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The Infinite-Planet Approach Won’t Solve the European Debt Crisis

by Eric Zencey

Last week European leaders met in Brussels and, like sophomores cramming before a final, pulled an all-nighter. Their exam was a real-world project: restore investor confidence in the Eurozone. A lot of pressure was put on David Cameron to bring the UK into the new agreement; he was adamant in his refusal. Even without the UK, the measures that the Eurozone nations have announced may restore investor confidence, but one thing is certain: they shouldn’t, because they’ll fail miserably at staving off future financial crisis.

That’s because “restoring investor confidence” and “fixing the broken system” are two very different goals.

If more investors were like Jeremy Grantham, who’s got a clear view of the origin of the financial crisis, the two would line up a lot better. But most investors, like all of the policy makers who met in Brussels, are working out of an old-fashioned and mistaken economic model. Restoring confidence in a system built on that model isn’t going to fix what’s wrong.

What, exactly, is wrong? The New York Times articulated the conventional thinking when it opined, a few days before the all-nighter in Brussels, that the root of the debt crisis is “lack of growth.” The first step toward success in solving any problem is to define it accurately, and the conventional diagnosis gets it wrong because it looks at just half the problem. A more complete diagnosis: Some of the European economies haven’t been able to grow fast enough to pay back the burden of debt that has been wagered on them.

This formulation lets us see the path to a sturdy solution: if we want to avoid crises of debt repudiation, we need to limit the total creation of debt, public and private, to the amount that we can reasonably expect to be paid back through economic growth.

But instead of solving the problem of recurrent (and increasingly painful) crises of debt repudiation by looking at the system as a whole, the policy makers who met in Brussels went after just the most recent and obvious symptom: government deficits and threatened government defaults by the weaker economies of the Eurozone. When deficits are created by sovereign governments — governments that have the power to print money to cover them — they’re inflationary, and inflation is one way that a system’s need for debt repudiation can be met. But within the Eurozone, the European Central Bank holds inflation in check, so the necessary and expected debt repudiation has to take a different form. It has come this time as Greece’s move to renegotiate bond liability under threat of default — holders of Greek government bonds will get fifty cents on the dollar, not the full amount they expect. The conventional view sees that and thinks, “if Greece didn’t run deficits it wouldn’t have to default.”

That’s true, but too limited to get at the root of the problem. What the conventional frame of analysis doesn’t foresee: If you let the burden of total debt grow unchecked, and if you control both inflation and governmental default by mandating balanced budgets, you’ll simply displace the pressure for debt repudiation to somewhere else in the system. It will come out as bankruptcies and foreclosures or other private defaults, as stock market crashes, as cuts in pension promises or wage contracts, as loss of paper assets or expected future income of any kind. We can’t forestall the next crisis of debt repudiation unless we rein in the total creation of debt.

The new EU plan would take a major step toward making the Eurozone monetary union into a fiscal union, with stronger centralized control of inflationary deficits. Under the new rules, Eurozone member nations will have to balance their budgets over the economic cycle (if they go into deficit in times of recession, they’ll have to run a surplus in times of growth) and submit their budgets to the European Commission for review and approval. Currently member nations face penalties if they run persistent deficits — penalties that Greece consciously chose to ignore rather than see its economy sink into unemployment and recession under the onslaught of cheap imports from countries running a surplus. The new plan would have Eurozone member nations suffer larger, automatic penalties if they don’t obey the budget-balancing rules.

That will control inflation and bond default as methods of debt repudiation by imposing austerity budgets on struggling Eurozone members. (There are no penalties for the countries, like Germany, that create the other half of the problem by running trade surpluses.) Governments will have to cut social services and regulatory enforcement — cuts that will be touted as the best way to restore growth, and which will work to the benefit of the 1%. The rich get richer and government gets smaller — just what neocons and moneyed interests like to see.

