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Use and Abuse of the “Natural Capital” Concept

by Herman Daly

Herman DalySome people object to the concept of “natural capital” because they say it reduces nature to the status of a commodity to be marketed at its exchange value. This indeed is a danger, well discussed by George Monbiot. Monbiot’s criticism rightly focuses on the monetary pricing of natural capital. But it is worth clarifying that the word “capital” in its original non-monetary sense means “a stock or fund that yields a flow of useful goods or services into the future.” The word “capital” derives from “capita” meaning “heads,” referring to heads of cattle in a herd. The herd is the capital stock; the sustainable annual increase in the herd is the flow of useful goods or “income” yielded by the capital stock–all in physical, not monetary, terms. The same physical definition of natural capital applies to a forest that gives a sustainable yield of cut timber, or a fish population that yields a sustainable catch. This use of the term “natural capital” is based on the relations of physical stocks and flows, and is independent of prices and monetary valuation. Its main use has been to call attention to and oppose the unsustainable drawdown of natural capital that is falsely counted as income.

Big problems certainly arise when we consider natural capital as expressible as a sum of money (financial capital), and then take money in the bank growing at the interest rate as the standard by which to judge whether the value of natural capital is growing fast enough, and then, following the rules of present value maximization, liquidate populations growing slower than the interest rate and replace them with faster growing ones. This is not how the ecosystem works. Money is fungible, natural stocks are not; money has no physical dimension, natural populations do. Exchanges of matter and energy among parts of the ecosystem have an objective ecological basis. They are not governed by prices based on subjective human preferences in the market.

Furthermore, money in the bank is a stock that yields a flow of new money (interest) all by itself without diminishing itself, and without the aid of other flows. Can a herd of cattle yield a flow of additional cattle all by itself, and without diminishing itself? Certainly not. The existing stock of cattle transforms a resource flow of grass and water into new cattle faster than old cattle die. And the grass requires sunlight, soil, air, and more water. Like cattle, capital transforms resource flows into products and wastes, obeying the laws of thermodynamics. Capital is not a magic substance that grows by creating something out of nothing.

While the environmentalist’s objections to monetary valuation of natural capital are sound and important, it is also true that physical stock-flow (capital-income) relations are important in both ecology and economics. Parallel concepts in economics and ecology aid the understanding and proper integration of the two realities–if their similarities are not pushed too far!

The biggest mistake in integrating economics and ecology is confusion about which is the Part and which is the Whole. Consider the following official statement, also cited by Monbiot:

As the White Paper rightly emphasized, the environment is part of the economy and needs to be properly integrated into it so that growth opportunities will not be missed.

—Dieter Helm, Chairman of the Natural Capital Committee, The State of Natural Capital: Restoring our Natural Assets, Second report to the Economic Affairs Committee, UK, 2014.

If the Chairman of the UK Natural Capital Committee gets it exactly backwards, then probably others do too. The environment, the finite ecosphere, is the Whole and the economic subsystem is a Part–a completely dependent part. It is the economy that needs to be properly integrated into the ecosphere so that its limits on the growth of the subsystem will not be missed. Given this fundamental misconception, it is not hard to understand how other errors follow, and how some economists, imagining that the ecosphere is part of the economy, get confused about valuation of natural capital.

Natural Capital, James Wheeler

How can we correctly price natural capital in a full world? Photo Credit: James Wheeler

In the empty world, natural capital was a free good, correctly priced at zero. In the full world, natural capital is scarce. How do we take account of that scarcity without prices? This question is what understandably leads economists to price natural capital, and then leads to the monetary valuation problems just discussed. But is there not another way to recognize scarcity, besides pricing? Yes, one could impose quotas–quantitative limits on the resource flows at ecologically sustainable levels that do not further deplete natural capital. We could recognize scarcity by living sustainably off of natural income rather than living unsustainably from the depletion of natural capital.

