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The Future History of Political Economy – Part 2

Thermodynamics in Economics: Revolutionary portent, future history

by Eric Zencey

Eric ZenceyEcological Economics represents the extension into economics of the thermodynamic revolution of the nineteenth and twentieth centuries. In physics, that revolution dethroned Newton and brought relativity. In biology, it was midwife to the birth of ecology, the study of ecosystems as wholes in which energy networks—food webs—are a defining structure. In chemistry the laws of thermodynamics brought clarity and rigor to a science that struggled to bring theoretical unity to diverse phenomena. So far, though, most economists are perfectly willing to treat their subject matter as if the laws of thermodynamics simply don’t apply to it.

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But the thermodynamic revolution in economics can’t be permanently forestalled. For one thing, it’s getting harder and harder for the neoclassical model to reassure us that its system of Newtonian abstractions is a good fit to the real world. The Great Collapse of 2008 demonstrated that whatever else it is, the discipline of economics isn’t very good at predicting major economic phenomena. Climate change and the Sixth Extinction make it hard for economics to maintain its pretense that economic activity takes place in abstractia, on the clean white pages of textbooks or on whiteboards holding formulae, with no roots in or consequences for anything outside of itself. Truths derived on the model of Newtonian mechanism are supposed to be abstract and ahistorical, but our planet and our economy are most assuredly evolving concretely and over time.

The driving dynamic of this economic and planetary change—the driver of history for the past three centuries—has been human use of high-EROI fossil fuel. The driving dynamic of the history yet to come will be the declining EROI of our civilization’s energy sources.

Oil Well 3.Texas State Archives

Oil used to gush out of the ground under pressure, making for a very high Energy Return on Energy Invested (EROI). In the 1920s, wells like this gave the industry an average EROI of 100 to 1 or more. Today’s petroleum industry has a much lower EROI. Photo Credit: Texas State Archives

You can see some of the consequences of declining EROI already:

  • Despite a rising real per capita GDP, for a significant percentage of workers in OECD nations personal income has flatlined or is declining. An increasing concentration of income helps explain this but another dynamic is at work as well. As EROI falls, it takes more economic effort to get the energy that’s needed to support economic effort. Even as gross economic activity (GDP) grows, production of net benefit is shrinking.
  • Other sectors of the economy have been affected by this ongoing increase in the economy’s matter-and-energy overhead. “Austerity” has become the watchword for governmental budgets, even in the wealthiest nations in the world. Developed countries find it increasingly difficult if not impossible to pay maintenance and upgrade costs on infrastructure investments made in the heyday of 100-to-1 oil.
  • In its 2013 report card on America’s infrastructure, The American Society of Civil Engineers estimated that the U.S. needs to invest $3.6 trillion over seven years to restore and maintain existing infrastructure.
  • Worldwide, many of the ecosystems that support human civilization are degraded and close to collapse. Forced by both ideology and declining EROI into austerity budgeting, governments are reducing their scope and energy at the exact moment that sustainability would have them take strong action to rein in the rational, free-market tendency of corporations to maximize profits by degrading the commons and externalizing other costs.
  • Pension-fund wipeouts are becoming common as one way to fulfill the economy’s structural need for debt repudiation—a need that lies in our system’s willingness to let debt grow faster than a declining EROI economy can pay back, even after growth has been stimulated by lifting or reducing regulations that limit the environmental damage done by economic activity.
  • The planetary carbon sink is full, producing climatic effects that even an abstraction-inhabiting, arithmo-morphizing economist has to acknowledge as a troubling reality.

Centuries from now economic historians are likely to understand the relationship between EROI and wealth creation much better than does the average economist of today. I think it likely that future political economists will express wonder not at the 20th century’s enormous economic success, but at how little we actually added to our stock of wealth for all the high-EROI coal and oil it was our pleasure to burn. They are almost certain to shake their heads in wonder that we, enjoying an energy supply and an EROI never seen on the planet before or since, could ever have experienced an economic downturn, could ever have let a human starve from want, could ever have been so programmatically blind to the physical origins of our fortunes.

The Future History of Political Economy – Part 1

Economics Ignores Thermodynamics

by Eric Zencey

Editor’s Note: An earlier version of this essay appeared as a comment in the Great Transition Network Forum, which will appear on the Great Transition Initiative website next week along with a new essay by Herman Daly, “Economics for a Full World.”

Eric ZenceyEcological Economics and its corollary, Steady State Economic thinking, represent a step forward for the discipline of economics and also a return to how it was practiced in the past. In the nineteenth century, economics was a part of a larger enterprise: political economy, the integrated treatment of morals and economics, ultimate ends and efficient means. Late in that century economics calved off from political economy, leaving behind political science and political philosophy as the residuum. It did this in service to the ideal of becoming rigorously scientific.

It’s odd, then, that alone among disciplines with any pretense to analytic rigor, economics has steadfastly resisted the thermodynamic revolution that swept physical and life sciences in the nineteenth and early twentieth centuries. Physics, biology, chemistry, geology, even the study of history were transformed, but not economics.

I think we can blame this on bad timing, willful ignorance, and oil.

Bad timing

In the late nineteenth century the archetypal science was physics and physics was Newtonian mechanism. Ignorant of what a young thermodynamic theorist named Albert Einstein would soon do to the Newtonian paradigm they emulated, Stanley Jevons and other economic “scientists” set about mathematically modeling the economy as sets and subsets of self-contained, equal-and-opposite actions and reactions, happily (and explicitly) assuming that all economic activity consists of ahistorical, which is to say completely reversible, processes. No one who has a nodding acquaintance with the law of entropy could have countenanced this. Entropy is Time’s Arrow, the law of irreversibility; it describes the one-way flow of energy use. A purely mechanical process can be run forward or backwards, but we’ll never invent a machine that can suck in exhaust gases, heat and motion and transform them into gasoline. The entropy law can tell you why. Newton couldn’t.

Just as a consumer might choose to keep a recently purchased appliance even though a newer, better model has been brought onto the market, neoclassical economists weren’t about to re-tool their brand-new thinking to reflect changes in the underlying metaphysics they had been so keen to adopt. It didn’t seem to them that there was any reason to.

“Seem” is the operative word here. Because the entropy process is time’s arrow, and because Ecological Economics places the entropy process at the center of its analysis, it’s entirely appropriate for Ecological Economics to understand its subject matter and itself as a discipline in historical terms. Like other paradigm-defining insights, this one seems obvious once it has been stated: elements of the neoclassical model that could pass for true on a large and forgiving planet a hundred years ago are obviously not true today, when the planet’s source-and-sink services are severely taxed, when natural capital is the limiting factor in production, when there are seven billion of us and our economic wants, capacities and expectations have been amplified by our access to the ancient sunshine of fossil fuels.

Willful ignorance

By modeling the economy as a closed and circular system, neoclassical economists have encouraged themselves to operate in a methodologically enforced state of denial about the physical roots and ecological consequences of our wealth-creating activities. And yet economics has experienced no paradigm-shaking crisis as a result. Neither climate change nor any of the other source-and-sink catastrophes facing civilization have been laid at the feet of bad economic theory. One reason: Neoclassical economists succeed in treating environmental costs as “externalities.” How could environmental degradation be the result of economic activity if it’s external to the economy?

Midas.Giovanni Caselli from the Age of Fable

The power to create wealth gave Midas an unsustainable life as a complete solipsist. Oil’s power to create wealth has had a similar effect on Neoclassical economics. Illustration by Giovanni Caselli from The Age of Fable.

