Wednesday, November 25, 2009

Lies and Statistics

Plenty of difficulties stand in the way of making sense of the economic realities we face at the end of the age of cheap abundant energy. Some of those difficulties are inevitable, to be sure. Our methods of producing goods and services are orders of magnitude more complex than those of previous civilizations, for example, and our economy relies on treating borrowing as wealth to an extent no other society has been harebrained enough to try before; these and other differences make the task of tracing the economic dimensions of the long road of decline and fall ahead of us unavoidably more difficult than they otherwise would be.

Still, there are other sources of difficulty that are entirely voluntary, and I want to talk about some of those self-inflicted blind spots just now. An economy is a system for exchanging goods and services, with all the irreducible variability that this involves. How many potatoes are equal in value to one haircut, for example, depends a good deal on the fact that no two potatoes and no two haircuts are exactly the same, and no two people can be counted on to place quite the same value on either one. Economics, however, is mostly about numbers that measure, in abstract terms, the exchange of potatoes and haircuts (and everything else, of course).

Economists rely implicitly on the claim that those numbers have some meaningful relationship with what’s actually going on when potato farmers get their hair cut and hairdressers order potato salad for lunch. As with any abstraction, a lot gets lost in the process, and sometimes what gets left out proves to be important enough to render the abstraction hopelessly misleading. That risk is hardwired into any process of mathematical modeling, of course, but there are at least two factors that can make it much worse.

The first, of course, is that the numbers can be deliberately juggled to support some agenda that has nothing to do with accurate portrayal of the underlying reality. The second, subtler and even more misleading, is that the presuppositions underlying the model can shape the choice of what’s measured in ways that suppress what’s actually going on in the underlying reality. Combine these two and what you get might best be described as speculative fiction mislabeled as useful data – and the combination of these two is exactly what has happened to the statistics on which too many contemporary economic and political decisions are based.

I suspect most people are aware by now that there’s something seriously askew with the economic statistics cited by government officials and media pundits. Recent rhetoric about “green shoots of recovery” is a case in point. In recent months, I’ve checked in with friends across the US, and nobody seems to be seeing even the slightest suggestion of an upturn in their own businesses or regions. Quite the contrary; all the anecdotal evidence suggests that the Great Recession is tightening its grip on the country as autumn closes in.

There’s a reason for the gap between these reports and the statistics. For decades now, the US government has systematically tinkered with economic figures to make unemployment look lower, inflation milder, and the country more prosperous. The tinkerings in question are perhaps the most enthusiastically bipartisan program in recent memory, encouraged by administrations and congresspeople from both sides of the aisle, and for good reason; life is easier for politicians of every stripe if they can claim to have made the economy work better. As Bernard Gross predicted back in the 1970s, economic indicators have been turned into “economic vindicators” that subordinate information content to public relations gimmickry. These manipulations haven’t been particularly secret, either;visit and you can get the details, along with a nice set of statistics calculated the way the same numbers were done before massaging the figures turned into cosmetic surgery on a scale that would have made the late Michael Jackson gulp in disbelief.

These dubious habits have been duly pilloried in the blogosphere. Still, I'm not at all sure they are as misleading as the second set of distortions I want to discuss. When unemployment figures hold steady or sink modestly, but you and everyone you know are out of a job, it's at least obvious that something has gone haywire. Far more subtle, because less noticeable, are the biases that creep in because people are watching the wrong set of numbers entirely.

Consider the fuss made in economic circles about productivity. When productivity goes up, politicians and executives preen themselves; when it goes down, or even when it doesn't increase as fast as current theory says it ought, the cry goes up for more government largesse to get it rising again. Everyone wants the economy to be more productive, right? The devil, though, has his usual residence among the details, because the statistic used to measure productivity doesn't actually measure how productive the economy is.

Check out A Concise Guide to Macroeconomics by Harvard Business School professor David A. Moss: "The word [productivity] is commonly used as a shorthand for labor productivity, defined as output per worker hour (or, in some cases, as output per worker)." Output, here as always, is measured in dollars – usually, though not always, corrected for inflation – so what "productivity" means in practice is dollars of income per worker hour. Are there ways for a business to cut down on the employee hours per dollar of income without actually becoming more productive in any more meaningful sense? Of course, and most of them have been aggressively pursued in the hope of parading the magic number of a productivity increase before stockholders and the public.

