Wednesday, July 29, 2009

The Economics of Entropy

Over the last few weeks, my posts here on The Archdruid Report have tried to sketch out a way of understanding economics that doesn’t contradict the laws of physics or the evidence of history. Perhaps the central concept I’ve been developing along these lines is the sense that there is no such thing as “the” economy in any human society; there are, rather, three economies, each of which follows distinctive rules.

The primary economy, in this way of looking at things, is the natural world itself, which produces something like three-quarters of the goods and services on which human beings rely for survival. The secondary economy, which depends on the primary one, is the collocation of labor, capital plant, and resources extracted from the primary economy that produces the other quarter or so of the goods and services human beings use. The tertiary economy, finally, is the system of social processes by which the products of the first two economies are allocated to people. This can take many different forms, of which the one most familiar to us is money.

The differences between these three economies run deep, and so do the differences in the way they are treated in conventional economic thinking. Unfortunately these two sets of differences do not run in parallel. One way to explore the resulting mismatch is to look at how the three economies, in reality and theory, are affected by the least popular of all the laws of physics: the second law of thermodynamics, more popularly known as the law of entropy.

To call this law unpopular is not to say that it suffers from any lack of recognition by scientists. The comment of Sir Arthur Eddington, one of the twentieth century’s greatest physicists, is typical: “If your theory is found to be against the second law of thermodynamics, there is nothing for it but to collapse in deepest humiliation” – a summing-up so useful that it probably deserves to be called Eddington’s Law. Entropy is the gold standard of physics, the one thing you can count on even when the rest of the cosmos seems to be going haywire. What makes it unpopular, rather, is that it stands in stark conflict with some of the most deeply and passionately held convictions of modern industrial humanity.

For all that, it’s a simple concept to grasp. Pour a cup of hot coffee on a cold morning and you can watch entropy in action. The coffee will gradually get colder and the air around it will get very slightly warmer. All energy everywhere, left to itself, always moves from higher to lower concentrations: that’s the second law of thermodynamics. On the way from higher to lower, the energy can be made to do useful work, and you can even force some energy to a higher concentration by allowing a larger amount of energy to go to a lower one, but one way or another entropy’s price must be paid.

We don’t like thinking in these terms, and for the last three hundred years, most of us in the industrial world haven’t had to. The 18th-century breakthroughs that allowed coal to be turned into steam power, and gave human beings command over amounts of highly concentrated energy never before wielded by our species, convinced most people in the western world that energy was basically free for the taking. In the halcyon days of industrialism, it was all too easy to forget that this vast abundance of energy was a cosmic rarity, a minor and finite backwash in the flow of energies on a scale almost too great for human beings to comprehend.

As far as we know, there are two and only two phenomena in the cosmos that naturally produce high concentrations of energy. The first is gravity. Unlike most physical phenomena, gravity has robust positive feedback: the more mass a body has, the more gravitational attraction it exerts, the more additional mass it can attract, and the more its gravitational attraction increases. This is why what starts as an eddy in an interstellar cloud of hydrogen gas, set in motion perhaps by the shockwave from a distant supernova, can attract steadily more hydrogen to itself until its gravity is strong enough to achieve the fantastic pressures needed for nuclear fusion, and a newborn star flares into life. Even so, entropy still rules; the light and heat that flows out from our Sun over the course of its ten billion year lifespan is still only a fraction of the potential energy of the gravitational collapse that brought it into being and keeps it going.

The second phenomenon that produces concentrated energy is biological life. Life combines positive and negative feedback loops, and so it’s much more fitful and fragile than gravity, but it can still surf the entropy of its neighboring star, tapping a small part of the vast streams of energy that flow entropically from the Sun’s core to the near-absolute-zero cold of interstellar space to concentrate chemical energy for its own use. Over the ages, the resulting concentrations of energy have transformed our planet, pumping oxygen into its atmosphere and burying trillions of tons of carbon underneath the ground in the form of coal, oil, and natural gas. Once that carbon was buried, gravity got to work on it, concentrating it further through heat and pressure. The energy stored in today’s fossil fuel deposits, in turn, is still only a fraction of the energy lost to entropy in the long slow process that brought those deposits into being.

This is why, as I’ve tried to point out in previous posts, those who expect to get some new and even more concentrated energy source to replace our dwindling reserves of fossil fuels are basically smoking their shorts. It took an extraordinarily complex series of processes, more time than the human mind has evolved the ability to grasp, and an equally unimaginable amount of energy lost to entropy, to produce the highly concentrated fossil fuels we’ve wasted so profligately over the last three hundred years. There are plenty of diffuse energy sources left, but raising them to concentrations that will allow them to power our current civilization would require huge amounts of additional energy to be sacrificed to entropy – and once you subtract the entropy costs of concentration from the modest energy supplies available to a deindustrial world, there isn’t much left. Try telling that to most people, though, and you’ll get a blank look, because we’ve lived with abundant concentrated energy for so long that very few people recognize just how rare it is in the broader picture.