In its self-confirming isolation of the economy from nature and theory from reality, neoclassical economics amounts to a highly principled practice of solipsism. When this pathology is manifest in an individual it produces unpleasant consequences that might eventually prompt some reflection and personal growth. Not so with the collective delusion of mainstream economists. Evidence of our ongoing ecological catastrophe falls far from their purview—not just disciplinarily but geographically, as the wealthier nations (wherein the vast majority of economists reside) export their ecological footprint to the impoverished nations of the world. And for several generations (at least since Reagan defeated Carter, removed Carter’s solar panels from the White House and ushered in an era of GDP growth through de-regulation of the social and ecological consequences of economic activity), there has been a strong self-selection among students of economics. Undergraduates with any kind of deep personal connection to natural systems tend to find the study of standard economics unattractive, displeasing, even soul-deadening. This leaves the field to those most willing to bracket off as irrelevant to their professional purpose any question about the moral and ethical consequences of economic activity, any question about the health and maintenance of nature, any question about the economy’s relation to the larger social and natural systems within which it operates.

Oil

Even so, you might expect that a discipline with such a demonstrably deficient view of its subject matter would fail of its object—would fail to offer wise counsel about the collective project of augmenting the stock of wealth that humans can enjoy. But economics has had much apparent success. Despite regular downturns and financial crises, the wealth produced by our economies has grown and grown and grown. I think there’s a ready explanation that becomes visible through the conceptual lens of Ecological Economics, which tells us that energy isn’t a commodity like any other but a fundamental factor of production (part of a trio: matter, energy and human design intelligence). When your economy operates on an energy source that cranks out wealth-making value in a ratio of 100 to 1 or better—the estimated Energy Return on Energy Invested that petroleum offered us in the early 20th Century—you can believe any damn thing you want about how economies operate and your economy will still generate a great deal of wealth.

Which is to say, high-EROI oil granted the new science of economics immunity from being proven false by events. But falsifiability of principles and propositions is one solid measure of a science. (Non-falsifiable beliefs are called faiths.)

In effect the discipline of economics has a free rider problem—it’s been given a free pass by the enormous power of oil to misunderstand itself and its subject matter. You could also call it a Midas Problem, after the legendary king whose touch turned everything he touched into gold, including his dinner and his daughter. The power of wealth-generation that oil granted to our economy made it impossible for the discipline of economics to connect in any fundamental way with otherness, including the otherness of the planet and its role in the very processes that economics presumes to model.

 

Integrating Ecology and Economics

by Herman Daly

Herman DalyAttempts to integrate economics and ecology have been based on one of three strategies: (1) economic imperialism; (2) ecological reductionism; (3) steady-state subsystem. Each strategy begins with the picture of the economy as a subsystem of the finite ecosystem. Thus all three recognize limits to growth. The differences concern the way they each treat the boundary between the economy and the rest of the ecosystem, and that has large policy consequences for how we accommodate to limits.

Ecology & Economy

 

Economic Imperialism

Economic imperialism seeks to expand the boundary of the economic subsystem until it encompasses the entire ecosphere. The goal is one system, the macro-economy as the whole. This is to be accomplished by complete internalization of all external costs and benefits into prices. Those myriad aspects of the biosphere not customarily traded in markets are treated as if they were by imputation of “shadow prices”–the economist’s best estimate of what the price of the function or thing would be if it were traded in a competitive market. Everything in the ecosphere is theoretically rendered comparable in terms of its priced ability to help or hinder individuals in satisfying their wants. Implicitly, the end pursued is ever-greater levels of consumption, and the way to effectively achieve this end is growth in marketed goods and services.

Economic imperialism is basically the neoclassical approach. Subjective individual preferences, however whimsical, uninstructed, or ill-considered, are taken as the ultimate source of value. Since subjective wants are thought to be infinite in the aggregate, as well as sovereign, there is a tendency for the scale of activities devoted to satisfying them to expand. The expansion is considered legitimate as long as “all costs are internalized.”

But many of the costs of growth we have experienced have come as surprises. We cannot internalize them if we cannot first imagine and foresee them. Furthermore, even after some external costs have become visible to all (e.g., climate change), internalization has been very slow and partial. Profit maximizing firms have an incentive to externalize costs. As long as the evolutionary fitness of the environment to support life is not perceived by economists as a value, it is likely to be destroyed in the imperialistic quest to make every molecule in creation pay its way according to the pecuniary rules of present value maximization.

Ironically, this imperialism sacrifices the main virtue of free market economists, namely their antipathy to the arrogance of central planners. Putting a price tag on everything in the ecosphere requires information and calculating abilities vastly beyond any imagined capacity.

There is no doubt that once the scale of the economy has grown to the point that formerly free environmental goods and services become scarce, it is better that they should have a positive price reflecting their scarcity than to continue to be priced at zero. But there remains the prior question: Are we better off at the new larger scale with formerly free goods correctly priced, or at the old smaller scale with free goods also correctly priced (at zero)? In both cases, the prices are right. This is the suppressed question of optimal scale, not answered, indeed not even asked, by neoclassical economics.

Ecological Reductionism

Ecological reductionism begins with the true insight that humans and markets are not exempt from the laws of nature. It then proceeds to the false inference that human action is totally explainable by, reducible to, the laws of nature. It seeks to explain whatever happens within the economic subsystem by exactly the same natural laws that it applies to the rest of the ecosystem. It subsumes the economic subsystem indifferently into the natural system, erasing its boundary. Taken to the extreme, in this view all is explained by a materialist deterministic system that has no room for purpose or will. This is a sensible vision from which to study the ecology of a coral reef. But if one adopts it for studying the human economy, one is stuck from the beginning with the important policy implication that policy makes no difference.

The reductionist vision frequently appeals to the Maximum Entropy Production Principle (often capitalized to elevate it to the same level as the Second Law of Thermodynamics). It says that whatever competing system maximizes entropy production will be competitively selected. Indeed one can appreciate the logic of this principle. The system that can monopolize and most rapidly degrade available sources of low entropy will displace competing systems by depriving them of their energy source. This insight should be taken seriously as a natural tendency. But when we apply it to the human economy it gives us an absurd policy implication. Namely, that the economy maximizes entropy production. Since maximizing entropy is the same as maximizing waste, that hardly offers a sensible rule for either understanding or directing the human economy!

The maximum entropy principle is more like the tragedy of open access commons than like the Second Law of Thermodynamics. That is, it is a trap–a competitive race to the bottom in the absence of collective action. The Second Law by contrast is an inevitability that we must recognize and adapt to; it has no known exceptions. The maximum entropy production principle is not a physical law. No action, collective or individual, can avoid the Second Law. Like the tragedy of the commons, the tragedy of entropy maximization is a detrimental competitive tendency that we must overcome by collective action. But if we mistakenly consider it a physical law on the level of the Second Law of Thermodynamics, then there is nothing to do but give up.

Economic imperialism and ecological reductionism have in common that they are monistic visions, albeit rather opposite monisms. It is the monistic quest for a single substance or principle by which to explain everything that leads to excessive reductionism on both sides. Certainly one should strive for the most reduced or parsimonious explanation possible without ignoring the facts. But respect for the basic empirical facts of natural laws on the one hand, and self-conscious purpose and will on the other hand, should lead us to a kind of practical dualism. After all, that our world should consist of two fundamental elements offers no greater inherent improbability than that it should rest on one only. How these two fundamental elements of our world (material cause and final cause) interact is a venerable mystery–precisely the mystery that the monists of both kinds are seeking to avoid. But economists are too much in the middle of things to adopt either extreme. Economists are better off denying the tidy-mindedness of either monism than denying the facts that point to an untidy dualism.