As plenty of commentators have noticed, fiscal integration under the new budget rules and procedures means a loss of national sovereignty within the Eurozone. As only some of those commentators have cautioned, this makes government in Europe less democratic and less responsive to citizen concerns. “No problem,” say bankers and financiers. Democratically empowered citizens are likely to demand the level of governmental services and environmental protection that well-to-do nations are expected to provide — and those are luxuries their country can’t afford, not if it’s to grow rapidly enough to pay back the burden of debt it labors under.

The movement toward fiscal union and budget austerity thus represents the victory of growth-for-the-sake-of-growth over democracy-for-the-sake-of-democracy.

On an infinite planet, the two need not be at odds, and in fact can be seen to support each other. They certainly seemed to track together through much of the nineteenth and twentieth centuries, as market economies expanded into an underdeveloped world. But in a world built out to the limits of what ecosystems can handle, it becomes increasingly obvious that there’s a tradeoff.

As should be obvious to policy makers, the expansionary phase of human economic history is over. It is no longer possible to have both democracy and robust, footprint-expanding growth. The freewheeling creation of debt, whether public or private, drives the latter. To preserve it as a very profitable feature of the economy, bankers and financiers are perfectly willing to sacrifice the former. That’s the deep and troubling lesson of the European Debt Crisis: today, the largest threat to democratic forms of government is the fact that the planet hosts a human debt-creation system suited for perpetual growth on an infinite planet.

Because an economy deals in physical reality — that is, it runs on matter and energy drawn from a finite planet — it is impossible for economic production to grow infinitely. Debt, being entirely imaginary, can grow however rapidly we choose to let it. A crisis of debt repudiation is the unavoidable result of a mismatch between the two. The conventional frame does not admit this, and it leads us straight toward regressive and destructive policies, including the elimination of environmental and social safeguards. Those safeguards set limits to what we let ourselves do in pursuit of economic growth, and thereby give us a higher standard of living by protecting us from environmental harms and economic insecurity.

Since a higher standard of living, and not growth for its own sake, is the ultimate purpose of the economy, it makes sense to allow for the possibility that the solution to our system’s regular crises of debt repudiation lies in controlling the creation of debt. The alternative — demanding more and more economic growth, ever larger throughput of matter and energy — is impossible to sustain on a finite planet.

Even in the short run, the infinite growth model is counterproductive. It leads to a declining standard of living and a loss of democratic freedom for the majority of the world’s population — Americans no less than Greeks, Italians and other Europeans. It does so because whether we’re prepared to admit it or not, we’ve reached the limits to growth. More often than not, further growth in GDP is uneconomic growth, because it costs us more in lost ecosystem services and other “disamenities” than we get in benefits.

Pro-growth people don’t see it that way, of course, no doubt because many of them are the ones who receive those benefits by imposing losses on the rest of us. Many of those losses emanate from, and aren’t fully contained within, the rapidly developing nations of China and India — countries whose leaders have mistakenly accepted a demonstrably flawed element of neoclassical thinking, the Environmental Kuznets Curve. This is the idea, much beloved of pro-growth advocates and members of the 1% everywhere, that environmental quality is a luxury that nations will be able to afford only after they develop more — which they can do by cashing out their natural capital for sale on world markets, and by hosting “sink” services, poisoning their land and mortgaging their future by absorbing the global economy’s waste stream.

The ecological footprint of the global economy is currently larger than the globe it inhabits. But you don’t have to believe that we’ve reached the limits to growth in order to see that the basic problem behind the European Debt Crisis is the mismatch between our rate of debt creation and the rate at which we can grow real wealth in order to pay that debt off.

How much can real wealth grow under reasonable environmental safeguards and with reasonable protection of worker (and citizen) health and safety? The answer is, in part, empirical. The non-empirical part has to do with those environmental and health and safety standards: what counts as “reasonable”? Opinions will differ, but only an out-and-out infinite planet theorist can argue that environmental constraints need to be lessened, and only an unreconstructed robber baron could argue that workers ought to be free — “free” — to starve or take on employment that could kill them.

