The Archdruid Report - Archive

Last week’s Archdruid Report post built on one of E.F. Schumacher’s more trenchant insights to propose a controversial way of making sense of modern economics. Schumacher, in Small Is Beautiful, drew a distinction between primary goods produced by natural processes, and secondary goods produced by human labor, and pointed out that secondary goods can’t be produced at all unless you have the necessary primary goods on hand.

This is quite true, though it’s a point often missed by today’s economists. There is at least an equal difference, though, between either of these classes of goods and a third class produced neither by nature nor by labor. These are tertiary or, more descriptively, financial goods; they form the largest single class of goods in the world today, in terms of dollar value, and the markets in which they are bought and sold dominate the economies of the industrial nations. To call this unfortunate is a drastic understatement, because the biases imposed on our societies by the domination of financial goods are among the most potent forces dragging the world to ruin.

A specific example of a tertiary good may be useful here to help clarify the concept. Consider a corporate bond with a face value of $1000. This is a good in the economic sense – that is, it can be bought for money, it can be sold for money, there are people who want to buy it and people who are able to produce and sell it. Compare it to any more tangible item of value, though, and the bond is clearly a very strange sort of good. It consists of nothing more than a promise, on the part of some corporation, to pay $1000 at some future date. That promise may or may not be honored – junk bonds are bought and sold, for example, in full knowledge of the fact that the chances the issuers will pay up are not good – but even then the chance of collecting on it is treated as an object of value.

The differences between a tertiary good and a primary or secondary one reach further than this. Tangible goods produced by natural cycles or human labor are available in amounts limited by the supply. If there’s only so much water in a river, for example, that’s how much water there is; the fact that people want more, if such is the case, does not produce any more water than the hydrologic cycle is already willing to provide. Equally, if a country’s labor force, capital plant, and resource base are fully engaged in making a certain quantity of secondary goods, producing more requires a good deal more than an agreement to do so; the country must increase its labor pool, its capital plant, its access to resources, or some combination of these, in order to increase the supply of goods.

Yet tertiary goods are available in amounts limited only by the demand. How many bonds can a corporation print? For all practical purposes, as many as people are willing to buy. A good number of the colorful bankruptcies that have enlivened the business pages in recent months, for example, took out firms that mistook a temporary bubble for permanent prosperity, issued bonds far beyond their ability to pay, and crashed and burned when all that debt started to come due. On an even more gargantuan scale, the United States government is currently trying to restart its economy by spending money it doesn’t have, selling bonds to cover the difference, and amassing debt on a scale that makes the most extravagant Third World kleptocracies look like a bunch of pikers. It’s hard to imagine any way in which the results of this absurd extravagance will be anything but ugly, and yet buyers around the world are still snapping up US treasury bonds as though there’s a scintilla of hope they will see their money again.

The difference between supply-limited and demand-limited goods, as this suggests, is among other things a difference between kinds of feedback. Think about a thermostat and it’s easy to understand the principle at work. When the temperature in the house goes below a certain threshold, the heat comes on and brings the temperature back up; when the temperature goes above a higher threshold, the heat shuts off and the temperature goes back down. This is called negative feedback.

In a market economy, all secondary goods are subject to negative feedback. That’s the secret of Adam Smith’s invisible hand: since the supply of any secondary good is limited by the available natural inputs, labor pool, and capital stock, increased demand pushes up the price of the good, forcing some potential buyers out of the market, while decreased demand causes the good to become less expensive and allows more buyers back into the market. Equally, rising prices for a good encourage manufacturers to allocate more resources, labor, and capital plant to producing that good, helping to meet additional demand, while falling prices make other uses of resources, labor and capital plant more lucrative and curb supply.

Negative feedback loops of a very similar kind control the production of primary goods by the Earth’s natural systems. Every primary good from the water levels in a river and the fertility of a given patch of soil, to more specialized examples such as the pollination services provided by bees to agricultural crops, is regulated by delicately balanced processes of negative feedback working through some subset of the planetary biosphere. The parallel is close enough that ecologists have drawn on metaphors from economics to make sense of their field, and it’s quite possible that an ecological economics using natural systems as metaphors for the secondary economy could return the favor and create an economics that makes sense in the real world.

It’s when we get to the tertiary economy of financial goods that things change, because the feedback loops governing tertiary goods are not negative but positive. Imagine a thermostat designed by a sadist. In the summer, whenever the temperature goes up above a certain level, the sadothermostat makes the heat come on and the house gets even hotter; in the winter, when the temperature goes below another threshold, the temperature shuts off and the house gets so cold the pipes freeze. That’s positive feedback, and it’s the way the tertiary economy works when it’s not constrained by limits imposed by the primary or secondary economies.