The Steady-State Subsystem

We must pay attention to the optimal scale of the human economy to protect the ecosystem we depend on. Photo Credit: Elisa Bracco

We must pay attention to the optimal scale of the human economy to protect the natural ecosystem we depend on. Photo Credit: Elisa Bracco

The remaining strategy is the steady-state subsystem. It does not attempt to eliminate the subsystem boundary, either by expanding it to coincide with the whole system or by reducing it to nothing. Rather, it affirms both the interdependence and the qualitative difference between the human economy and the natural ecosystem. The boundary must be recognized and drawn in the right place. The scale of the human subsystem defined by the boundary has an optimum, and the throughput by which the ecosphere physically maintains and replenishes the economic subsystem must be ecologically sustainable. That throughput is indeed entropic, but rather than maximizing entropy the goal of the economy is to minimize low entropy use needed for a sufficient standard of living–by sifting low entropy slowly and carefully through efficient technologies aimed at important purposes. The economy should not be viewed as an idiot machine dedicated to maximizing waste. Its final cause is not the maximization of waste but the maintenance and enjoyment of life.

The idea of a steady-state economy comes from classical economics, and was most developed by John Stuart Mill (1857), who referred to it as the “stationary state.” The main idea was that population and the capital stock were not growing, even though the art of living continued to improve. The constancy of these two physical stocks defined the scale of the economic subsystem. Birth rates would be equal to death rates and production rates equal to depreciation rates. Today we add that both rates should be equal at low levels rather than high levels because we value longevity of people and durability of artifacts, and wish to minimize throughput, subject to maintenance of sufficient stocks for a good life.

Ecological economics should seek to develop the steady-state vision, and get beyond the dead ends of both economic imperialism and ecological reductionism.

Economics as if the Laws of Thermodynamics Mattered

by David Jones

There is no wealth but life. –John Ruskin

Have you ever considered the question: what is life? If we are aiming for a new economic system that will preserve and enhance life, rather than the current system, which more often than not seems to destroy and degrade life, perhaps we should consider what life is and how it is made possible. I recall learning about “living things” in high school biology classes, but always found the definitions of these “living things” to be somewhat vague. Let me try a physicist’s definition then, which might feel unfamiliar at first. A living thing is a kind of low-entropy-maintenance machine: a configuration of differentiated parts that succeeds in performing complex, interdependent functions for a prolonged period of time.

Having used the word “entropy” in the previous sentence, I should try to explain what it is. All living and non-living things (and hence all human economies, whether or not economists pay attention to the fact!) obey the laws of thermodynamics. The second law, in particular, introduces the concept of entropy and the idea that the entropy of a closed system must either remain constant or increase, but never fall. Entropy is a measure of how “special” a particular arrangement of parts is — the lower the entropy, the more “special” the arrangement. Life is “special.”

To illustrate this concept of “specialness,” imagine first a set of red and blue gas molecules, fifty of each say, bouncing around in a room. Which is more likely: (A) that all 50 red molecules will be in one half of the room and all 50 blue in the other half, or (B) that some roughly even mixture of red and blues will be present in both halves? Scenario B, is the less “special” and more likely one, but why? The answer is that there are many ways of arranging the molecules to have “some roughly even mixture” of red and blue — a great many pairs of molecules can be swapped between the halves without making a difference. However, with the perfect red and blue split, if any molecule is swapped with a partner in the other half of the room, then each half gets “contaminated” with one molecule of the “wrong” color — such a swap does make a difference. Hence what we see tends to be an equal mixture of each color, just because there are vastly many more ways of seeing an equal mixture.

Now I can state the notion of entropy precisely — the entropy of such a set of molecules is a number that is large when there are many ways of swapping pairs of molecules and getting the same overall state, and small when there are few ways of swapping them and getting the same overall state. Explicitly, an entropy S is given by Boltzmann’s entropy law:

S = k log W

Here k = 1.38 x 10−23 joule/kelvin (Boltzmann’s constant), W is the number of ways of swapping the components of a state (say red and blue molecules) without making an overall difference to that state and log W means “the natural logarithm of W” — the power you have to raise Euler’s number (e = 2.718) to in order to get W (for example if W is equal to e then log W is equal to 1, because e to the power 1 is e).

Boltzmann's tomb, with his famous entropy law above the bust

That little equation of Boltzmann’s explains a huge number of phenomena. For example, why do hot things tend to get colder and cold things hotter? Easy — bring a hot thing and a cold thing into contact and it’s like the red and blue molecules all over again — there are many, many more ways for hot molecules and cold ones to get mixed together equally than for them to stay separated into a hot part and a cold part. So the temperature equalizes.

Another example: why do balls bounce lower and lower, but never start bouncing higher and higher? Easy — after they’re done falling, ball molecules are moving more, on average, than floor ones. During each bounce, there are more ways of sharing out this motion randomly amongst the ball and floor than there are of keeping all the faster molecules in the ball and all the slower molecules in the floor. So this sharing out is what happens, and the ball eventually stops bouncing. The opposite case — a ball spontaneously bouncing higher and higher — never happens in practice because it is so unlikely. That’s how you can tell a film is being played backwards; everything that happens is so unlikely that it is never seen to happen in practice. These examples demonstrate the second law of thermodynamics: the total entropy always increases and never decreases because of how incredibly unlikely a decrease is.

What about life and entropy? A living thing has a very low entropy compared to its surroundings, because there are not many ways of swapping its constituent parts and leaving it in an invariant state. For example, swapping molecules between your heart and brain wouldn’t leave you in “an invariant state” — it would kill you! In fact, coming into thermodynamic equilibrium with your surroundings is also known as being dead!

Next question: how is life able to maintain this low-entropy state, in apparent defiance of the second law? Well, life is part of the Earth-sun system. We can regard this as “a closed system” to a very good approximation — a vast ocean of space separates it from other systems. But the Earth alone (plus moon, of course!) is not “a closed system.” The sun — a nuclear fusion reactor — provides the Earth with a constant input of low-entropy “organized” energy in the form of high-intensity photons (particles of light). Plants use this energy to make food which animals (including humans) eat, keeping the low-entropy-maintenance machinery of life running.

The Earth-sun (plus moon) system, of which the human economy is a sub-system

Save for a few ocean vent ecosystems, this low-entropy input from the sun makes all life on Earth possible, and hence all human economies (again, whether or not economists pay attention to the fact!). When we humans burn reserves of oil and coal laid down over millennia in a geological eye-blink, we are liberating the low-entropy energy captured from ancient sunlight and buried deep underground.

The second law of thermodynamics has profound implications for our economic systems. A constant stream of low-entropy energy from the sun is required to maintain life’s organized state. Without this “entropy gradient” the machinery of life would soon wind down, like the bouncing balls or mixing molecules did. So in order to prolong life on Earth, we should try to use this vital low-entropy input as efficiently as possible, to recycle it through all sectors of the economy. We should certainly not waste it and assume that we will be able to increase our use of it more and more and more, forever.

