The Visible Hand: Manipulating Market Prices by Influencing Laws and Regulations

by Max Kummerow

Recently a member of a mailing list for resource economists asked how to value endangered species given that they are not bought and sold in markets. A common method is to infer prices (“existence values”) by indirect methods such as answers to surveys (e.g., “How much would you be willing to pay to keep tigers from going extinct?”). An issue raised in the online discussion was whether species grow more valuable as they become more scarce and their numbers fall toward zero. If prices keep changing, what is the “right” price?

Thought experiment: suppose a keystone species is about to go extinct, but few people know about the threat. Oh, heck, let’s be more realistic. Leading ecological authorities believe that the effects of climate change will drive 1/3 or more of the world’s species to extinction by 2100 with unpredictable system-wide effects. Meanwhile, the owners of $17 trillion of fossil-fuel reserves are spending hundreds of millions of dollars to convince the public that the threats from climate change are overstated or non-existent (See Bill McKibben’s Rolling Stone article or Oreskes and Conway’s Merchants of Doubt).

How can we have any idea about fundamental values (that is, “correct” utility-maximizing efficient market prices) with so much misinformation floating around? Advertising creates a set of consumption preferences tilted towards items sold by companies more concerned about profits than benefits to society.

Prices depend on preferences, and preferences depend on information. Knowledge of the unhealthy and even fatal effects of smoking changed preferences about and prices of tobacco. Such changes would also occur over time as people gain knowledge about the threats of extinction and climate change.

By similar means, misinformation and strategic uncertainty lead to mispricing. If such mispricing in the carbon market continues, the predicted result is a “tragedy of the commons” (collective irrationality, market failure) with features like Miami, Washington, DC, and Los Angeles ending up below sea level, mass species extinctions, crop failures, etc.

Economic systems are complex, and many external costs and benefits are not factored into prices or people’s decisions in the market. Time lags add to the complexity. What if it will take 2,000 years before climate change makes the planet too hot for human life? Such a time lag makes it harder to come to the best decision about whether to build a new coal-fired power plant.

Species extinctions may be portents of broader problems (e.g., climate change), akin to canaries in a coal mine. The same factors driving them extinct — various impacts of growing human populations and economies — may be driving us extinct in the longer run. Does it make sense to value threatened species without considering the linkage to these other related problems? An endangered species itself might be worth $1, yet the factors driving it toward extinction might cause $100,000 worth of damage over the long run, or maybe even infinite damage from our point of view if extinction extends to humans. We need a better benefit-cost picture — a larger, genuine, and more complete accounting.

Another major problem with prices is that they only reflect the preference of those who hold power in markets. Perhaps polar bears should have standing when it comes to determining prices. They are intelligent, sentient beings with the most at stake when ice melts, so maybe their preferences ought to be factored into decisions about the Keystone Pipeline and exploitation of tar sands oil. What about future generations? Nobel Prize winner Joseph Stiglitz called this problem “incomplete markets” leading to market failure and universal mispricing.

There are some things markets do very well, but only if the institutional framework (rules of the game) ensures that prices reflect all costs and benefits. Laws, lobbying, culture, taxes, regulations — all kinds of institutions collectively created by societies — have enormous influences on market prices or even the existence of markets. So, to some degree, through these institutions, we choose price levels through a “visible hand” of policies and institutions. Stiglitz points out that the deregulation policies that led to the Global Financial Crisis of 2008 did not come out of nowhere, but rather from intense lobbying by stakeholders at banks and other people whose profits were restricted by regulations — a situation in which prices were set by something like a visible-policy hand instead of the invisible hand of the market.

Because of the difficulty of getting prices right, we might do better to regard creation as sacred and take the conservative position of Aldo Leopold who said, “The first rule of intelligent tinkering is to save all the parts.”

Valuations always depend on preferences. Economists call prices “revealed preferences.” If we “prefer” to settle for a world without many wonderful creatures, then we won’t attach much worth to them. But if we value them for their intrinsic beauty and their relationship to us (we do share DNA with every living thing), then we’ll attach more worth to them. So rather than measuring values, perhaps we should be trying to create value by improving preferences.

Examples of worldwide mispricing and market failures that need institutional corrections include:

  • Energy — too cheap due to climate change, extinctions, and negative effects on future generations.
  • Having children — too cheap since growing population will raise real prices of land, food, and energy, and contribute to climate change and other global environmental problems.
  • Endangered species — too cheap because ecosystem interrelationships are poorly understood, and indirect effects could be enormous.
  • Economic growth — overvalued because growth negatively affects aggregate utility and public goods (“the commons” such as air, water, soil, species diversity, ecosystem health, and climate) once we begin to reach the limits to growth.