The late and loudly lamented housing bubble is a case in point. It’s a remarkable case, not least because houses – which are usually part of the secondary economy, being tangible goods created by human labor – were briefly and disastrously converted into tertiary goods, whose value consisted primarily in the implied promise that they could be cashed in for more than their sales price at some future time. (As a tertiary good, their physical structure had no more to do with their value than does the paper used to print a bond.) When the price of a secondary good goes up, demand decreases, but this is not what happened in the housing bubble; instead, the demand increased, since the rising price made further appreciation appear more likely, and the mis-, mal- and nonfeasance of banks and mortgage companies willing to make six- and seven-figure loans to anyone with a pulse removed all limits from the supply.

The limits, rather, were on the demand side, where they always are in a speculative bubble: eventually the supply of buyers runs out because everyone who is willing to plunge into the bubble has already done so. Once this happened, prices began to sink, and once again positive feedback came into play. Since the sole value of these homes to most purchasers consisted, again, of the implied promise that they could be cashed in someday for more than their sales price, each decline in price convinced more people that this would not happen, and drove waves of selling that forced the price down further. This process typically bottoms out around the time that prices are as far below the median as they were above it at the peak, and for a similar reason: as a demand-limited process, a speculative bubble peaks when everyone willing to buy has bought, and bottoms when everyone capable of selling has sold.

It’s important to note that in this case, as in many others, the positive feedback in the tertiary economy disrupted the workings of the secondary economy. Long before the housing boom came to its messy and inevitable end, there was a massive oversupply of housing in many markets – there are, for example, well over 50,000 empty houses in Phoenix, Arizona right now. Absent a speculative bubble, the mismatch between supply and demand would have brought the production of new houses to a gentle halt. Instead, due to the positive feedback of the tertiary economy, supply massively overshot demand, leading to a drastic misallocation of resources in the secondary economy, and thus to an equally massive recession.

It’s long been popular to compare the tertiary economy to gambling, but the role of positive feedback in the tertiary economy introduces an instructive difference. When four poker players sit down at a table and the cards come out, their game has negative feedback. The limiting factor is the ability of the players to make good on their bets; the amount of wealth in play at the start of the game is exactly equal to the amount at the end, though it’s likely to go through quite a bit of redistribution. For every winner, in other words, there is an equal and opposite loser.

The tertiary economy does not work this way. When a market is going up, everyone invested in it gains; when it goes down, everyone invested in it loses. Paper wealth appears out of thin air on the way up, and vanishes into thin air on the way down. The difference between this and the supply-limited negative feedback cycles of the environment could not be more marked. In this sense it’s not unreasonable to call the tertiary economy a kind of anti-ecology, a system in which all the laws that govern ecology are stood on their heads – until, that is, the delusional patterns of behavior generated by the tertiary economy collide with the hard limits of ecological reality.

It’s not all that controversial to describe financial bubbles in this way, though you can safely bet that during any given bubble, a bumper crop of economists and pundits will spring up to insist that the bubble isn’t a bubble and that rising prices for whatever the speculation du jour happens to be are perfectly justified by future prospects. On the other hand, it’s very controversial just now to suggest that the entire tertiary economy is driven by positive feedback. Still, I suggest that this is a fair assessment of the financial economy of the industrial world, and the only reason that it’s controversial is simply that we, our great-grandparents’ great-grandparents, and all the generations in between have lived during the upward arc of the mother of all speculative bubbles.

The vehicle for that bubble has not been stocks, bonds, real estate, derivatives, or what have you, but industrialism itself: the entire project of increasing the production of goods and services to historically unprecedented levels by amplifying human labor with energy drawn from the natural world, first from wind and water, and then from fossil fuels in ever-increasing amounts. Like the real estate at the core of the recent boom and bust, this project had its roots in the secondary economy, but quickly got transformed into a vehicle for the tertiary economy: people invested their money in in industrial projects because of the promise of more money later on.

Like every other speculative bubble, the megabubble of industrialism paid off spectacularly along its upward arc. It’s inaccurate to claim, as some of its cheerleaders have, that everybody benefited from it; one important consequence of the industrial system was a massive distortion of patterns of exchange in favor of the major industrial nations, to the massive detriment of the rest of the planet. (It’s rarely understood just how much of today’s Third World poverty is a modern phenomenon, the mirror image and necessary product of the soaring prosperity of the industrial nations.) Still, for some three hundred years, standards of living across the industrial world soared so high that people of relatively modest means in America or western Europe had access to goods and services not even emperors could command a few centuries before.

In the absence of ecological limits, it’s conceivable that such a process could have continued until demand was exhausted, and then unraveled in the usual way. The joker in the deck, though, was the dependence of the industrial project on the extraction of fossil fuels at an ever-increasing pace. Beneath the giddy surface of industrialism’s bubble, in other words, lay the hard reality of the tertiary economy’s dependence on resources from the primary economy. The positive feedback loop driving the industrial bubble can’t make resources out of thin air – only money can be invented so casually – but it has proven quite successful at preventing industrial economies from responding to the depletion of their fossil fuel supplies fast enough to stave off what promises to be the great-grandmother of all speculative busts.

The results of this failure are beginning to come home to roost in our own time. To understand the economics of the resulting collision, though, it’s necessary to note the relationship between economics and the least popular law of physics – a subject central to next week’s post.