In economics, “income” is by definition the maximum amount that can be consumed this year without reducing the capacity to produce the same amount next year. In other words, income is by definition sustainable, and the whole reason for income accounting is to avoid impoverishment by inadvertent consumption of capital. This prudential rule, although a big improvement over present practice, is still anthropocentric in that it considers nature in terms only of its instrumental value to humans. Without denying the obvious instrumental value of nature to humans, many of us consider nature to also have intrinsic value, based partly on the enjoyment by other species of their own sentient lives. Even if the sentient experience of other species is quite reasonably considered less intrinsically valuable than that of humans, it is not zero. Therefore we have a reason to keep the scale of human takeover even below that indicated by maximization of instrumental value to humans. On the basis of intrinsic value alone, one may argue that the more humans the better–as long as we are not all alive at the same time! Maximizing cumulative lives ever to be lived with sufficient wealth for a good (not luxurious) life is very different from, and inconsistent with, maximizing simultaneous lives.

In addition, speaking for myself, and I expect many others, there is a deeper consideration. I cannot reasonably conceive (pace neo-Darwinist materialists) that our marvelous world is merely the random product of multiplying infinitesimal probabilities by infinitely many trials. That is like claiming that Hamlet was written by infinitely many monkeys, banging away at infinitely many typewriters. A world embodying mathematical order, a system of evolutionary adaptation, conscious rational thought capable of perceiving this order, and the moral ability to distinguish good from bad, would seem to be more like a creation than a happenstance. As creature-in-charge, whether by designation or default, we humans have the unfulfilled obligation to preserve and respect the capacity of Creation to support life in full. This is a value judgment, a duty based both historically and logically on a traditional theistic worldview. Although nowadays explicitly rejected by materialists, and by some theists who confuse dominion with vandalism, this worldview fortunately still survives as more than a vestigial cultural inheritance.

Whatever one thinks about these deeper issues, the point is that determination of the scale of resource throughput cannot reasonably be based on pseudo prices. But scale does have real consequences for prices. Fixing the scale of the human niche is a price-determining macro decision based on ethical and religious criteria. It is not a price-determined micro decision based on market expression of individual preferences weighted by ability to pay.

However the scale of the macro-limited resource flow is determined, we next face the question of how to ration that amount among competing micro claimants? By prices. So we are back to pricing, but in a very different sense. Prices now are tools for rationing a fixed predetermined flow of resources, and no longer determine the volume of resources taken from nature, nor the physical scale of the economic subsystem. Market prices (modified by taxes or cap-auction-trade) ration resources as an alternative to direct quantitative allocation by central planning. The physical scale of the economy has been limited, and the resulting scarcity rents are captured for the public treasury, permitting elimination of many regressive taxes. Dollars become ration tickets; no longer votes that determine how big the scale of the economy will be relative to the ecosystem. The market no longer conveys the message “we can grow as much as we want as long as we pay the price.” Rather the new message is, “there is only so much to go around, and dollars are your ration ticket for a part of the fixed quota, not a vote that can be cast for growth.” Equitable distribution of dollar incomes (ration tickets) will then be seen as the serious matter that it is, to be solved by sharing, not evaded by growth, especially not by uneconomic growth.

Unfortunately, the more common approach in economics has been to try somehow to calculate that price that internalizes sustainability and impose it via taxes. The right price, given the demand curve, will result in the corresponding right quantity. However, there is a two-fold problem: first, methods of calculating the “right” price are usually specious (e.g. contingent valuation); and second, we don’t really know where the shifting demand curve is, except on the blackboard. In fixing prices, errors in demand estimation result in variations in quantity. In fixing quantity, errors result in variations in price. The ecosystem is sensitive to quantity, not price. It is ecologically safer to let errors in estimation of demand result in price changes rather than quantity changes. This is one advantage of the cap-auction-trade system relative to carbon taxes. Although a great improvement over the present, carbon taxes attempt to ration carbon fuels without having really limited their supply. Nor are the “dollar ration tickets” limited, given the fractional reserve banks’ ability to create money, and the Fed’s policy of issuing more money whenever growth slows down.

A monetary reform to 100% reserve requirements on demand deposits would be a good policy for many reasons, to which we can add, as a necessary supplement to a carbon tax. It would not be necessary as a supplement to cap-auction-trade, but should be adopted for independent reasons. A good symbol should not be allowed to do things that the reality it symbolizes cannot do. One hundred percent reserves would require the symbol of money to behave more like real wealth, at least in some important ways. But this is another story.