Economics, once again, feeds this blindness. Most economic models, interestingly enough, admit entropy into what I’ve called the secondary economy: there’s a clear sense that producing goods and services consumes resources and produces waste, and that energy fed into the process is lost to entropy in one way or another. Most of them, however, explicitly reject the role of entropy in the primary economy, insisting that resources are always available by definition if you only invest enough labor and capital. As for the tertiary economy, most economic theories accept it as given that money is anti-entropic – it produces a steady increase in value over time, which is the theoretical justification for interest.

In the real world, by contrast, the primary economy is just as subject to entropy as the secondary one. Oil that has been pumped out of the ground and burned is no longer available to use as an energy resource, and if enough of it has been pumped out, the oil field runs dry and it stops being a resource too. Natural cycles can keep some resources available at a steady level by surfing the entropy of the Sun, but only if human action doesn’t mess up those cycles – something we are doing a great deal too much of just now. By ignoring the reality of entropy in the primary economy of nature, we are setting ourselves up for a very awkward future.

And the tertiary economy? This is where things get interesting, because the anti-entropic nature of money posited by mainstream economic theories has been accepted even by most critics of those theories. There’s accordingly been a flurry of proposals for changing the way money works so that it loses value over time. This is understandable, but it’s also unnecessary, because money as it exists today has an exquisitely subtle mechanism for losing value over time. The only difficulty is that mainstream economists and the general public alike treat it with the same shudder of dread and indignation their Victorian ancestors directed toward sex.

We’re talking, of course, about inflation.

I’ve come to think of inflation as the primary way that the tertiary economy resolves the distortions caused by the mismatch between the limitless expansion of the tertiary economy and the hard limits ecology and entropy place on the primary and secondary economies. When the amount of paper wealth in the tertiary economy outstrips the production of actual, nonfinancial goods and services in the other two economies, inflation balances the books by making money lose part of its value. I suspect – though it would take a good econometrician to put this to the test – that in the long run, the paper value lost to inflation equals the paper value manufactured by interest on money, once the figures are adjusted for actual increases or decreases in the production of goods and services.

It’s instructive to note what happens when governments attempt to stop the natural balancing process of inflation. In American economic history, there are two good examples – between the Civil War and the First World War, on the one hand, and between 1978 and 2008 on the other. In the first of these periods, the US treasury reacted against the inflation of the Civil War years by imposing a strict gold standard on the currency, and since the pace at which new gold entered the economy was less than the rate at which the production of goods and services expanded. The result was the longest sustained bout of deflation in the history of the country.

Despite the claims of precious-metal advocates today, this did not produce economic stability and prosperity. Quite the contrary, the economic terrain of the second half of the 19th century was a moonscape cratered by disastrous stock market collapses and recurrent depressions. The resulting bank and business failures probably eliminated as much paper value from the economy as inflation would have, but did so in a chaotic and unpredictable way: instead of everybody’s corporate bonds losing 5% of their value due to inflation, for example, some bonds were paid in full while others became worthless when the companies backing them went out of existence. The same calculus has come into play since the beginning of the Volcker era at the Federal Reserve Board, when “fighting inflation” became the mantra of the day; since then we’ve had a succession of crashes as colorful as anything the 19th century produced.

Thirty years of economic policy dedicated to minimizing inflation have guaranteed a sizable second helping of economic collapse in the years to come – it’s only in the imaginations of politicians and publicists that the recent “dead cat bounce” in the stock market, and various modest decreases in the rate at which economic statistics are getting worse, add up to a recovery of any kind, much less a return to the unsustainable pseudoprosperity of the years just past. Still, in the longer term, I suspect inflation will also play a major role in the unraveling of the current mess. With the end of the age of cheap abundant fossil fuels, the world faces a very substantial decrease in the amount of primary and secondary wealth in the world, and the notional wealth of the tertiary economy will have to lose value even faster to make up for that decline. Just how this will play out is anyone’s guess, but one way or another it’s unlikely to be pretty.

Wednesday, July 22, 2009

The Anti-Ecology of Money

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.