Unfortunately, most mainstream economists don’t seem to have heard of the second law of thermodynamics. Perhaps this isn’t really their fault, since it’s not in their textbooks. But it should be. It governs all life and all systems on Earth, including the economy. As our leaders in business and government race to implement misguided economic models that are not founded upon the laws of thermodynamics, and as nation after nation refuses to question the pursuit of never-ending economic growth, we draw closer to a fate that will end in tears for the human race. I worry that the tears have already begun falling.

David A. Jones is a PhD student in theoretical physics at Southampton University in the UK. He writes frequently for the Positive Money blog.

Technological Progress for Dummies

by Brian Czech

Not you, CASSE signatory. You’re no dummy. You already know that the fundamental conflict between economic growth and environmental protection can’t be overcome with technological progress.

But we’re all dummies about something. Most of us are dummies about toothpick manufacturing, for example. Toothpick dummies range from presidents to pot-scrubbers. So do plasma physics dummies, Arabic language dummies, and root canal instrument dummies. So don’t take this the wrong way if you think technological progress can overcome the conflict between economic growth and environmental protection. You may be wrong about that, but you are legion!

Now among dummies, there’s dumb and dumber. That’s just the way it is. But toothpick dummies and other specific dummies can be smart overall. So the generally smart and smarter are specifically dumb and dumber.

Technological progress sure brings out the dumb in the smarter. This I discovered by trying to get scientific organizations to adopt positions on economic growth. Invariably, the biggest hurdle was the notion that, with technological progress, economic growth and environmental protection could go hand-in-hand.

And frankly, it is an extremely difficult notion to refute, at least in plain language. It’s different if you’re a physicist; you probably get it immediately. You know that, no matter how much invention and innovation, you can’t make something from nothing and you can’t get perpetually more efficient. You know it because you’re steeped in the first two laws of thermodynamics.

But there we go, with “laws of thermodynamics,” already outside the vernacular, way beyond plain language. Few among us are physicists. Legion are we thermodynamic dummies, from presidents to pot-scrubbers.

That doesn’t mean you must be a physicist to get it. Farmers tend to get it too, as do many people who work with their hands, city or country. The fact that you can’t make something from nothing, that you can’t have your cake and eat it too, is really a matter of common sense. Or it should be.

The problem is that common sense is not very common any more. It’s been vanquished by disingenuous marketers, truth-bending politicians, and scholarly “smart-dummies” (generally smart, specifically dumb on technological progress) who have legions thinking there is no limit to economic growth. But surely it’s not far below the surface. Surely there is latent common sense to invoke.

For several years in the early 2000’s, I looked high and low for a thorough explanation of why technological progress could not reconcile the conflict between economic growth and environmental protection. I felt I had common sense — horse sense, farm sense, construction sense — and I couldn’t believe the best-selling authors blathering about perpetual growth in the “information economy” and the politicians chanting the mantra, “there is no conflict between growing the economy and protecting the environment.” All this was based on a fuzzy notion of technological progress, and had most Americans (64% according to a Roper poll) believing there was no limit to economic growth. So I searched for scientific literature to refute the fallacious rhetoric.

Much to my chagrin, there was almost nothing. There were rigorous explanations for limits to growth, most notably by our Daly News namesake. Herman Daly had used laws of thermodynamics to demonstrate limits to growth and to advocate a steady state economy. He and others also described how economic growth required natural capital, which helped to explain the basic trade-off between growth and environmental protection. All this implied that technological progress could not reconcile the trade-off, at least in the long run, and here and there were statements to that effect.

There were also critiques of technological progress that were focused less on limits to growth and more on cultural impacts. Perhaps the most famous was by E. F. Schumacher in Small is Beautiful. Schumacher called for “appropriate technology.”

Yet there seemed to be a missing concept. Nowhere was there a thorough, rigorous, and compelling explanation for why technological progress could not allow a nation, or the world, to continue growing the economy without necessarily degrading the environment in the process. After all, there seemed to be many examples of technological progress that helped protect the environment, even in the midst of rapid economic growth. These examples, along with the lack of a rigorous trade-off thesis, explained why legions were unwilling to acknowledge limits to growth, or even a trade-off between economic growth and environmental protection.

It also explains why very smart dummies in academia, government, and the private sector are paid handsomely for “science and technology policy” affairs. These folks are often brilliant in general terms, and about many specific topics, yet many are dumber than a boot about the relationships among economic growth, technological progress, and environmental protection. Invariably they recognize that economic growth and technological progress are tightly linked, and they know that many new technologies are “greener.” They therefore figure it’s a slam dunk that economic growth may be reconciled with environmental protection via technological progress. For them, the object of science and technology policy is to steer science toward providing technological progress, thereby growing the economy and protecting the environment. It’s a classic win-win!

Partly because they’re paid so handsomely, jetting from conference to conference, most others think they must be experts on the subject. They should, therefore, be believed. Meanwhile, because their win-win message is political gold, politicians find them useful. Smart-dummies are appointed to high governmental posts, becoming more credible yet in the eyes of the public.

If you go to a typical science and technology policy conference, you’ll find one group of speakers talking about where the money for science is coming from or could come from. Another group will point to where the money is going; what kind of science is being conducted, who is conducting it, and what new technologies are coming online as a result. Another group will address what it means to the environment, and another will address what it means to the economy. Keynote speakers weave these threads into the tired message that we need newer technology and therefore more science – we’ll just have to find funding for it – so we can continue growing the economy while protecting the environment. Then it’s time for wine and hors d’ oeuvres and planning for the next highfalutin conference.

Clearly we have to look elsewhere for a clear description of why the conflict between economic growth and environmental protection cannot be reconciled with technological progress. Ideally this description would not rely exclusively on the laws of thermodynamics, either, but could be put in much plainer language. That would make it relevant to the public and policy makers.

When I found no such description during those years around 2000, I decided to attempt it myself. The experience was daunting and taught me how easy it would be to slip into accepting the idea of perpetual economic growth, or at least the idea of reconciling growth with environmental protection for extended periods of time. But I got lucky in stumbling upon an overlooked concept — maybe the overlooked concept in these matters. It’s a concept necessary to explain how economic growth and technological progress can continue in lockstep, but not without environmental degradation. It’s actually a well-known concept in the economics profession, but hadn’t been applied to the issue at hand. I stumbled upon it while studying the methods and findings of national income accounting, especially the findings of the late Edward Denison, a pioneer in the measurement of GDP.

Now I won’t claim that the concept — “economies of scale” — is exactly plain language either. Yet it is much plainer than laws of thermodynamics. For one thing, far more citizens are businessmen than physicists, and economies of scale resonate with them.

I wrote it all up in a peer-reviewed paper published in 2008 for the journal Conservation Biology. The paper isn’t plasma physics, but neither is it plain language. So I haven’t yet completed the plain-language part of the task. There’s no better place to try than the Daly News.

Frankly, I’m not sure I can do it, and I’m not sure it can be done by anyone. The topic may be just tricky enough to defy the vernacular. We’ll see how it goes in the conclusion of this two-part column next week…

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.

The Financial Crisis Is the Environmental Crisis

by Eric Zencey

In May of 2009, U.S. federal legislation created the Financial Crisis Inquiry Commission, charged with investigating the causes of the financial crisis that led to the largest economic downturn since the Great Depression. The Commission’s report is due in January. But don’t get your hopes up; they’re more than likely to get it wrong.