Top 10 Policies for a Steady-State Economy

by Herman Daly

Herman DalyLet’s get specific. Here are ten policies for ending uneconomic growth and moving to a steady-state economy. A steady-state economy is one that develops qualitatively (by improvement in science, technology, and ethics) without growing quantitatively in physical dimensions; it lives on a diet — a constant metabolic flow of resources from depletion to pollution (the entropic throughput) maintained at a level that is both sufficient for a good life and within the assimilative and regenerative capacities of the containing ecosystem.

Ten is an arbitrary number — just a way to get specific and challenge others to suggest improvements. Although the whole package here discussed fits together in the sense that some policies supplement and balance others, most of them could be adopted singly and gradually.

1. Cap-auction-trade systems for basic resources. Caps limit biophysical scale by quotas on depletion or pollution, whichever is more limiting. Auctioning the quotas captures scarcity rents for equitable redistribution. Trade allows efficient allocation to highest uses. This policy has the advantage of transparency. There is a limit to the amount and rate of depletion and pollution that the economy can be allowed to impose on the ecosystem. Caps are physical quotas, limits to the throughput of basic resources, especially fossil fuels. The quota usually should be applied at the input end because depletion is more spatially concentrated than pollution and hence easier to monitor. Also the higher price of basic resources will induce their more economical use at each upstream stage of production, as well as at the final stages of consumption and recycling. Ownership of the quotas is initially public — the government periodically auctions them to individuals and firms. There should be no “grandfathering” of quota rights to previous users, nor “offshoring” of quotas for new fossil fuel power plants in one by place by credits from planting trees somewhere else. Reforestation is a good policy on its own.  It is too late for self-canceling half measures — increased carbon sequestration and decreased emissions are both needed. The auction revenues go to the treasury and are used to replace regressive taxes, such as the payroll tax, and to reduce income tax on the lowest incomes. Once purchased at auction the quotas can be freely bought and sold by third parties, just as can the resources whose rate of depletion they limit. The cap serves the goal of sustainable scale; the auction serves the goal of fair distribution; and trading allows efficient allocation — three goals, three policy instruments. Although mainly applied to nonrenewable resources, the same logic works for limiting the off-take from renewable resources, such as fisheries and forests, with the quota level set to approximate a sustainable yield.

2. Ecological tax reform. Shift the tax base from value added (labor and capital) to “that to which value is added,” namely the entropic throughput of resources extracted from nature (depletion), and returned to nature (pollution). Such a tax shift prices the scarce but previously un-priced contribution of nature. Value added to natural resources by labor and capital is something we want to encourage, so stop taxing it. Depletion and pollution are things we want to discourage, so tax them. Payment above necessary supply price is rent, unearned income, and most economists have long advocated taxing it, both for efficiency and equity reasons. Ecological tax reform can be an alternative or a supplement to cap-auction-trade systems.

3. Limit the range of inequality in income distribution with a minimum income and a maximum income. Without aggregate growth poverty reduction requires redistribution. Unlimited inequality is unfair; complete equality is also unfair. Seek fair limits to the range of inequality. The civil service, the military, and the university manage with a range of inequality of a factor of 15 or 20. Corporate America has a range of 500 or more. Many industrial nations are below 25. Could we not limit the range to, say, 100, and see how it works? This might mean a minimum of 20 thousand dollars and a maximum of two million. Is that not more than enough to give incentive for hard work and compensate real differences? People who have reached the limit could either work for nothing at the margin if they enjoy their work, or devote their extra time to hobbies or public service. The demand left unmet by those at the top will be filled by those who are below the maximum. A sense of community, necessary for democracy, is hard to maintain across the vast income differences current in the United States. Rich and poor separated by a factor of 500 have few experiences or interests in common, and are increasingly likely to engage in violent conflict.