Wednesday, July 15, 2009

Nature, Wealth, and Money

Since the beginning of the current series of Archdruid Report posts on economics, I’ve wondered in an idle sort of way if it might come to the attention of a professional economist or two. Last week’s post, though, seems to have settled that issue. I deliberately begged a question in that post, one that cuts to the core of conventional economic theory, and it would have taken a degree of self-control exceedingly rare in any profession for a mainstream economist to read the discussion and not rise to the bait.

I’m referring, of course, to the cavalier way in which the concept of money was treated in last week’s post. In terms of mainstream economics, it’s nonsense to talk about wealth or value without discussing how those things are reflected in some form of pricing mechanism – that is, how they’re measured in money. The widely held belief that the wealth produced by nature is valueless until it’s transformed into something else by human labor, in fact, bases itself largely on the fact that nobody has to pay the nonhuman world for that wealth, and so figuring out its price poses a major challenge – not insoluble, but significant enough that few economists have been willing to take it up.

Since Adam Smith launched modern economics in 1776 with The Wealth of Nations, unresolved disputes over the nature of money have formed a fault line running straight through the heartland of economic thought. Some economists – these days, the majority – treat wealth and money as interchangeable concepts. Others – the minority nowadays – draw a sharp distinction between them. Those who accept the identity of money and wealth seem most often to think of the rules governing money as something akin to laws of nature, untainted by human purposes and agendas; those who draw a distinction between them tend to see those rules as social constructs that benefit some people at the expense of others.

Longtime readers of The Archdruid Report will probably have little trouble guessing where along this spectrum of debate I can be found. It’s simple cultural chauvinism to insist that the particular, and peculiar, form of money used in contemporary Western societies is the only one that matters. Over the span of human history, money is a fairly late invention, and until very recently it played only a small part in the lives of most people even in the societies that used it; until the eighteenth century, even in the Western world, a majority of all goods and services were produced and exchanged within the household economy, or in local customary economies that made no use of money, and only the well off could expect to handle money on a daily basis.

Every human society has had some social mechanism for distributing goods and services. Paleoanthropologists have argued that it was precisely the evolution of food sharing within bands of ancestral humans that gave our species the evolutionary edge to expand across the globe in the face of wide variations in habitat and the rigors of ice age climates. Hunting and gathering societies around the world have intricate arrangements for sorting out who gets how much of the various natural sources of wealth available to them; so do the horticultural and pastoral human ecologies that evolved out of the hunter-gatherer pattern. Some of these latter use a particular trade good in certain contexts as a general marker for value – think of the shell-bead wampum strands used by the First Nations in eastern North America, for example – but these get used only in a restricted class of prestige exchanges, and play no role in everyday exchanges of goods and services. The same thing was true of gold and silver coinage in many ancient and medieval societies; most of the population of medieval England, for example, could expect to go from one winter to the next without seeing more than a handful of silver coins.

From a broader perspective, then, a money system of the sort we use today is simply one way of managing the distribution of goods and services within a particular kind of human society. Modern economics textbooks dodge this point by comparing money to only one other form of exchange – simple barter, in which (let’s say) a physician and a farmer have to negotiate how many bushels of wheat are worth a cure for an illness – and insisting on that basis that money is inevitable because the alternative is so clumsy. Surely, though, this puts the cart before the horse. It’s only when exchanges have already become subject to a market system that exchanges are conceptualized in such terms, and that presupposes that some standard measure of abstract value – that is, money – already exists. It’s worth mentioning that such great civilizations as Egypt of the pharaohs had farmers and physicians aplenty for tens of centuries before anybody thought of money.

What sets money apart from other systems is not its convenience – quite the contrary, as such alternatives as household production of goods and services, or traditional economies of gift and customary exchange, are quite a bit more convenient for most purposes, since the extra steps imposed by the need to bring money into the situation can be done without. Rather, money has three distinctive features relevant to the present discussion. First, to the extent that it can replace other forms of distribution and exchange, it draws all economic activity into its own ambit. That can (and very often is) used for political control, but this is a side effect. The principal effect of this property of money is to turn a society into an economic monoculture.

This elimination of economic diversity has been discussed in previous posts, but it deserves more attention than I’ve given it so far. Diversity is the basis of stability in any ecosystem, human or otherwise; when a significant proportion of goods and services are produced in the household economy, for example, the vagaries of the market economy have a limited influence on everyday life; that limitation goes away once goods once made at home have to be purchased in the market with money. Thus it’s no accident that over the last four centuries, as the market has supplanted the household economy and other patterns of production and distribution of wealth, economic crises have become progressively more frequent, more severe, and more widely felt. The effects of the Dutch tulip mania and the South Sea bubble were restricted to a relatively small proportion of their respective societies; this was hardly true of the Great Depression of the 1930s, and seems to be turning out even less true of the Great Recession now under way.