Perhaps the simplest way to increase productivity along these lines is to change over from products that require high inputs of labor per dollar of value to those that require less. As a very rough generalization, manufacturing goods requires more labor input overall than providing services, and the biggest payoff per worker hour of all is in financial services – how much labor does it take, for example, to produce a credit swap with a theoretical value of ten million dollars? An economy that produces more credit swaps and fewer potatoes is in almost any real sense less productive, since the only value credit swaps have is that they can, under certain arbitrary conditions, be converted into funds that can buy concrete goods and services, such as potatoes; by the standards of productivity universal in the industrial world these days, however, replacing potato farmers with whatever you call the people who manufacture credit swaps (other than "bunco artists," that is) counts as an increase in productivity. I suspect this is one reason why the US auto industry got so heavily into finance in the run-up to the recent crash; GMAC's soaring productivity, measured in terms of criminally negligent loans per broker hour, probably did a lot to mask the anemic productivity gains available from the old-fashioned business of making cars.

As important as the misinformation generated by such arbitrary statistical constructs is the void that results because other, arguably more important figures are not being collected at all. In an age that will increasingly be constrained by energy limits, for example, a more useful measure of productivity might be energy productivity – that is, output per barrel of oil equivalent (BOE) of energy consumed. An economy that produces more value with less energy input is arguably an economy better suited to the downslope of Hubbert's peak, and the relative position of different nations, to say nothing of the trendline of their energy productivity over time, would provide useful information to governments, investors, and the general public alike. For all I know, somebody already calculates this figure, but I'm still waiting to see a politician or an executive crowing over the fact that the country now produces 2% more output per unit of energy.

Now it's true that a simplistic measurement of energy productivity would still make the production of credit swaps look like a better deal. This is one of the many places where the distinction already made in these essays between primary, secondary, and tertiary economies becomes crucial. To recap, the primary economy is nature itself, or specifically the natural processes that provide the human economy with about 3/4 of its total value; the secondary economy is the application of human labor to the production of goods and services; and the tertiary economy is the exchange of abstract units of value, such as money and credit, which serve to regulate the distribution of the goods and services produced by the secondary economy.

The economic statistics used today ignore the primary economy completely, measure the secondary economy purely in terms of the tertiary – calculating production in dollars, say, rather than potatoes and haircuts – and focus obsessively on the tertiary. This fixation means that if an economic policy boosts the tertiary economy, it looks like a good thing, even if that policy does actual harm to the secondary or the primary economies, as it very often does these days. Thus the choice of statistics to track isn't a neutral factor, or a simple one; if it echoes inaccurate presuppositions – for example, the fantasy that the human economy is independent of nature – it can feed those presuppositions right back in as a distorting factor into every economic decision we make.

How might this be corrected? One useful option, it seems to me, is to divide up several of the most important economic statistics into primary, secondary, and tertiary factors. (Of course the first step is to get honest numbers in the first place; governments aren't going to do this any time soon, for obvious reasons, but there's no reason why people and organizations outside of government can't make a start.) Consider, as a good example, what might be done with the gross domestic product.

To start with, it's probably a good idea to consider going back to the gross national product; this was quietly dropped in favor of the current measure some years back, because it puts a politically uncomfortable spotlight on America's economic dependence on the rest of the world. Whichever way that decision goes, the statisticians of some imaginary Bureau of Honest Figures might sort things out something like this:

The gross primary product or GPP might be the value of all unprocessed natural products at the moment they enter the economy – oil as it reaches the wellhead, coal as it leaves the mine, grain as it tumbles into the silo, and so on – minus all the costs incurred in drilling, mining, growing, and so on. (Those belong to the secondary economy.)

The gross secondary product or GSP might be the value of all goods and services in the economy, except for raw materials from nature and financial goods and services.

The gross tertiary product or GTP might be the value of all financial goods and services, and all money or money equivalents, produced by the economy.

The value of having these three separate numbers, instead of one gross domestic (or national) product, is that they can be compared to one another, and their shifts relative to one another can be tracked. If the GTP balloons and the other two products stay flat or decline, for example, that doesn't mean the country is getting wealthier; it means that the tertiary economy is inflating, and needs to have some air let out of it before it pops. If the GSP increases while the GPP stays flat, and the cost of extracting natural resources isn't soaring out of sight, then the economy is becoming more efficient at using natural resources, in which case the politicians and executives have good reason to preen themselves in public. Other relative shifts have other messages.