Most economics students are still taught that following market price signals leads to the best of all possible worlds (market efficiency and maximum aggregate utility). But the examples of under- and over-valuation contained in the short list above suggest that humanity is headed for trouble if we choose to let market prices and self-interested institutions’ manipulation of prices control outcomes. The markets we rely on fail to generate utility-maximizing prices for goods and services and for the future of humanity. Thinking of ourselves as an endangered species, what is it worth to keep us alive?

Max Kummerow has a Ph.D. in urban and real-estate economics.  He is currently studying population issues in Perth, Australia.

Limits to Growth – of Stuff, Value, and GDP

by Brian Czech

I’m starting to think that perpetual growth notions are the Achilles heel of the human brain. They pop up like munchkins on a Whac-a-Mole machine. You smash one and up come two.

A recent example comes from Tim Worstall, a business and technology writer for Forbes. Like the long lineage of Homo polyannas before him, he assures his poor readers that we can have perpetually growing GDP without using more resources. He uses a variety of the old “growth is more value, not stuff” argument.

Worstall says, “It really is true that as value increases we have economic growth. And how are we determining that value? Through the market prices that people are willing to pay for them. And what is the determinant of that? Well, actually, it’s us. Our own often arbitrary and always subjective estimations of what something is worth to us. Which isn’t, as I hope can be seen, something that is bounded by any physical limit at all.”

Now I don’t know about you, but when someone is compelled to announce, “It really is true,” my “Prove It” flag pops up. And sure enough, Mr. Worstall has a lot to prove.

For starters, just exactly what evidence does Mr. Worstall have to support his notion that our estimations of value are unbounded? I don’t recall having or hearing of an experience where something just seemed to increase in value more, more yet, and forevermore. Do you? Now it may have seemed that way for some short period of time with something like coffee. But unless you’re moving into ecstasy ad nauseum – an oxymoron if there ever was one – the value of the experience was bounded. Right?

Why can’t Worstall and the perpetual growthers just face it with the rest of us: life is all about limits. Life, death, taxes, and limits. What’s wrong with limits, anyway? If there weren’t any, what value would a certain level of progress or satisfaction have? How would you measure it?

Now sure, you might “value” living more as you get closer to dying. You might try to measure this value and say, “I’m twice as concerned with living now.” You might even spend twice as much money on health food. That’s fine and understandable, but it’s not economic growth. If you spent more on health food, you had less to spend on coffee, chiropractic, or bingo at the Elks Club.

That brings us to an even bigger burden of proof begged by Mr. Worstall. The main point of his article is that all this ever-increasing appreciation or satisfaction or happiness, which requires not one jot or tittle of energy or material, will result in GDP growth! This, he lectures the scientists, is really what GDP growth is all about: increasing value, where value may increase without increasing use of energy and material.

Where’s the proof? Have we ever seen GDP increase without increasing use of energy and material? If the Worstalls of the world would only put their money where their mouths were, we could cap energy and material flows and test their hypothesis. But no, their mouths are preoccupied with perpetual growth slogans like “drill baby drill!”

But just for the sake of argument, let’s say we can wave a magic wand or a hypnosis gismo and have ever-growing value without the use of more energy and materials. All of a sudden, bread tastes better, suits look spiffier, hymns even sound holier. And that’s without using more energy or material. It’s all in the mind, you see.

So we spend more on it? Thus increasing GDP?

Prove it.

While the Worstalls of the world are busy with an exercise in futility, the rest of us can think about something more evident. Where does the money come from to spend on things of value? As Adam Smith noted in the Wealth of Nations, money originates when there is agricultural and extractive surplus. With agricultural surplus, not everyone has to farm. That frees the hands for the division of labor and the generation of real money to be spent on a variety of goods and services. Agricultural surplus is the physical basis of money and market expenditures.

Oh sure, we can double the supply of money overnight if we really want to. If we all wake up one morning insisting that we value everything twice as much, why not double the money supply to account for it? But that’s not growth in real GDP. It’s mental and monetary only. The mental part is fine — a nice mood at the least — but the monetary part is called inflation!

The foundation of the real human economy is the producers. Only with surplus production will there be expenditures on consumption. Growing GDP takes more surplus production. Such are the trophic origins of money, in ecological terms. But as Worstall said, “when extremely bright people step off their own knowledge base they can make very interesting mistakes when they attempt to explore other fields.” I don’t know if Worstall is extremely bright or not, but he obviously isn’t conversant with ecology, also known as the economy of nature. That sets him up poorly for economic matters. If you don’t get the basics of the real sector, you can make a real mess of the monetary sector.