Here’s how to begin to fix the broken system: Agree to minimum standards for environmental and health and safety regulation, such as those promulgated by the UN; find the sustainable rate of economic activity that’s possible within those limits; and limit the growth in debt — all debt, public and private — to what’s needed to support that activity. With such a fix, the human standard of living would be raised not though footprint- expanding growth, but through technological innovation that allows us to achieve more benefit from a constant, sustainably sized throughput.

If more investors understood that the excessive creation of debt in all its forms — not just government deficits — is the driver of our crises of debt repudiation, this reining in of the creation of debt would be the only way to restore their confidence.

Educating investors and policymakers about the economic and financial realities of a finite planet is a huge task, but eventually they’ll come around. They’ll have to. The planet is, after all, finite, and it’s going to keep offering the lesson until everybody gets it.

Two Schools and the Path to the Steady State

by Eric Zencey

All of economics is divided into two schools:  steady state theory and infinite planet theory.  They can’t both be right.  You’d think the choice between them would be obvious, but infinite planet theory still holds sway in classrooms and in the halls of power where policy is made.   Last month, though, brought a significant development:   the manager of a major hedge fund registered a carefully reasoned dissent from infinite planet theory.  And in doing so, Jeremy Grantham offered a glimpse of how and why steady state economic theory will ultimately come to prevail.

Grantham is the head of GMO LLC, a hedge fund with $100 billion under management. His latest letter to his investors was headlined “Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever”—a title that calls to mind the urgent warnings raised by steady-staters as far back as the 1970s.  Those warnings were dismissed by most economists as Chicken-Little fears that could safely be ignored—and the western industrial world proceeded to do just that.  Infinite planet theorists pointed to the work of Julian Simon, who argued that human ingenuity is The Ultimate Resource (as he put it in the title of a book). Since technology, a human invention, is a factor of production, and since human capacity for invention is infinite, there can be no resource limits to economic growth.  Infinity times anything is infinity, right?

You can get to that conclusion only if you ignore the laws of thermodynamics. However inventive humans have been or may yet prove to be, they’ll never invent a way around the first and second law.  You can’t make something from nothing and you can’t make nothing from something (the first law).  You can’t push a car backwards and fill the gas tank (the second).  Together these laws rule out perpetual motion, schemes in which energy is created out of nothing or recycled and used again.

In steady state theory, the economy is seen as a thermodynamic machine, drawing in matter and energy, processing them with more energy, and excreting a high entropy wake.  The economy thus has two ecological footprints:  one on the uptake and one on the discharge side.  Since both footprints land outside the abstract world of theory and in the physical reality of a finite planet, neither can increase forever.

Economists might have put these truths into practice decades ago.  Had they done so, they would have been in good company.  Physics had its thermodynamic revolution in the person of Albert Einstein, whose path from Newton to relativity began with thermodynamics, as he played out the un-mechanical implications of the second law.  (Mechanical motion is reversible; energy use is not.)  Biology was transformed in the 1920s and 1930s, as biologists saw that evolution is driven by competition for energy, which structures and maintains ecosystems—food webs—in which sunlight becomes green plant then herbivore, carnivore, detritivore.

Why, then, has the thermodynamic revolution in economics been postponed? The question will intrigue historians of the future, who will wonder at the profligacy of our culture and our cavalier disregard for ecological limit.

Part of the answer is the bet that Julian Simon made in 1980 with population activist Paul Ehrlich.  Simon maneuvered Ehrlich into wagering on the future price of any group of resources that Ehrlich cared to pick:  if Simon’s theory was right, he claimed, the prices would be lower within ten years.  Simon won.