4. Free up the length of the working day, week, and year — allow greater option for part-time or personal work. Full-time external employment for all is hard to provide without growth. Other industrial countries have much longer vacations and maternity leaves than the United States. For the classical economists the length of the working day was a key variable by which the worker (self-employed yeoman or artisan) balanced the marginal disutility of labor with the marginal utility of income and of leisure so as to maximize enjoyment of life. Under industrialism the length of the working day became a parameter rather than a variable (and for Karl Marx was the key determinant of the rate of exploitation). We need to make it more of a variable subject to choice by the worker. Milton Friedman wanted “freedom to choose” — OK, here is an important choice most of us are not allowed to make! And we should stop biasing the labor-leisure choice by advertising to stimulate more consumption and more labor to pay for it. At a minimum advertising should no longer be treated as a tax-deductible expense of production.

5. Re-regulate international commerce — move away from free trade, free capital mobility, and globalization. Cap-auction-trade, ecological tax reform, and other national measures that internalize environmental costs will raise prices and put us at a competitive disadvantage in international trade with countries that do not internalize costs. We should adopt compensating tariffs to protect, not inefficient firms, but efficient national policies of cost internalization from standards-lowering competition with foreign firms that are not required to pay the social and environmental costs they inflict. This “new protectionism” is very different from the “old protectionism” that was designed to protect a truly inefficient domestic firm from a more efficient foreign firm. The first rule of efficiency is “count all the costs” — not “free trade,” which coupled with free capital mobility leads to a standards-lowering competition to count as few costs as possible. Tariffs are also a good source of public revenue. This will run afoul of the World Trade Organization/World Bank/International Monetary Fund, so….

Ten pieces of the policy puzzle for an earth-centric economy

Ten pieces of the policy puzzle for an earth-centric economy

6. Downgrade the WTO/WB/IMF. Reform these organizations based on something like Keynes’s original plan for a multilateral payments clearing union, charging penalty rates on surplus as well as deficit balances with the union — seek balance on current account, and thereby avoid large foreign debts and capital account transfers. For example, under Keynes’s plan the U.S. would pay a penalty charge to the clearing union for its large deficit with the rest of the world, and China would also pay a similar penalty for its surplus. Both sides of the imbalance would be pressured to balance their current accounts by financial penalties, and if need be by exchange rate adjustments relative to the clearing account unit, called the “bancor” by Keynes. The bancor would also serve as the world reserve currency, a privilege that should not be enjoyed by any national currency, including the U.S. dollar. Reserve currency status for the dollar is a benefit to the U.S. — rather like a truckload of free heroin is a benefit to an addict. The bancor would be like gold under the gold standard, only you would not have to tear up the earth to dig it out. Alternatively a regime of freely fluctuating exchange rates is a viable possibility requiring less international cooperation.

7. Move away from fractional reserve banking toward a system of 100% reserve requirements. This would put control of the money supply and seigniorage (profit made by the issuer of fiat money) in the hands of the government rather than private banks, which would no longer be able to live the alchemist’s dream by creating money out of nothing and lending it at interest. All quasi-bank financial institutions should be brought under this rule, regulated as commercial banks subject to 100% reserve requirements. Banks would earn their profit by financial intermediation only, lending savers’ money for them (charging a loan rate higher than the rate paid to savings or “time-account” depositors) and charging for checking, safekeeping, and other services. With 100% reserves every dollar loaned to a borrower would be a dollar previously saved by a depositor (and not available to him during the period of the loan), thereby re-establishing the classical balance between abstinence and investment. With credit limited by prior saving (abstinence from consumption) there will be less lending and borrowing and it will be done more carefully — no more easy credit to finance the massive purchase of “assets” that are nothing but bets on dodgy debts. To make up for the decline in bank-created, interest-bearing money the government can pay some of its expenses by issuing more non-interest-bearing fiat money. However, it can only do this up to a strict limit imposed by inflation. If the government issues more money than the public voluntarily wants to hold, the public will trade it for goods, driving the price level up. As soon as the price index begins to rise the government must print less and tax more. Thus a policy of maintaining a constant price index would govern the internal value of the dollar. The Treasury would replace the Fed, and the target policy variables would be the money supply and the price index, not the interest rate. The external value of the dollar could be left to freely fluctuating exchange rates (or preferably to the rate against the bancor in Keynes’s clearing union).