The Commission has held hearings with and gathered testimony from quite a few experts, all of them entrenched within the mainstream of neoclassical economic theory. The experts have named the usual suspects: cyclical swings between greed and fear; feedback effects that “disequilibrate” markets; cheap and “poorly documented” mortgage financing; bank accounting that kept some liabilities “off balance sheet;” the international sale of debt that guaranteed that a collapse in one market in one country would ripple out to affect the world; foreign demand for American debt, which created demand-pull for riskier and riskier American investments; and unworkable hedge funds that appeared to transform sure-to-fail loans into sure-to-pay investments.

It’s likely that all of these played a role. Fixes for most of them ought to be undertaken on their own merits. (Who could be in favor of “poorly documented mortgages” or “off-balance-sheet” investments?) But none of the testimony makes this point: the financial crisis is also the environmental crisis. We won’t solve the former until we start solving the latter.

Two facts about this crisis stand out: the world came to the brink of global economic collapse, and the world is and remains on the brink of ecosystem collapse. The economy is humanity’s primary instrument for interacting with its environment; this suggests that these two facts are somehow related. And yet none of the standard diagnoses come anywhere close to acknowledging that there might be a connection, let alone start to illuminate it. In the standard view, the financial crisis beset an economy that consists solely of humans acting within formalized systems of their own creation —systems that have no connection to a larger world.

And that’s why the standard view won’t succeed in fixing the problem. The spasm of debt repudiation with which the crisis began — the collapse of the sub-prime lending market — is what happens when an infinite-growth economy runs into the limits of a finite world.

That insight comes from the reference frame suggested by Frederick Soddy, as elaborated by Nicholas Georgescu-Roegen, Herman Daly, and others. Soddy offered a vision of economics as rooted in physics — the laws of thermodynamics, in particular. An economy is often likened to a machine, though few economists follow the parallel to its logical conclusion: like any machine the economy must draw energy from outside itself. The first and second laws of thermodynamics forbid perpetual motion, schemes in which machines create energy out of nothing or recycle it forever. Soddy criticized the prevailing belief in the economy as a perpetual motion machine, capable of generating infinite wealth. That belief is nowhere more clearly manifest than in how we treat money. Soddy distinguished between wealth, virtual wealth, and debt. Real wealth, even the provision of services, is irreducibly rooted in physical reality. The money we use to represent this wealth isn’t real wealth, but virtual wealth — a symbol representing the bearer’s claim on an economy’s ability to generate real wealth. Debt, for its part, is a claim on the economy’s ability to generate wealth in the future. “The ruling passion of the age,” Soddy said, “is to convert wealth into debt” — to exchange a thing with present day real value (a thing that could be stolen, or broken, or rust or rot before you can manage to use it) for something immutable and unchanging, a claim on wealth that has yet to be made. Money facilitates the exchange; it is, Soddy said, “the nothing you get for something before you can get anything.”

Problems arise when wealth and debt are not kept in proper relation. The amount of wealth that an economy can create is limited by the amount of low-entropy materials and energy that it can sustainably suck from its environment and by the amount of high-entropy effluent that natural systems can sustainably absorb. (We can in practice exceed those sustainable limits, but only temporarily; that is the definition of “unsustainable.”)

There are only two ways that an economy can increase the rate at which it creates wealth: it can process a larger and larger flow of matter and energy, increasing its ecological footprint on both the uptake and the effluent side; or it can achieve efficiencies in its use of a constant flow of matter and energy. Both means of growth have limits. Increasing an economy’s ecological footprint decreases the ability of healthy ecosystems to provide us with a civilization-sustaining flow of ecosystem services (like climate stability, a service currently in critically short supply). Efficiency gains in the use of a constant flow offer large returns today and will probably do so into the future, but those gains will become harder and harder to achieve as we run into diminishing returns. Technological advances and efficiencies will allow us to make more with less, especially in places where we’ve been profligate in our use of low-entropy inputs; but no technical advance will get us around the first law of thermodynamics, which tells us “you can’t make something from nothing, nor can you make nothing from something.” Creation of wealth is irreducibly physical, and all physical phenomena obey the laws of thermodynamics.

Thus, the creation of wealth has physical constraints, set by ecosystem limits, physical law, and the limits of the technology we currently employ. But debt, being imaginary, has no such limit. It can grow infinitely, compounding at any rate we choose to let it.

These considerations led Soddy to this incontrovertible truth: whenever an economy allows debt — a claim on wealth — to grow faster than wealth can be created, that economy has a structural need for debt to be repudiated.

Inflation can do the job, decreasing debt gradually by eroding the purchasing power of the monetary units in which debt is denominated. And debt repudiation can be exported — some of the pressure to reconcile wealth and debt is released when other nations in the system inflate their currencies or default on obligations.

But when there is no inflation, and when the economy becomes one integrated global system in which export to outside the system is no longer possible, overgrown claims on future wealth will produce regular crises of debt repudiation — stock market crashes, waves of bankruptcies and foreclosures, defaults on bonds or loans or pension promises, the disappearance of paper assets in any shape or form. As Lawrence Summers noted in a speech last year at the Brookings Institute, “In little more than two decades, we have seen the stock market crash of 1987, the savings and loan scandals, the decline of the real estate market, the Mexican crisis, the Asian crisis, LTCM, Enron and long-term capital. That works out to one big crisis every two and a half years.” He went on to add: “We can and must do better.” Each and every one of the crises he listed was, at bottom, a crisis of debt repudiation. We are unlikely to avoid their recurrence until we stop allowing claims on real wealth to grow faster than real wealth can grow.

The cause of the financial crisis, Soddy would certainly say, isn’t simply opportunistic financiers exploiting the lag between innovation and regulation, isn’t simply ignorance, isn’t a failure of regulatory diligence, isn’t a cascading lack of confidence that could be solved with some new and different version of the F.D.I.C. The problem is a systemic flaw in our treatment of money. Whenever and wherever growth in claims on wealth outstrips growth in wealth, our system creates a niche for entrepreneurs who are all too willing to invent instruments of debt that will someday be repudiated. There will always be a Bernie Madoff or a subprime mortgage repackager or a hedge fund innovator willing to play their part in setting us up for a spasm of debt repudiation. Regulation will always be retrospective.

The best solution is to eliminate that niche. To do that, we must balance claims on future production of wealth with the economy’s power to produce that wealth.

Soddy distilled his vision into five policy prescriptions, each of which was taken at the time as evidence that his theories were unworkable. One: abandon the gold standard. Two: let international exchange rates float against one another. Three: use federal surpluses and deficits as macroeconomic policy tools, countering cyclical trends. Four: establish bureaus of economic analysis to produce statistics (including a consumer price index) that will facilitate this effort. These proposals are now firmly grounded in conventional practice. Only Soddy’s fifth proposal remains outside the bounds of conventional wisdom: stop banks from creating money, and debt, out of nothing.

Soddy’s work helped to inspire the short-lived “100% Money” movement that emerged during the Depression, which offered a diagnosis that went beyond treatment of symptoms (the cascading collapse of confidence that led to bank failures, which was addressed through creation of the F.D.I.C.) to reach the underlying cause: the leveraging of debt through the practice of fractional reserve banking. Irving Fisher at Yale and Frank Knight, the prominent Chicago School economist, also supported the elimination of fractional reserve banking. For a time the movement counted no less an economic eminence than Milton Friedman as a sympathizer. (Perhaps because he saw that the tide of history was against him, Friedman eventually dropped his call for elimination of fractional reserve banking from his policy recommendations.) The 100% money movement finds a contemporary advocate in ecological economist Herman Daly, who has called for the gradual institution of a 100 percent reserve requirement on demand deposits. This would begin to shrink what he has called “the enormous pyramid of debt that is precariously balanced atop the real economy, threatening to crash.”