The second distinctive feature of a money economy is that it makes it harder, not easier, to value certain classes of goods. What E.F. Schumacher called primary goods – goods produced directly by nature without human intervention – are perhaps the best examples. Most traditional societies around the world, it bears noticing, have no trouble whatever recognizing the value of primary goods and finding ways to integrate that value into their own systems of exchange. The salmon ceremonies of First Nations along the northwest coast of North America are good cases in point.

These societies have a gift economy in which rank and social influence are gained by giving away goods – a system that once provided a very efficient means of distributing wealth of many kinds through their societies – and they treat the arrival of the annual salmon runs in exactly the same spirit, as a mighty gift from the Salmon People that must receive an appropriate response. Anthropologists who treat these arrangements purely under the heading of religion (or, less politely, superstition) are missing one of their central points; they are, among other things, ways of integrating relationships between human communities and the natural world into the traditional economy, so that the value of the salmon harvest is always weighed in decisions that might affect it, and traditional practices that preserve salmon runs are given potent economic sanction.

Such arrangements are common – indeed, very nearly universal – in moneyless economies. They can also be found in money economies; one of these days I ought to devote a post to the elegant ways in which the classical Greeks, who had money and weren’t at all afraid to use it, set up lively economic exchanges with their own fragile ecosystem. (Like the salmon ceremonies, these are normally treated purely in terms of religion or superstition, and their economic and ecological dimensions have thus rarely been noticed.) Still, the more completely an economy becomes subject to money, the more difficult it becomes to include primary goods in economic calculations. The Salmon People are perfectly capable of participating in a gift economy, one might say, but there’s no way they can cash a check – or, for that matter, write one.

The third distinctive feature of money is subtler, and very often misunderstood. Unlike other systems of distributing goods and services, money functions as a good in its own right, and the right to use it functions as a service. To some extent this is a legacy of the time when money was made of some culturally valued substance – wampum strings in eastern Native North America, say, or gold and silver in medieval Europe – but it opens the door to unexpected developments.

If money is treated as a good in its own right, and the use of money is treated as a service in its own right, then instead of exchanging money for ordinary goods and services and ordinary goods and services for money, it becomes possible and profitable to exchange money for money. The entire world of finance, from savings accounts and installment loans up through the dizzying abstractions of today’s derivative markets, unfolds from this third property of money. When money plays a relatively minor role in a society, this dimension is correspondingly small; as the volume and pervasiveness of money expands, so does the scale and impact of the arrangements by which money makes money; when money dominates a society, so does the world of finance, and the amount of money being traded for money can exceed by several orders of magnitude the amount of money being traded for goods and services.

What makes this problematic is that the rules governing money are not the same as those governing other goods and services. Unlike goods and services that have their own value, money is only worth what it can buy; unlike goods and services that must be produced by labor from resources, money can be conjured from thin air by dozens of different kinds of financial alchemy, or by the momentary whim of a government. Nor does the amount of money in circulation have to have anything at all to do with the amount of other goods and services available. All these differences mean that the economy of money can very easily slip out of balance with the economy of nonfinancial goods and services.

It’s useful, in fact, to extend one of E.F. Schumacher’s insights further than he did, and speak of the economy of money as the tertiary economy of the modern world. If the primary economy consists of the natural processes that provide goods and services to human beings without human labor, and the secondary economy consists of the conjunction of human labor and natural goods that produces those goods and services nature itself doesn’t provide, the tertiary economy consists of the circulation of monetary goods and financial services that, at least in theory, fosters the distribution of the products of the secondary economy.

Last week’s post pointed out that the secondary economy depends on the primary economy. In the same sense, the tertiary economy depends on the secondary economy – all the money in the world, it’s fair to say, won’t allow you to buy a good or a service that the secondary economy doesn’t produce. Perhaps the greatest problem with contemporary economic thought is that it inverts this relationship, treating the tertiary economy of money as the prime mover, with the secondary and primary economies dependent on the world of money. This odd and disastrous inversion, and its implications in a world of rapidly depleting natural resources, will be the theme of next week’s post.

Wednesday, July 08, 2009

The Wealth of Nature

Last week’s Archdruid Report pointed out that modern economic thought, through its lasting difficulties in coming to terms with the dependence of human economic activity on the world of nature, has played a very large role in backing industrial civilization into its present difficulties. It probably would have been wise, though, to point out that the word “modern” here is being used in a historical sense, for these difficulties date straight back to the beginning of economics as a distinct field of study.