The point that has to be grasped, in this as in so many other contexts, is that the three economies, and the three kinds of wealth they produce, are not interchangeable. Trillions of dollars in credit swaps and derivatives will not keep people from starving in the streets if there's no food being grown and no housing being built, or maintained, or offered for sale or rent. The primary economy is fundamental to survival; the secondary economy is the source of real wealth; the tertiary economy is simply a way of measuring wealth and managing its distribution; and treating these three very different things as though they are one and the same makes rank economic folly almost impossible to avoid.

Now it deserves to be said that the chance that any such statistical scheme will be adopted in the United States under current political and social arrangements is effectively nonexistent. Far too many sacred cows would have to be put out to pasture or rounded up for slaughter first. Still, current political and social arrangements may turn out to be a good deal less permanent than they sometimes seem. What might replace them, here and elsewhere, is a topic I plan on exploring in a future essay here.

Wednesday, November 18, 2009

How Relocalization Worked

One of the points that I’ve tried to make repeatedly in these essays is the place of history as a guide to what works. It’s a point that deserves repetition. A good many worldsaving plans now in circulation, however new the rhetoric that surrounds them, simply rehash proposals that were tried in the past and failed repeatedly; trying them yet again may thus not be the best use of our limited resources and time.

Of course there’s another side to history that’s more hopeful: something that worked well in the past can be a useful guide to what might work well in the future. I’d like to spend a little time discussing one example of this, partly because it ties into the theme of the current series of posts – the abject failure of current economic notions, and the options for replacing them with ideas that actually make sense – and partly because it addresses one of the more popular topics in the ongoing peak oil discussion, the need for economic relocalization as the age of cheap abundant energy comes to an end.

That relocalization needs to happen, and will happen, is clear. Among other things, it’s clear from history; when complex societies overshoot their resource bases and decline, one of the things that consistently happens is that centralized economic arrangements fall apart, long distance trade declines sharply, and the vast majority of what we now call consumer goods get made at home, or very close to home. Now of course that violates some of the conventional wisdom that governs economic decisions these days; centralized economic arrangements are thought to yield economies of scale that make them more profitable by definition than decentralized local arrangements.

When history conflicts with theory, though, it’s not history that’s wrong, so a second look at the conventional wisdom is in order. The economies of scale and resulting profits of centralized economic arrangements don’t happen by themselves. They depend, among other things, on transportation infrastructure. This doesn’t happen by itself, either; it happens because governments pay for it, for purposes of their own. The Roman roads that made the tightly integrated Roman economy possible, for example, and the interstate highway system that does the same thing for America, were not produced by entrepreneurs; they were created by central governments for military purposes. (The legislation that launched the interstate system in the US, for example, was pushed by the Department of Defense, which wrestled with transportation bottlenecks all through the Second World War.)

Government programs of this kind subsidize economic centralization. The same thing is true of other requirements for centralization – for example, the maintenance of public order, so that shipments of consumer goods can get from one side of the country to the other without being looted. Governments don’t establish police forces and defend their borders for the purpose of allowing businesses to ship goods safely over long distances, but businesses profit mightily from these indirect subsidies nonetheless.

When civilizations come unglued, in turn, all these indirect subsidies for economic centralization go away. Roads are no longer maintained, harbors silt up, bandits infest the countryside, migrant nations invade and carve out chunks of territory for their own, and so on. Centralization stops being profitable, because the indirect subsidies that make it profitable aren’t there any more.

Ugo Bardi has written a very readable summary of how this process unfolded in one of the best documented cases, the fall of the Roman Empire. The end of Rome was a process of radical relocalization, and the result was the Middle Ages. The Roman Empire handled defense by putting huge linear fortifications along its frontiers; the Middle Ages replaced this with fortifications around every city and baronial hall. The Roman Empire was a political unity where decisions affecting every person within its borders were made by bureaucrats in Rome. Medieval Europe was the antithesis of this, a patchwork of independent feudal kingdoms the size of a Roman province, which were internally divided into self-governing fiefs, those into still smaller fiefs, and so on, to the point that a single village with a fortified manor house could be an autonomous political unit with its own laws and the recognized right to wage war on its neighbors.

The same process of radical decentralization affected the economy as well. The Roman economy was just as centralized as the Roman polity; in major industries such as pottery, mass production at huge regional factories was the order of the day, and the products were shipped out via sea and land for anything up to a thousand miles to the end user. That came to a screeching halt when the roads weren’t repaired any more, the Mediterranean became pirate heaven, and too many of the end users were getting dispossessed, and often dismembered as well, by invading Visigoths. The economic system that evolved to fill the void left by Rome’s implosion was thus every bit as relocalized as a feudal barony, and for exactly the same reasons.