If anyone still views this as an argument, maybe we can settle it democratically. After all, it seems that plenty of folks value democracy, so the more democratic the approach, the more valuable it should be (within limits, I’d say). So let’s take a vote. What do readers think is more feasible: Ever-growing satisfaction and ever-growing GDP with no additional stuff? Or declining satisfaction and declining GDP as the supply of stuff declines?

I’d like to hear your thoughts. I do value your opinion. But whether you give it or not, I won’t be spending a dime on it. GDP will just have to sit there.

Not Production, Not Consumption, but Transformation

by Herman Daly

Herman DalyWell-established words can be misleading. In economics “production and consumption” are such common terms that it is easy to forget that they do not really mean what they literally say. Physically we do not produce anything; we just use energy to rearrange matter into a more useful form. Production really means transformation of what is already here. Likewise, consumption merely reflects the disarrangement of carefully structured materials by the wear and tear of use into a less useful form — another transformation, this time from useful product into worn out product and waste. Of course one might say that we are producing and consuming “value” or “utility”, not really physical things. However, value is always added to something physical, namely resources, by labor and capital, which are also physical things ultimately made from the same low-entropy energy and materials that go into products. Nor does the service sector escape physical dimensions — services are always rendered by something or somebody. To abstract from physical dimensions and focus only on utility is to throw out the baby and pour bathwater on the diaper.

If we were to speak of a “transformation function” rather than a production function then we would naturally have to specify what is being transformed, into what, by the agency of what? Natural resource flows are transformed into flows of goods (and wastes), by the fund agents of labor and capital. A transformation function must show both the agents of transformation (funds of labor and capital that are not themselves transformed into the product but are needed to effect the transformation), and the flow of resources that are indeed physically embodied in the flow of products, or waste. This distinction between fund and flow factors immediately reveals their complementary roles as efficient cause and material cause — any substitution between them is very limited. You cannot bake the same cake with half the flour, eggs, etc. by doubling the number of cooks and the size of the oven. One natural resource can often substitute for another, and capital can often substitute for labor or vice versa, but more labor and capital can hardly substitute for a smaller resource flow, beyond the very limited extent of sweeping up and re-using process waste such as scraps, sawdust, etc. which ought to have already been accounted for in specifying a technically efficient production function. In most textbooks the production function depicts output as a function of inputs, undifferentiated as to their fund or flow nature, and all considered fundamentally substitutable.

But if the usual production function does not distinguish fund agents of transformation from the flow of natural resources being transformed, then how does it envisage the process of converting factor inputs into product outputs? Usually by multiplying them together, as in the Cobb-Douglas and other multiplicative functions. What could be more natural linguistically than multiplying “factors” to get a “product”? But this is mathematics, not economics. There is absolutely nothing analogous to multiplication going on in what we customarily call production — there is only transformation. Try to multiply the resource flow by labor or capital to get product outflow and your “production function” will have immediately run afoul of the law of conservation of mass. Perhaps to escape such incongruities most production functions contain only labor and capital, omitting resources entirely. We can now bake our cake with only the cook and her oven, no ingredients to be transformed at all! You can multiply cooks times ovens all you want and you still won’t get a meal.

How did this nonsense come into economics? I suspect it represents a confusion between the production function as a theoretical analytical description of the physical process of transformation (a recipe), and production function as a mere statistical correlation between outputs and inputs. The latter is common in macroeconomics, the former in microeconomics, although that is not a hard and fast rule because the distinction between a theoretical description and a statistical correlation is often ignored in both areas. The statistical approach usually includes only labor and capital as factor inputs, and then discovers that these two factors “explain” only 60% of the historical change in output, leaving a 40% residual to be explained by “something else”. No problem, say the growth economists, that large residual is “obviously” a measure of technological progress. However, the statistical residual is in fact a measure of everything that is not capital and labor — including specifically the quantity and quality of resources transformed. Increased resource use gets counted in the residual and attributed to technological progress. Then that same measure of technical progress is appealed to in order to demonstrate the unimportance of resources! If we thought in terms of a transformation function, rather than production ex nihilo it would be hard to make such an error.

The basic points just made were developed more rigorously forty years ago by Nicholas Georgescu-Roegen in his fund-flow critique of the neoclassical production function. Neoclassical growth economists have never answered his critique. Why bring it up again, and what is the relevance to steady-state economics? It is worth raising the issue again precisely because it has never been answered. What kind of a science is it that can get away with ignoring a fundamental critique for forty years? It is relevant to steady-state economics because it views production as physical transformation subject to biophysical limits and the laws of thermodynamics. Also it shows that the force of resource scarcity is in the nature of a limiting factor, and not so easy to escape by substitution of capital for resources, as often claimed by neoclassical growth economists.