Adam Smith, who set the whole ball rolling with his The Wealth of Nations, started that book with the following sentence: “The annual labor of every nation is the fund which originally supplies it with all the necessities and conveniences of life.” It does not seem to have occurred to Smith that the annual labor of a nation would be utterly useless without the natural raw materials, goods, and services – in the language suggested in last week’s post, the primary goods – that enable labor to be done at all, by making human life possible in the first place and by providing all that labor with something to labor on. Certainly it has occurred to very few of his successors.

The classic example is David Ricardo, who remains an influential figure in economics, not least because his theories – he was a vocal proponent of free trade, and provided what are still the standard arguments in its favor – proved to be highly useful to the British Empire in its time, and of course to the American empire in ours. Ricardo is famous for, among other things, building a significant part of his economic theories on the claim that land retains its “original and indestructible” economic value no matter what economic use is made of it.

This is an odd claim. Even in the early 19th century, when Ricardo originally made it, plenty of people could have set him straight. Bad farming practices that led to soil sterility were known in Ricardo’s time, and so was the impact of industrial pollution – though of course we have gotten much better at both since then. It may be relevant that Ricardo was born and raised in London, as far from the realities of agricultural life as you could get in his time; it is at least as relevant that his theories show the habit of dodging inconvenient facts for what look uncomfortably like ideological reasons – his arguments in favor of free trade, for example, only work if you grant the unstated assumption that international trade and its supporting infrastructure cost nothing in terms of labor, materials, or money, and also dodge the extent to which control of the transport routes and exchange processes determine who profits from the trade.

What is far more interesting, though, is that his definition of land prefigured the way that natural resources have been treated by most economists ever since. This is as true of radical economists as of their capitalist rivals; recent proponents of “green socialism,” for example, might want to reread Marx, who explicitly rejected the idea that the “free gifts of nature” could have any value at all. (The disastrous mistreatment of the environment common under Marxist regimes in the 20th century was not accidental, but a natural outgrowth of Marxist theory.) Nearly the only concession made to the ecological dimensions of economics in the mainstream, and it’s a fairly recent one, is the concept of “externalities” – the recognition that if somebody does something that fouls the environment, other people may suffer a loss of economic value as a result, and might deserve compensation for that.

Now of course this is true, and Garrett Hardin’s famous essay “The Tragedy of the Commons” built on that insight to remind us that a society that permits the advantages of ecological abuse to go to individuals, while the costs are shared by the whole society, is effectively subsidizing the destruction of its environment. Still, both the “externalities” argument and the structure Hardin built on it miss the central issues raised by the interface between environment and economics. Both tacitly accept Ricardo’s fantasy of invulnerable land as the normal state of affairs, apply it to the entire environment, and then focus attention on the exceptional situation when somebody does manage to make land (or some other environmental resource) less valuable.

Let’s take a closer look at the land whose value Ricardo considered “indestructible.” He was talking primarily about land as an economic factor in agriculture, and so shall we. What he apparently did not realize, but ecologists have shown in exact detail since his time, is that fertile land suitable for growing crops does not simply happen. Like anything else of value, it must be made, and once made, it must be maintained; the only difference is that the laborers that make and maintain it do not happen to be human beings.

Soil suitable for crops, after all, is not simply rock dust. A large part of it – sometimes more than half – is organic matter, some living, some dead but not yet wholly decayed, some dissolved into organic colloids complex enough to give analytical chemists sleepless nights, and all of it is put there by the activity of living things over long periods of time. Energy and raw materials flow through soil, uniting bacteria, fungi, algae, worms, insects, and many other living things into one of the most intricate ecosystems on Earth. Plants participate in and depend on this bewilderingly complex world; they draw water and mineral nutrients from it, and cycle leaves and a wide range of chemical compounds back into it.

The farmer who wants to grow crops is attempting to extract wealth from the underground ecosystem of the soil. She can ignore that, and simply plant and harvest with no attention to the needs of the soil, but the soil will be depleted of nutrients in a few years and her crops will fail. Alternatively, she can replace nutrients with chemical fertilizers, predators with pesticides, and so on; if she does this she will have to use steadily larger doses of chemicals to get the same yields, and when the chemical feedstocks run out – as they eventually will – she will be left with soil too sterile and pest-ridden to grow much of anything. If she wants to fulfill Ricardo’s promise and hand the land on to her grandchildren in the same condition that it came from her grandparents, she will have to provide the things the soil needs for its long-term health. Put another way, she will have to barter with the soil, giving it the things it will accept in exchange for crops.