Here’s how it worked. Each city – and “city” in this context means anything down to a town of a few thousand people – was an independent economic center; it might have a few industries of more than local fame, but most of its business consisted of manufacturing and selling things to its own citizens and the surrounding countryside. The manufacturing and selling was managed by guilds, which were cooperatives of master craftsmen. To get into a guild-run profession, you had to serve an apprenticeship, usually seven years, during which you got room and board in exchange for learning the craft and working for your master; you then became a journeyman, and worked for a master for wages, until you could produce your masterpiece – yes, that’s where the word came from – which was an example of craftwork fine enough to convince the other masters to accept you as an equal. Then you became a master, with voting rights in the guild.

The guild had the legal responsibility under feudal municipal laws to establish minimum standards for the quality of goods, to regulate working hours and conditions, and to control prices. The economic theory of the time held that there was a “just price” for any good or service, usually the price that had been customary in the region since time out of mind, and the municipal authorities could be counted on to crack down on attempts to push prices above the just price unless there was some very pressing reason for it. Most forms of competition between masters were off limits; if you made your apprentices and journeymen work evenings and weekends to outproduce your competitors, for example, or sold goods below the just price, you’d get in trouble with the guild, and could be barred from doing business in the town. The only form of competition that was encouraged was to make and sell a superior product.

This was the secret weapon of the guild economy, and it helped drive an age of technical innovation. As Jean Gimpel showed conclusively in The Medieval Machine, the stereotype of the Middle Ages as a period of technological stagnation is completely off the mark. Medieval craftsmen invented the clock, the cannon, and the movable-type printing press, perfected the magnetic compass and the water wheel, and made massive improvements in everything from shipbuilding and steelmaking to architecture and windmills, just for starters. The competition between masters and guilds for market share in a legal setting that made quality and innovation the only fields of combat wasn’t the only force behind these transformations, to be sure – the medieval monastic system, which put a good fraction of intellectuals of both genders in settings where they could use their leisure for just about any purpose that could be chalked up to the greater glory of God, was also a potent factor – but it certainly played a massive role.

The guild system has nonetheless been a whipping boy for mainstream economists for a long time now. The person who started that fashion was none other than Adam Smith, whose The Wealth of Nations castigates the guilds of his time for what we’d now call antitrust violations. From within his own perspective, Smith had a point. The guilds were structured in a way that limited the total number of people who could work in any given business in any given town, and of course the just price principle kept prices from fluctuating along with supply and demand. Thus the prices paid for the goods or services produced by that business were higher, all things considered, than they would have been under the free market regime Smith advocated.

The problem with Smith’s analysis is that there are crucial issues involved that he didn’t address. He lived at a time when transportation was rapidly expanding, public order was more or less guaranteed, and the conditions for economic centralization were coming back into play. Thus the very different realities of limited, localized markets did not enter into his calculations. In the context of localized economics, a laissez-faire free market approach doesn’t produce improved access to better and cheaper goods and services, as Smith argued it should; instead, it makes it impossible to produce many kinds of goods and services at all.

Let’s take a specific example for the sake of clarity. A master blacksmith in a medieval town of 5000 people, say, was in no position to specialize in only one kind of ironwork. He might be better at fancy ironmongery than anyone else in town, for example, but most of the business that kept his shop open, his apprentices fed and clothed, and his journeymen paid was humbler stuff: nails, hinges, buckles, and the like. Most of this could be done by people with much less skill than our blacksmith; that’s why he had his apprentices make nails while he sat upstairs at the table with the local abbot and discussed the ironwork for a dizzyingly complex new cutting-edge technology, just introduced from overseas, called a clock.

The fact that most of his business could be done by relatively unskilled labor, though, left our blacksmith vulnerable to competition. His shop, with its specialized tools and its staff of apprentices and journeymen, was expensive to maintain. If somebody else who could only make nails, hinges, and buckles could open a smithy next door, and offer goods at a lower price, our blacksmith could be driven out of business, since the specialized work that only he could do wouldn’t be enough to pay his bills. The cut-rate blacksmith then becomes the only game in town – at least, until someone who limited his work to even cheaper products made at even lower costs cut into his profits. The resulting race to the bottom, in a small enough market, might end with nobody able to make a living as a blacksmith at all.