8. Stop treating the scarce as if it were free, and the free as if it were scarce. Enclose the remaining open-access commons of rival natural capital (e.g., the atmosphere, the electromagnetic spectrum, and public lands) in public trusts, and price them by cap-auction-trade systems, or by taxes.  At the same time, free from private enclosure and prices the non-rival commonwealth of knowledge and information. Knowledge, unlike the resource throughput, is not divided in the sharing, but multiplied. Once knowledge exists, the opportunity cost of sharing it is zero, and its allocative price should be zero. International development aid should more and more take the form of freely and actively shared knowledge, along with small grants, and less and less the form of large interest-bearing loans. Sharing knowledge costs little, does not create un-repayable debts, and increases the productivity of the truly rival and scarce factors of production. Patent monopolies (aka “intellectual property rights”) should be given for fewer “inventions,” and for fewer years. Costs of production of new knowledge should, more and more, be publicly financed and then the knowledge freely shared. Knowledge is a cumulative social product, and we have the discovery of the laws of thermodynamics, the double helix, polio vaccine, etc. without patent monopolies and royalties.

9. Stabilize population. Work toward a balance in which births plus in-migrants equals deaths plus out-migrants. This is controversial and difficult, but as a start contraception should be made available for voluntary use everywhere. And while each nation can debate whether it should accept many or few immigrants, and who should get priority, such a debate is rendered moot if immigration laws are not enforced. We should support voluntary family planning and enforcement of reasonable immigration laws, democratically enacted.

10. Reform national accounts — separate GDP into a cost account and a benefits account. Natural capital consumption and “regrettably necessary defensive expenditures” belong in the cost account. Compare costs and benefits of a growing throughput at the margin, and stop throughput growth when marginal costs equal marginal benefits. In addition to this objective approach, recognize the importance of the subjective studies that show that, beyond a threshold, further GDP growth does not increase self-evaluated happiness. Beyond a level already reached in many countries, GDP growth delivers no more happiness, but continues to generate depletion and pollution. At a minimum we must not just assume that GDP growth is economic growth, but prove that it is not uneconomic growth.

Currently these policies are beyond the pale politically. To the reader who has persevered this far, I thank you for your willing suspension of political disbelief. Only after a significant crash, a painful empirical demonstration of the failure of the growth economy, would this ten-fold program, or anything like it, stand a chance of being enacted.

To be sure, the conceptual change in vision from the norm of a growth economy to that of a steady-state economy is radical. Some of these proposals are rather technical and require more explanation and study. There is no escape from studying economics, even if, as Joan Robinson said, the main reason for it is to avoid being deceived by economists. Nevertheless, the policies required are far from revolutionary, and are subject to gradual application. For example, 100% reserve banking was advocated in the 1930s by the conservative Chicago School and can be approached gradually, the range of distributive inequality can be restricted gradually, caps can be adjusted gradually, etc. More importantly, these measures are based on the impeccably conservative institutions of private property and decentralized market allocation. The policies here advocated simply reaffirm forgotten pillars of those institutions, namely that: (1) private property loses its legitimacy if too unequally distributed; (2) markets lose their legitimacy if prices do not tell the truth about opportunity costs; and as we have more recently learned (3) the macro-economy becomes an absurdity if its scale is required to grow beyond the biophysical limits of the Earth.

Well before reaching that radical biophysical limit, we are encountering the classical economic limit in which extra costs of growth become greater than the extra benefits, ushering in the era of uneconomic growth, whose very possibility is denied by the growthists. The inequality of wealth distribution has canceled out the traditional virtues of private property by bestowing nearly all benefits of growth to the top 1%, while generously sharing the costs of growth with the poor. Gross inequality, plus monopolies, subsidies, tax loopholes, false accounting, cost-externalizing globalization, and financial fraud have made market prices nearly meaningless as measures of opportunity cost. For example, a policy of near zero interest rates (quantitative easing) to push growth and bail out big banks has eliminated the interest rate as a measure of the opportunity cost of capital, thereby crippling the efficiency of investment. Trying to maintain the present growth-based Ponzi system is far more unrealistic than moving to a steady-state economy by something like the policies here outlined. It is probably too late to avoid unrealism’s inevitable consequences. But while we are hunkered down and unemployed, enduring the crash, we might think about the principles that should guide reconstruction.