His victory was widely taken as proof of his infinite planet theory, despite the obvious flaw in it.  The market price of any commodity is a human construct, the result of market supply and demand, not an indicator of scarcity in any absolute sense.  From a limited stock of a finite resource—oil, say—we can choose to extract the resource at a greater or lesser rate.  If the rate at which we pump oil out of the ground exceeds the rate at which demand for oil increases, the market price will fall.  This doesn’t prove that oil is plentiful, let alone infinite.  It doesn’t prove that we’ve invented our way around the laws of thermodynamics.  It merely proves that we’ve extracted oil fast enough to keep its market price from rising.

Grantham goes head-to-head with Simonism not on these theoretical grounds but with solid empirical evidence:  commodity prices are rising and aren’t likely ever to come down again.  Volatility in prices can be assessed by looking at change in terms of standard deviations from the mean:  how big, exactly, are the swings, as measured against average variability over time?  Sharp increases in the prices of significant commodities since 2002 fall well outside the standard deviation; for iron ore, the rise has been 4.9 times the standard deviation, a result that (Grantham tells us) has a one in 2.2 million chance of being “normal” variation.  More likely, it signals a new and different reality.  For coal, copper, corn, silver, sorghum, palladium, rubber, etc., the odds aren’t as long, but still pretty sizable:  one to 48,000, one to 17,000, one to fourteen- and nine- and four thousand.  This basic, deep-seated trend lies beneath the statistical noise—price spikes and troughs, including those created by speculation and subsequent “market corrections.”

Based on this analysis, and on a review of energy use that reaches back to when wood was our primary fuel, Grantham concludes that we have entered a new era:  we are on the cusp of what he calls The Great Paradigm Shift, “one of the giant inflection points in economic history”—the moment, he warns, that lies at “the beginning of the end for the heroic growth spurt in population and wealth caused by…the Hydrocarbon Revolution.”

You don’t find too many economists, let alone market analysts, reaching back to look at energy use before the era of coal.  In the infinite planet neoclassical model, anything before James Watt is quaint and distant, and everything before Adam Smith is simply darkness.  It’s true enough that steam-driven factories, embodying the division of labor that Smith celebrated, were game changers, leading to phenomenal economic growth; but you can’t see the scope of the game, or even begin to see that it has an end, unless you put those inventions into an historical and geophysical perspective that reaches back before Watt and Smith.

That’s why the Industrial Revolution is more properly called the Hydrocarbon Revolution.  In focusing on the machinery, “Industrial Revolution” leads us to think that the engine of economic growth was human invention—and thus leads to the mistaken idea that more and better invention will let us increase productivity forever.  “Hydrocarbon Revolution” makes clear that the modern economic miracle has thermodynamic roots.  Economic history changed when we began systematically to exploit a new stock of energy, the stored fossil sunlight of coal and oil, with its historically unprecedented rate of energy return on energy invested (EROI)—as high as 100:1 for oil in the early part of the twentieth century.  “Hydrocarbon Revolution” reflects the reality that the enormous productivity gains of the machine age are rooted in that very favorable EROI.  It also implicitly includes the warning that the modern economic miracle must end when this stock of thermodynamically cheap energy is used up.

The essence of steady-state thinking is that we have to shape our economy to operate on a finite planet, within a stable, sustainable budget of matter-and-energy throughput.  That throughput has to be sized so that the economy’s two footprints fit into the available ecological shoes.  Grantham has noticed that one of the shoes is pinching, and he’s begun to articulate the reasons why, to an audience highly motivated to listen.  If they heed his warning— “From now on, price pressure and shortages of resources will be a permanent feature of our lives”—the considerable engine of self-interest will be hitched to the adoption of steady state economic theory.

If practitioners adopt steady-state principles, the economists who theorize about them can’t remain far behind.

Upton Sinclair once observed, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”  In the past that logic has worked against the spread of steady-state thinking.  Now the logic has turned:  if you want to make money, you’d better acknowledge reality, including the reality that on a finite planet there are limits to growth.  To those of us concerned about the fate of a civilization that’s outgrown its ecological niche, this is a welcome development.