This is the premise of organic agriculture, of course. It’s a premise that has proven itself over millennia, in the Asian farming regions that inspired the organic pioneers of the early 20th century to devise a more general way of doing the same thing, and over decades, in the farms now using organic methods to get yields roughly comparable to those of chemical agriculture. The organic approach has many dimensions, but one may not have received the importance it deserves. To an organic farmer, land is not a commodity that can be owned but a community with which she interacts, and that community has its own economy on which the farmer’s own economy depends.

Imagine, to develop this concept into a metaphor, that our farmer got crops, not from the fields, but from a village of some indigenous tribe near her home. The inhabitants of the village are deeply conservative, and their own economy follows traditional patterns not subject to change. If the farmer wants crops, she must find out what the villagers are willing to take in exchange for them, and that will be determined by the internal dynamics of the village economy: what is already produced in surplus amounts, what is scarce, what is desired and what is detested by the villagers. Her relations with the village, in other words, would be exactly the same in outline as those of an organic farmer with her land.

The same thing is true of every other form of economic activity, though the dependence on nature may be less obvious in some cases than in others. Behind the human activities that produce secondary goods lie nonhuman activities that produce primary goods – the biological cycles that yield soil fertility, crop pollination, and countless other things; the hydrological cycles that put fresh water into reservoirs and taps; the tectonic processes in the crust that put economically useful metals and minerals into veins in the rocks; and, of central importance just now, the extraordinarily complex interplay of biological and geological processes that stored away countless billions of tons of carbon under the earth’s surface in the form of fossil fuels.

Conventional economics assumes that these things get there by some materialist equivalent of divine fiat. This misstates the situation disastrously. Primary goods are produced by an exact analogue of the way that secondary goods are produced: raw materials are transformed, through labor, using existing capital and energy, to produce goods and services of value. The difference is simply that all this takes place in the nonhuman world. Human beings do not manage the production of primary goods, and the disastrous results of trying to do so suggest that we probably never will; on the other hand, in at least some cases – maltreated farmland is a good example – we can interfere with the production of primary goods, and suffer the consequences.

E.F. Schumacher’s insight, that goods produced by nature are the primary goods in any economy, and those produced by human labor are secondary goods, thus needs to be extended further. There is also a primary and secondary economy. The cycles of nature that produce goods needed by human beings constitute the primary economy, while the process by which human beings produce goods is the secondary economy. The secondary economy depends utterly on the primary in at least two ways. First, as discussed last week, something like three-quarters of all economic value in today’s world is produced by nature – that is, by the primary economy – and only around a quarter is produced by human labor. Second, even that quarter is made directly or indirectly from primary goods, and cannot be made at all if the necessary primary goods aren’t there. This is why the attempt to replace a depleted natural resource with something else always involves substitution costs: human labor must be brought in to replace some part of the work previously done by nature, and the costs of that part of the work thus end up having to be paid out of the secondary economy.

We have become so used to thinking of economics as a matter of human labor that it’s probably best to point out that what are sometimes called “primary industries” – farming, mining, and the like – belong to the secondary economy, not the primary one. The primary economy consists wholly of those nonhuman processes that yield economic goods to human beings. Thus a farm and the crops grown on it are part of the secondary economy, while the soil, water, sun, and genetic potential in the seed stock that make the farm and its crops possible are part of the primary economy. In the same way, a mine is part of the secondary economy, while the slow geological processes that put ore in the ground where it can be mined are part of the primary economy. If you examine any human economic activity, you’ll find behind it natural processes that make that activity possible; those processes are the inputs from the primary economy that make the secondary economy possible.

Thus Adam Smith’s dictum cited earlier badly needs reformulation. The product of the natural environment of every nation is the fund which originally supplies it with all the necessities and conveniences of life; the annual human labor is simply the energy input required to turn some of that product into forms useful for human beings. The wealth of nations, it turns out, is ultimately the wealth of nature, and the sooner the value of natural cycles and primary goods is taken into account, the better chance our descendants will have of avoiding the self-defeating habits that are pushing modern industrial system down the long road to collapse. To do so, however, will require a clear sense of the difference between value and price, or to put matters another way, between wealth and money – the theme of next week’s post.

Wednesday, July 01, 2009

Where Economics Fails

It’s occurred to me more than once that we might be wise to set aside an annual weekend to mourn the death of Osiris or Persephone or Bladud the wind-god or some other divinity, as our pagan ancestors did, or as those Christians who still take the narratives of their faith seriously do each year on Good Friday. It might at least put a merciful end to the media’s frantic and macabre efforts to bestow a belated sainthood on each new member of the dead celebrities’ club, no matter how far from sanctity the trajectory of their lives might have been.