In such a system, banks would support themselves by charging fees for safekeeping, check clearing, loan intermediation, and all the other legitimate financial services they provide. They would not generate income by lending out, at interest, the money entrusted to them for safekeeping — money that does not belong to them. Banks would still make loans and still be able to lend at interest “the real money of real depositors,” people who forego consumption today in order to take money out of their checking account and put it in time deposits (e.g., CDs, passbook savings, and 401Ks). In return these savers would still receive interest payments — a slightly larger claim on the real wealth of the community in the future.

In a 100% money system, every increase in spending by borrowers would have to be matched by an act of saving — abstinence — on the part of a depositor. This would re-establish a one-to-one correspondence between the real wealth of the community and the claims on that real wealth. To achieve 100% money, the creation of monetarized debt through other mechanisms — repackaged mortgages and securitized derivatives and the like — would also have to be brought under control.

An added benefit: establishing 100% money would have an enormous and positive effect on the public treasury. Seigniorage, the profit that comes from the creation of money, is currently given away free to banks (which collect it as the payment of interest and the repayment of principle on loans made with money that is not actually theirs). Under a 100% money regime, money would be created — spent into existence — by a public authority. (This is what Friedman advocated.) The capture of seigniorage would have obvious benefits for governmental budgeting: the seigniorage on a modest 3% growth in M1 (one of the chief measures of the money supply) amounts to $40 billion a year. And, when you come right down to it, to whom does seigniorage, by rights, belong? Despite long-standing custom to the contrary, the profit that comes from the issuance of money belongs to the sovereign power that guarantees that money. In the U.S., that’s us: We, the People.

This change in our banking system would eliminate the structural cause of spasms of debt repudiation. It would also eliminate one strong driver of uneconomic growth —growth that costs more in lost ecosystem services and other disamenities than it brings in the form of increased wealth. The change is thus economically and ecologically sound. It is, obviously, politically difficult — so difficult that advocacy for it sounds hopelessly unrealistic. But consider: in the 1920s, the abolition of the gold standard and the implementation of floating exchange rates sounded absurd. If the laws of thermodynamics are sturdy, and if Soddy’s analysis of their relevance to economic life is correct, we’d better expand the realm of what we think is realistic.

Real Economies and the Illusions of Abstraction

by Hazel Henderson © 2010

Editor’s Note:  Hazel Henderson, guest contributor and true champion of the steady state economy, digs deep into the deficiencies of our economic and financial systems.

The yawning gap between the real world and the discipline and profession of economics has never been wider.  The ever-increasing abstractions in finance and its models based on “efficient markets” and “rational actors”: capital asset pricing, Value-at-Risk, Black-Scholes Options Pricing, have been awarded most of the Bank of Sweden prizes since they were founded in the 1960s and foisted onto the Nobel Prize Committee.  Most of these abstract models, based on misuse of mathematics, contributed to the financial crises of 2007-2008.  Now, the family of Alfred Nobel, led by lawyer Peter Nobel, has disassociated itself from the Bank of Sweden Prize in Economics In Memory of Alfred Nobel.[1] They point out that Nobel never would have approved of a prize in economics since it is not a science – and would have disapproved even more that most of the prizes were given to Western, neoclassical economists using mathematized, abstract models – far from Nobel’s wider concerns.

Nowhere is this abstraction more devastating than in the mathematical compounding of interest rates on borrowed money, now sinking individuals, companies and nations in unrepayable debt as explored in lawyer Ellen Brown’s Web of Debt (2007).

In The Politics of the Solar Age (1981, 1988), I warned that compound interest violated the Second Law of Thermodynamics:

Much confusion arises because economics inappropriately analogizes from some of these models from the physical, social, and biological realms.  For example, the best example of a “runaway” can be found in the hypothetical model that economists have imposed on the real world: compounded interest.  Here, they have set up an a priori, positive feedback system (based on the value system of private property and its accumulation), in which the interest earned on a fixed quantity of money (capital) will be compounded and the next calculation of interest added on cumulatively.  But this “runaway” accumulation process bears no relationship to the real world – only to the value system.  However, it has profound real-world effects if enough people believe it is legitimate and employ lawyers, courts, etc., to enforce it!  (p. 228)

I also pointed out that Frederick Soddy, Nobel laureate in chemistry, decided that economists’ dangerous drift into pseudo-scientific abstraction must be halted before they destroyed industrial societies, because their uninformed ideas contravened the first and second laws of thermodynamics.  (p. 225)

The mathematical fantasy that money is wealth and can reproduce itself is revealed again in the US housing and foreclosure crisis.  Money is a useful information system for tracking our use of nature’s resources and scoring the games we humans play, but it gradually became mistakenly equated with the real wealth of nations.  Similarly, too often economists and politicians describe money flows in economies as analogous to the human body’s circulatory system.  Yet human blood’s hemoglobin cells do not charge money or interest for the life-giving oxygen they deliver to every other cell in our bodies.

Charging interest for lending money was frowned on by our ancestors and considered a sin in Christian, Judaic as well as Islamic and other religious traditions.  This view survives today in Sharia finance where lending at interest is shunned in favor of requiring the investor or creditor to share risks of any enterprise with the entrepreneur.

Generations of scholars since Aristotle’s treatises on “just prices” have examined the myths and human experiments in creating money and systems of exchange, from mutual fund manager Stephen Zarlenga’s The Lost Science of Money (2002) and Prof. Margrit Kennedy’s Interest and Inflation Free Money (1995) to lawyer Ellen Brown’s Web of Debt (2007).  In my Creating Alternative Futures (1978), I posed the question: Is there any such thing as profit without some equal, unrecorded debt entry in some social or environmental ledger or passed on to future generations?  My answer was “yes,” provided all costs of production were internalized and thermodynamic, not economic, measures of efficiency were calculated.

The mismatch is between the real-world economies, where real people grow food, make shoes, clothes, shelter and tools in real factories, versus the human mind’s tendencies toward abstraction.  Understanding the real world in which we live requires us to recognize patterns and to abstract reality into mental models.  The map is not the territory, as we have been reminded by many epistemologists.  The danger is that we routinize our perception through these models, forgetting the need for constant updating and course-correcting as conditions change around us.  Thus our mental models are memes that crystallize into habits, dogmas and outdated theories such as those in conventional economics and finance.  These led to collective illusions: about “efficient markets,” “humans as rational actors” and the lure of “compound interest” that still guide the decisions of too many asset managers.  New models of triple bottom line accounting for environmental, social and governance (ESG) have been adopted by responsible investors and institutional investors, including those engaged with the UN Principles of Responsible Investment, managing $22 trillion in assets.  The current US mortgage and foreclosure mess provides a new teachable moment where we can re-examine the obsolete beliefs still at the core of economics and now refuted by physicists, thermodynamics, endocrinologists, brain and behavioral scientists.[2]

The computerized efficiency of digitizing mortgages for rapid securitization in the Mortgage Electronic Registration System (MERS) is at the root of the foreclosure and toxic assets dilemma.  We must examine how computers when introduced into Wall Street, financial and housing markets drove economic theories further into mathematization, led by the Arrow-Debreu modeling of national economies in the 1960s, beyond earlier attempts by Leon Walras.  Bank of Sweden Prizes in Memory of Alfred Nobel were given to Arrow and Debreu and others for mathematical models inappropriately applied to economics and finance.[3] Similar mathematical models on which economists still rely, accept Arrow-Debreu’s assumption of a process of “market completion” where markets could be extended to enclose ever more of the global commons: air, carbon emissions, water, forests, biodiversity, ecological assets and their productivity which supports all life.  The newest commons are global communications infrastructure, the internet, the electromagnetic spectrum and space, all of which required massive public investments and underpin global finance and its extensive bailouts.  The report of the Global Commission to Fund the UN,  The UN: Policy and Financing Alternatives, Eds. H. Cleveland, H. Henderson and I. Kaul (Elsevier Science Press, UK, 1995) proposed taxing all commercial uses of the global commons and fines for misuse, including a tax on currency speculation.

