dismissal of diminishing returns on natural capital undermines the credibility of the discipline.

Economics as we know it was developed in a world of natural abundance and this is why it neglected to take into account the impact of economic activity on the environment but this is irresponsible is an age of scarcity. There are absolute limits to the supply of natural resources, no matter how high the demand for them. Greer notes that one cannot buy a perpetual motion machine as the laws of thermodynamics do not allow one to exist.

Related to the constraints place by natural laws on economic activity, the author contends that energy is a special type of commodity. It is required to transform primary goods into secondary goods through labor and production. It is the one that makes the production of many others possible. Greer describes the Industrial Revolution and subsequent economic growth and development as a bubble made possible by the abundance of energy from fossil fuels.  Even the internet would not have been developed in a more energy-scarce economy. Someday this blog  and myriad others will vanish (including the Archdruid's own) when the servers hosting them finally blink out.

Greer divides the economy into three distinct economies and I think it's fair to say the titles he assigns them indicate their order of importance. The primary economy is the wealth of nature that is currently left out of economic accounting; the secondary economy consists of the services and goods not drawn directly from nature but transformed by energy and/or human labor; and, the tertiary economy is the financial economy that measures the value of the wealth produced by the other economies and manages the distribution of that capital wealth. Economics measures the value of goods and services in terms of what can they can be exchanged for and this is relatively easy to do in the secondary economy.

It is quite difficult to calculate the exchange value of ecosystem services and natural resources, like air and water. (And, as human history illustrates, difficult decisions or undertakings tend to be put off as long as possible.) What market value is placed on ensuring that those resources are not ruined? There are regulations in place but those are insufficient to actually keep the air and water clean. So that is not an adequate measure of their value. It is this primary economy that poses the insuperable limit to human economic growth and the environmental costs must be internalized with regulations stringent enough to take its value into account. Atop this shaky foundation rests the secondary economy, the value of which is measured and used as the stock of value upon which the tertiary economy trades.

The growth of the tertiary economy has outstripped the growth of the secondary economy for decades. Market bubbles in recent years have occurred in a tertiary economy whose value far exceeds the underlying stock, even after those bubbles collapsed. The utility of the tertiary economy is measuring the value of actual goods and distributing capital to productive ends based on that measured value. But, as financial wealth has come to be regarded as valuable in itself, the tertiary economy has grown far out of proportion to the secondary economy. Greer describes this divergence thus:

"The consequence of all this pyramid building is that there are not enough goods and services on Earth to equal, at current prices, more than a small percentage of the face value of stocks, bonds, derivatives, and other fiscal exotica now in circulation. The vast majority of economic activity in today's world consists purely of exchanges among these representations of representations of representations of wealth."
A recent example is the housing bubble that burst into the financial crisis of 2008. It was precipitated by massive fraud in the mortgage lending industry that lent to borrowers who could not afford to actually pay. As lending grew more reckless, property values rose and lending to buy those overvalued homes proceeded apace. And the risk to lenders was low as mortgage debt was securitized and sold to other firms in the tertiary economy. Those mortgage-backed securities were insured against default by other financial instruments and those instruments were backed by other ones. But, when borrowers couldn't actually make the payments on their overvalued homes, it set off a cascade of debt-related financial obligations in the tertiary economy that could not be met by the actual value of the assets upon which those transactions were supposed to have been based.

The pursuit of financial wealth hampers the efficient allocation of capital (as we saw in the housing market) and the bloated tertiary economy papers over the divergence between the exchange value and the actual value of the resource base of the secondary economy. The primary economy is largely absent from the calculations of modern economics.

On his blog, Greer described The Wealth of Nature as his latest peak oil book. Although we've used up a lot of it, peak oil has not been reached as new reserves continue to be discovered, extracted, refined, and burned. The issue is not so much of it running out but the impact that burning it for energy is having on the environment. Peak oil would be a more forceful demonstration of the limits we face. It would almost be preferable to the more gradual depletion of natural resources and degradation of the natural environment that are bringing those absolute natural limits to productivity into view. But we still have plenty of fossil fuel to burn and people still claim that there is no correlation between atmospheric CO2 levels and climate weirdness. It is amazing to me that something as uncontroversial as the greenhouse effect could be subject to such debate. But I digress.

As a non-specialist writing a book on economics, Greer is careful to remind us that Adam Smith was not an economist, which is true. He was a social and moral philosopher. His great work, The Wealth of Nations, described the working of the free market as being guided by an "invisible hand," and this notion that the market works best when it is allowed to regulate itself has been the basis for free market fundamentalism ever since. But Smith was aware of limits upon productivity that are temporarily pushed back by innovations, such as the division of labor he trumpeted. In the long run, however, these limits would impose themselves upon economic activity, regardless of how freely and efficiently the free market operated. By his estimate, such flourishing could last 200 years at most.

Greer's contention that economic development since the Industrial Revolution is a bubble inflated by cheap energy is largely consistent with Smith's estimate, although we've stretched it out another century (and counting) through innovation in the extraction and use of fossil fuels. Greer puts globalization in terms of energy vs. labor costs by he takes a position at odds with his main point about cheap energy, stating that "outside of the industrialized nations, labor proved to be enough cheaper than energy that the result was profitable, and allowed industrial nations to maintain their inflated standards of living for a few more years."

I would argue that the outsourcing of manufacturing from developed countries has, in large part, resulted from corporations exploiting labor that was cheap enough to offset the loss in labor productivity that accompanied the shift. There are more people involved in producing goods overseas (lower labor productivity) but cheap energy lowers the total costs to firms by reducing transportation costs. This places cheap energy at the heart of the argument which is more in keeping with Greer's argument that economic development as we know it is one big bubble based on the use of fossil fuels that took millions of years for the earth to produce through physical processes.

Greer's is certainly a grim assessment of our situation and of our ability to improve it but he does offer a suggestion about how to prepare of the future.
Any step toward the direct production of goods and services for one's own use, with one's own labor, using resources under one's direct control, is a step toward the world that will emerge after money; it's also a safety cushion against the disintegration of the tertiary economy going on around us.
It's not much but you cannot say it is all doom and gloom from Archdruid Greer. He is deeply (and justifiably) skeptical that our civilization can adapt to the ecological limits we face when our economic soothsayers are so blinded by their own brilliance. For those of us who are more than 30 years from retirement, he suggests that we plan for a very different world and, in the meantime, learn to be more self-reliant.

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