Thus you’d be correct in guessing that I didn’t put much time this past weekend into paying attention to the media furore over the death of Michael Jackson. I was, instead, busy with my usual research. While tens of millions of people spent the weekend glued to their TVs reviewing the catastrophic fall from grace of an undeniably brilliant cultural phenomenon that achieved unparalleled success, and then was brought down by a supertanker-sized load of unresolved inner conflicts heated to crisis by a disastrous mismatch between an extravagant lifestyle and faltering income – well, I suppose that’s a fair description of what I was doing, too.

Still, the decline and fall of industrial civilization, that troubled and dysfunctional superstar still wobbling across the historical stage, can’t be tracked that effectively by taking in music videos or soundbite interviews. Instead, I spent the weekend reading through economics textbooks. “Thriller” is not exactly the word I’d use to describe these hefty tomes, but I’d recommend that anyone concerned with the future of our society ought to read at least one. This is not because current economic textbooks offer useful guidance to the challenges of our time. Quite the contrary; the world they describe is as imaginary as Oz, and rather less relevant to contemporary life. What makes them important is precisely that so many of the decision makers of our time treat this fantasy as reality.

Understand current economic thought and you understand most of the mistakes that are dragging industrial civilization down to ruin. The Energy Information Administration (EIA), a branch of the US government, has become infamous in the peak oil scene over the last decade or so for publishing estimates of future petroleum production that have no relationship to geological reality. Their methodology, as described in EIA publications, was simply to estimate probable increases in demand, and then to assume that increased demand would automatically be met with a corresponding increase in supply. Quite a few peak oil writers have suggested some dark conspiracy behind this blithe disregard for the limits of a finite planet, but it takes only a few minutes’ worth of reading to identify the real culprit as the standard notion of the law of supply and demand taught in every first-year economics textbook today.

According to this model of the world, the amount of any commodity available in a free market is controlled by the demand for that commodity. When consumers want more of a commodity than is available on the market, and are willing to pay more for it, the price of the commodity goes up; this provides an economic incentive for producers to produce more of the commodity, and so the amount of the commodity on the market goes up. Increased production sets an upper limit on price increases, since producers competing against one another will cut prices to gain market share, and the willingness of consumers to pay rising prices is also limited. Thus, in theory, the production and price of a commodity are set by a shifting balance between the desire of consumers to buy it and the desire of producers to make a profit from producing it.

What makes the theory so seductive is that within certain limits, and in certain circumstances, it works tolerably well. The problem creeps in when economists lose track of the existence of those limits and circumstances, and this, to a remarkable degree, is exactly what they have done. To be fair, they had good reason to do so, because during the three-hundred-year boom that created the industrial world following the successful harnessing of fossil fuels, the limits rarely applied and the circumstances were far more often present than not. Among the most important roots of the current crisis, in turn, are the hard facts that the limits have begun to come into play, and the circumstances no longer exist.

Let’s start with the obvious. Imagine that a plane full of investment bankers makes a forced landing in the Pacific close to a desert island. The island has no food, no water, and no shelter; it’s just a bare lump of rock and sand with a few salt-tolerant grasses on it. As the bankers struggle ashore from the sinking plane, the need for food, water, and shelter on that island is going to be considerable, but even if each of the bankers have a suitcase full of $134 billion dollars in bearer bonds – like those guys who were caught trying to enter Switzerland a little while back – that need is going to go unfilled, until and unless a ship arrives from somewhere else. The lesson here is simple: economics doesn’t trump physical reality.

More generally, the theoretical relationship between supply and demand functions only when supply is not constrained by factors outside the economic sphere. The constraints in question can be physical: no matter how much money you’re willing to pay for a perpetual motion machine, for instance, you can’t have one, because the laws of thermodynamics don’t take bribes. They may be political: Nazi Germany had a large demand for oil from 1943 to 1945, for example, and the Allies had plenty of oil to sell, but anyone who assumed on that basis that a deal would be cut was in for a big disappointment. They may be technical: no matter how much you spend on health care, for instance, sooner or later it’s going to fail, because nobody’s yet been able to develop an effective treatment for death. Economists have come up with various workarounds to deal with external factors of this sort, some more convincing than others.

Another set of factors that can crumple up the law of supply and demand and toss it into the wastebasket, though, has received far less attention. These are constraints that we might as well call “ecological,” and they unfold from the awkward fact that human economic activity is far less independent of the natural world than economists often try to pretend. The scale of this dependence is as rarely recognized as it is hard to overstate. One of the few attempts to quantify it, an attempt to work out the replacement costs for natural services carried out a few years back by a team headed by heretical economist Robert Costanza, came up with a midrange figure equal to around three times the gross domestic product of all human economic activity on earth.