For any market to efficiently allocate resources, buyers and sellers must have equal information and power, while their transactions should not harm any innocent bystanders.  These conditions identified by Adam Smith in The Wealth of Nations in 1776 are now violated everywhere due to the scale and technological reach of global corporations and finance.  Examples include the earliest forms of industrial pollution and exploitation of workers to today’s toxic sludge dam failure in Hungary; BP’s Gulf oil contamination and the growing costs in lives and ecological destruction of coal mining; the Wall Street volatility due to program trading; the financial meltdown of 2007-2008; the May 6, 2010 “flash crash,” and the new revelations of US mortgage and foreclosure frauds.  An ingenious enterprise, the Open Models Company (OMC) founded by Prof. Chuck Bralver at the Fletcher School of Tufts University, based on Linux principles, provides an open-source platform for global experts and critics in finance to examine the assumptions underlying derivatives and risk models – a huge help for underfunded regulators.[4] Mervyn King, head of the Bank of England, called for restructuring beyond Dodd-Frank, Basel III and other recent reforms of today’s unsustainable “financial alchemy.”[5] King reflects most of the issues identified by experts in our Transforming Finance statement of September 13, 2010.

The scale of industrial and financial operations becomes global and ever more computerized and digitized, accelerating the abstraction of management, global supply chains, risk assessment, calculations of accountants for profits and losses, strategies of national governments and central bankers using defunct models such as NAIRU (non-accelerating inflation rate of unemployment) to set interest rates, along with subsidies, tax policies, and quantitative easing to “manage” their economies.  All are based on levels of aggregation in statistical indicators akin to assessing national economies while over-flying a country’s territory at 50,000 feet.  The digitization of Wall Street and security analysis is cancelling out strategies for diversification of portfolios.  In the post-Bretton Woods, turbulent global casino, the $3 trillion plus daily electronic trading of currencies and sovereign bonds are driven largely by speculation, credit default swaps, and high-frequency trader’s algorithms.  The proliferation of electronic trading platforms, credit cards and digital payment and credit systems bypass regulatory models of governments and central banks.

Today’s ad hoc global financialization cannot be described as a system since it is still driven by the long-outdated assumptions and models in economics and the sloppy generalizations and categories that underlie economics and its theories: “capital” (not clearly defined); “growth” (GDP is the output of goods and services measured in money without subtracting social and environmental costs or adding the unpaid services in families and communities which support official paid production); “innovation” (does not distinguish between new brands of dog food, potato chips, credit default swaps vs. computer chips, gene sequencing or renewable energy); “productivity” (if measured as output per worker, this leads to further automation and technological unemployment); “free trade” (which led to the hollowing out of the US economy, outsourcing of jobs in manufacturing and services, trade deficits); “inflation” and “deflation.”  Statistical illusions: CPI, “core CPI” (which excludes energy and food), drives Fed policies, Social Security, taxes as well as employment and macroeconomic policies (see www.calvert-henderson.com Current Issues).

Perhaps the most obvious policy errors were the models used by Alan Greenspan to describe the global economy in the dot.com boom and by Ben Bernanke during the period from 2003-2006 as “The Great Moderation” (economic cycles had been tamed) and then, as the global imbalances grew, labeling them “the Global Glut of Savings” (China, Japan and other countries supposedly saved too much).  Instead, I and others labeled this a growing global bubble of fiat currencies, led by the US dollar, acting as a global reserve currency.  The crisis was one of macro-economic management – sinking under mounting deficits, debt and compound interest, while facing growing systemic risks due to deregulation in the global casino.

Nassim Nicholas Taleb pointed out all these conceptual errors in Fooled by Randomness (2005) and The Black Swan (2007), digging even deeper into the fallacies of the human mind, including confirmation bias, herd behavior and excessive optimism verified by behavioral psychologists.  Mathematician Benoît Mandelbrot warned of the limits of statistical models of probability and risk informed by Gaussian normal distribution “bell curves.”  Fat tails, black swans and perfect storms entered the language, but instead of examining these human perceptual errors, they became excuses for Robert Rubin and his protégés, Larry Summers, Tim Geithner, as well as central bankers, Wall Street CEOs and asset managers – all claiming that “no one could have predicted the financial crises.”   As Richard Bookstaber described in A Demon of Our Own Design (2007), Wall Street’s financial models were bound to fail.

The truth is that thousands of critics, scholars and market players, including the author[6] accurately predicted and warned of the coming debacle – but were ignored by the leading elites in business, government and academia.  Mainstream media accepted conventional wisdom, funded by advertising from incumbent industries and their financial allies while their lobbyists took control of Congress.  After the half-hearted reforms  of Dodd-Frank, the IMF, the World Bank, the BIS and the G-20, how can a paradigm shift allow new voices, new models and more accurate modeling and control of systemic risk to emerge in the global financial system?

First, we must recognize the crises we face are not black swans, fat tails or perfect storms, but symptoms of our limited perception, fragmentary reductionist mindsets, models, research methods and academic curricula , particularly in economics and business schools.  Second, we must move beyond economics to capture all their “externalities” in multi-disciplinary frameworks, systems models, multiple metrics and pluralistic research, such as that pioneered by the US Office of Technology Assessment (OTA) on whose founding Technology Assessment Advisory Council I was honored to serve from 1974 until 1980.  This useful messenger, with its ground-breaking research, now copied in many countries, was decapitated by Congress in 1996 by Speaker Newt Gingrich and his Republican colleagues.  Luckily, OTA’s studies are still highly relevant and archived at Princeton University and the University of Maryland.  Signs of awakening include new memes, including describing fragmented approaches as “silos” and narrow research as “stovepipe information” with frequent calls to “connect the dots.”

Equally urgent are the phasing out of all the hundreds of billions of dollars of perverse subsidies propping up obsolete, incumbent companies and industries still blocking the emergence of cleaner, greener information-rich technologies and new companies.  Governments’ conceptual confusion over climate issues is evident in still subsidizing carbon-based industries while at the same time trying to cap and price carbon emissions.  This Green Transition to the Solar Age is underway as we gradually exit the earlier, fossil-fueled Industrial Era.  Ethical Markets Media measures private investments since 2007 in solar, wind, energy efficiency, renewables and smart infrastructure worldwide in our Green Transition Scoreboard®.