Out of every dollar of value circulating in the world’s economy, in other words, something like 75 cents were provided by natural processes rather than human labor. What’s more, most if not all of that 75 cents of value had to be there in advance in order for the production of the other 25 cents to be possible at all. Before you can begin farming, for example, you need to have arable soil, water, and an adequate growing season, as well as more specialized natural services such as pollination. These are nonnegotiable requirements; if you don’t have them, you can’t farm. The same is true of every other kind of productive work in the human economy: nature’s contribution comes first, and generally determines how much the human economy can produce.

It’s for this reason that E.F. Schumacher, the maverick economist whose ideas are the launching pad for this series of posts, drew a hard distinction between what he called primary goods and secondary goods. Secondary goods are the goods and services provided by human labor, the ordinary subject of economic theory. Primary goods are the goods and services provided by nature, and they make the production of secondary goods possible. The difference between the two is very much like the difference between income and profit in a business: you have to have income in order to have profit, and if you neglect income while maximizing your profit, sooner or later you go bust.

A failure to distinguish between primary and secondary goods is at the root of a great deal of current economic nonsense. It’s usually possible, for example, to substitute one secondary good for another if the supply runs short or the price gets too high, and for this reason it’s a standard assumption of economics – and one of the foundations of the law of supply and demand – that consumers can meet their needs equally well with many different goods. Yet this assumption does not apply to natural goods. In the world of nature, a different rule – Liebig’s law of the minimum – applies instead: production is limited by the scarcest necessary resource. Thus if you have a farm and can’t get water for your crops, it doesn’t matter if you have excellent soil and all the other requisites of farming; you can’t grow anything.

In certain limited situations, to be sure, it’s possible to substitute one primary good for another – for instance, to use low-grade iron ores such as taconite when the high-grade ores have been exhausted. Even when this can be done, though, a law of diminishing returns always applies. You can get iron out of low-grade ore, but the extraction process is less efficient and takes much larger inputs of energy. When energy is cheap, you can ignore this – and this is exactly what happened over the course of the 20th century, as the iron industry retooled itself to use steadily lower grades of ore and steadily larger inputs of energy – but that in itself simply passes costs onto the future, since the fossil fuels that provided the energy inputs are themselves subject to depletion, and to a law of diminishing returns. One way or another, the substitution imposes additional costs without providing any additional economic benefit.

This same rule also applies to every other natural good. Consider the valuable service provided to the world’s economies by the honeybees that pollinate most nongrain food crops. If we succeed in adding the honeybee to the already long list of the world’s extinct life forms, it would doubtless be possible to replace their pollination services by other means, whether that took the form of huge pollinating machines rumbling across the fields or the simpler and probably more economical approach of migrant workers using little brushes to wipe pollen from a bag onto the stamen of every single flower. Note, though, that no farmer in his or her right mind would hire a thousand laborers with brushes instead of calling up the local beekeeper and arranging for a few hives to be left in the fields; substituting some other pollination method for bees would add a huge additional cost to farming, without yielding any additional benefit.

I’ve come to think that the unrecognized difference between secondary goods, which can be readily replaced by other goods without additional cost, and primary goods, which cannot, is among the most important forces driving our current crisis. For the last three centuries, the industrial economies of the world have been using up every primary good that can be converted into secondary goods at extravagant and steadily increasing rates. Think of any good or service provided by nature – from topsoil to oceanic fish stocks, from the pollution-absorbing capacities of rivers to the storm-buffering properties of wetlands, from breathable air and drinkable water to the mineral stocks and fossil fuel reserves that keep the entire system running – and you’ve just identified something that’s being used up rapidly by industrial societies, with no thought of the potential costs of substituting something else for it, much less of the hard fact that nothing we can possibly do can provide a substitute for some of them once they’re gone.

The mismatch between this hopelessly shortsighted approach and the unforgiving limits of nature is imposing a rising toll of substitution costs on industrial economies around the world. Of course there are other factors involved. Still, as I hope to show in a future post, the best explanation for the “stagflation” that beset economies and baffled economists in the 1970s was the unrecognized burden of substitution costs for a range of natural goods depleted or damaged during the previous decades. Equally, the economic dysfunctions that led central banks around 2002 to flood financial markets with cheap credit – a disastrous decision that ended up powering the boom and bust that landed us in the current Great Recession – were driven by mounting substitution costs for another range of natural goods that had been depleted or overused in the previous decades of prosperity. As peak oil adds a new round of substitution costs to those already in play, this same process is likely to have even more dramatic impacts on the future.