Meanwhile, a below 1% financial transaction tax on all transactions can curb high frequency trading and currency speculators, limit positions by hedge funds and other institutional investors – while sparing legitimate hedging by commercial firms.  Such long-debated taxes, proposed by James Tobin in the 1970s and Larry Summers in his 1989 paper,[7] are now supported by the EU and are on the G-20’s agenda.  See my “Financial Transaction Taxes: The Commonsense Approach.”[8]

To finally correct our money-creation ceded to private banks by Congress in 1913 through the Federal Reserve system, Congress could enact the Monetary Reform Act long proposed and vetted by seasoned market veterans of the American Monetary Institute.  This would entail a rolling readjustment in money issuance – now obviously dysfunctional under the Fed and private banks and return it to a public function as in the US Constitution.  Meantime, many states could adopt state banking as in North Dakota, the only state with a surplus and full employment – unharmed by the depredations of Wall Street extractions from Main Street.

I agree with others from E.F. Schumacher, author of Small is Beautiful (1973), Simon Johnson, author of 13 Bankers (2009), Laurence Kotlikoff, author of Jimmy Stewart is Dead (2009) to Nassim Nicholas Taleb: if systems are too large and interconnected to manage and banks are “too big to fail,” then they need to be carefully dismantled and decentralized to restore diversity and resilience following nature’s design principles.  Monetary monocultures now on a global scale have demonstrably failed.  Healthy, homegrown, local economies need protection from global bankers and their casino.   Complimentary local currencies and peer-to-peer finance are flourishing (see my “Democratizing Finance“).  Bloated financial sectors can be downsized and return to their role of serving real economies.  In the USA, small non-profit community development finance institutions (CDFIs) are growing to fill the needs of micro-businesses.[9]

Trickle down economics has failed utterly, even as the politicians and central bankers still believe that pouring taxpayers funds and printed money into big banks and bloated financial sectors will somehow trickle down to Main Street and local businesses.  Instead of creating US jobs, the rest of us see the Wall Street traders and big asset managers investing these funds in China, India, Brazil and other emerging markets where US multinationals have shifted their plants, jobs and research.  Worse still, big banks take the Fed’s funds and rather than lending to Main Street, use it for gambling on currencies, oil, interest rates and other derivatives.  All this money-creation is fueling currency wars.  Hopefully, all this together with ballooning debts, deficits and un-repayable compound interest, the foreclosure and mortgage securitization scandals and auditing Fannie, Freddie and the Fed, will provide enough evidence to Washington and voters in many countries of the needed paradigm shift and new policies.

Calls in the USA for facing up to these painful truths are coming from all sides, from Republicans, including Congressman Ron Paul to Democrats including Congressman Dennis Kucinich and Independents including Senators Bernie Sanders and Byron Dorgan.  Indeed, Republicans and Democrats are now both minority parties as most voters are now independents.

Exposing all the statistic illusions, inoperative models, dysfunctional economic dogmas – including their unsustainable offspring: debt-based money and compound interest – can begin the Green Transition to the emerging economies of the 21st century.  The new coalition is now visible: responsible and green investors and companies, environmentalists, Millennials, progressive labor unions and their pension funds, students, independent media and voters, systems thinkers, futurists and academics pioneering new courses in sustainability, as well as dispossessed homeowners, jobless workers, professionals and veterans eager to put their skills to work – all are ready to help grow the green economies of the future.

Hazel Henderson, D. Sc.Hon., FRSA, author of nine books, is President of Ethical Markets Media (USA and Brazil) and its Green Transition Scoreboard; co-creator with the Calvert Group of the Calvert-Henderson Quality of Life Indicators (regularly updated at www.calvert-henderson.com) and the Transforming Finance initiative.  Her company is signatory of the UN Principles of Responsible Investing.


[1] Söderbaum, Peter.  “Nobel Prize in Economics Diminishes the Value of Other Nobel Prizes.”  Dagens Nyheter, Sweden, October 10, 2004

[2] Henderson, Hazel.  “The Cuckoo’s Egg in the Nobel Prize Nest,”  InterPress Service, October 2006.

[3] Henderson, Hazel.  “Abolish the ‘Nobel’ in Economics? Many Scientists Agree.”  InterPress Service, 2004.

[4] Tapscott, Don and Williams, Anthony. Macrowikinomics, Penguin Group, USA, 2010

[5] “King plays God.”  The Economist Online, October 26, 2010

[6] Henderson, H. Building a Win-Win World, Berrett-Koehler, 1996 (now an e-book)

Henderson, H. “New Markets and New Commons,” FUTURES, Elsevier Science, vol. 27 #2, 1995

[7] Summers, Larry.  “When Financial Markets Work Too Well: A cautious case for a securities transactions tax”, Journal of Financial Services Research vol. 3(2-3) 1989

[8] Henderson, Hazel. “Financial Transaction Taxes: The Common Sense Approach,” Responsible Investor, London, October 19, 2010

[9] Pinsky, Mark. “Help for Small Businesses: Loans are just a start” Bloomberg Businessweek, Oct. 25, 2010, p. 74

Presuppositions of Policy

Wouldn’t it be great to get advice directly from Herman Daly?  It’s no surprise that  his speech to graduating public policy students contains wisdom for all of us.

Herman DalyAs you graduate I want to remind you of something you already know. Since you have not only chosen to study public policy, but have persevered to graduate with a Master’s degree, you must already have rejected the perennial and pernicious philosophical doctrines of determinism and nihilism. That is what I want to remind you of.

Determinists believe that there is only one possible future, rigidly determined either by atoms in motion, selfish genes, dialectical materialism, toilet training, or the puppet strings of a predestining deity. If there is only one possible future state of the world then there are no options, nothing to choose from, and therefore no need for policy — or schools of public policy or Master’s degrees in public policy. You should head straight to the unemployment office! You are necessarily non-determinists who must believe that there are at least a few possible alternative future states of the world, and that purposive policy can be causative in choosing among them.

Of course there are also many merely conceivable or imaginary futures that really can be ruled out as impossible – such as, for example, growing the economy forever on a finite planet that is subject to the laws of thermodynamics and ecological interdependence. Our commitment to the fantasy of unlimited growth as the foundation of all national policy should top the list of things to be reconsidered. But that is a story for another time. My point for today is that after eliminating all impossible futures we are still left with more than one possible future.

To choose from the remaining menu of possible futures we need a criterion of value by which to distinguish better from worse states of the world. Nihilists, or extreme relativists, deny the existence of any such criterion. For them it is all a matter of subjective individual preferences, suitably weighted by ability to pay, as modified by gender, race, and class interests. The nihilists say that there is no such thing as the common good or objective value, and that therefore we cannot distinguish better from worse future states. So even though real alternatives may exist, policy still would make no sense without an objective criterion of value, and some vision of the common good.

Without choice there can be no responsibility, so the determinists and nihilists are often undeservedly comfortable in their irresponsible irrelevance. “Never knowing where they are going, they can never go astray.” As future policy makers I am sure that you will have to confront some complacent determinists and nihilists, perhaps disguised as political pollsters, apocalyptic televangelists, cost-benefit analysts, bio-ethicists, evolutionary neuropsychologists, or growth economists. One way or another they will insist that there is no alternative, and even if there were, it would not matter. That such people should bother to argue publically about anything already involves them in a logical contradiction to which they are evidently blind. That makes rational dialog with them unpromising. But, as I said earlier, this is something you must already know or you would not be here. I am just reminding you of it on your way out, like your mother telling you not to forget your umbrella.