Thus in a restricted market where specialization is limited, a free market in which prices are set by supply and demand, and there are no barriers to entry, can make it impossible for many useful specialties to be economically viable at all. This is the problem that the guild system evolved to counter. By restricting the number of people who could enter any given trade, the guilds made sure that the income earned by master craftsmen was high enough to allow them to produce specialty products that were not needed in large enough quantities to provide a full time income. Since most of the money earned by a master craftsman was spent in the town and surrounding region – our blacksmith and his family would have needed bread from the baker, groceries from the grocer, meat from the butcher, and so on – the higher prices evened out; since nearly everyone in town was charging guild prices and earning guild incomes, no one was unfairly penalized.

Now of course the guild system did finally break down; by Adam Smith’s time, the economic conditions that made it the best option were a matter of distant memory, and other arrangements were arguably better suited to the new reality of easy transport and renewed economies of scale. Still, it’s interesting that in recent years, the same race to the bottom in which quality goods become unavailable and local communities suffer has taken place in nearly the same way in most of small-town America.

A torrent of cheap shoddy goods funneled through Wal-Mart and its ilk, in a close parallel to the cheap blacksmiths of the example, have driven local businesses out of existence and made the superior products and services once provided by those businesses effectively unavailable to a great many Americans. In theory, this produces a business environment that is more efficient and innovative; in practice, the efficiencies are by no means clear and the innovation seems mostly to involve the creation of ever more exotic and unstable financial instruments: not necessarily the sort of thing that our society is better off encouraging.

Advocates of relocalization in the age of peak oil may thus find it useful to keep the medieval example and its modern equivalent in mind while planning for the economics of the future. Relocalized communities must be economically viable or they will soon cease to exist, and while viable local communities will be possible in the future – just as they were in the Middle Ages – the steps that will be necessary to make them viable may require some serious rethinking of the habits that now shape our economic lives.

Wednesday, November 11, 2009

A Gesture from the Invisible Hand

It’s been a long road, but we’ve finally reached the point in these essays at which it’s possible to start talking about some of the consequences of the primary economic fact of our time, the arrival of geological limits to increasing fossil fuel production. That’s as challenging a topic to discuss as it will be to live through, because it cannot be understood effectively from within the presuppositions that structure most of today’s economic thinking.

It’s common, for example, to hear well-intentioned people insist that the market, as a matter of course, will respond to restricted fossil fuel production by channeling investment funds either in more effective means of producing fossil fuels, on the one hand, or new energy sources on the other. The logic seems impeccable at first glance: as the price of oil, for example, goes up, the profit to be made by bringing more oil or oil substitutes onto the market goes up as well; investors eager to maximize their profits will therefore pour money into ventures producing oil and oil substitutes, and production will rise accordingly until the price comes back down.

That’s the logic of the invisible hand, first made famous by Adam Smith in The Wealth of Nations more than two centuries ago, and still central to most mainstream ideas of market economics. That logic owes much of its influence to the fact that in many cases, markets do in fact behave this way. Like any rule governing complex systems, though, it is far from foolproof, and it needs to be balanced by an awareness of the places where it fails to work.

Energy is one of those places: in some ways, the most important of all. Energy is not simply one commodity among others; it is the ur-commodity, the foundation for all economic activity. It follows laws of its own – the laws of thermodynamics, notably – which are not the same as the laws of economics, and when the two sets of laws come into conflict, the laws of thermodynamics win every time.

Consider an agrarian civilization that runs on sunlight, as every human society did until the rise of industrialism some three centuries ago. In energetic terms, part of the annual influx of solar energy is collected via agriculture, stored in the form of grain, and transformed into mechanical energy by feeding the grain to human laborers and draft animals. It's an efficient and resilient system, and under suitable conditions it can deploy astonishing amounts of energy; the Great Pyramid is one of the more obvious pieces of evidence for this fact.

Such civilizations normally develop thriving market economies in which a wide range of goods and services are exchanged. They also normally develop intricate social abstractions that manage the distribution of these goods and services, as well as the primary wealth that comes through agriculture from the sun, among their citizens. Both these, however, depend on the continued energy flow from sun to fields to granaries to human and animal labor forces. If something interrupts this flow -- say, a failure of the harvest -- the only option that allows for collective survival is to have enough solar energy stored in the granaries to take up the slack.

This is necessary because energy doesn't follow the ordinary rules of economic exchange. Most other commodities still exist after they've been exchanged for something else, and this makes exchanges reversible; for example, if you sell gold to buy marble, you can normally turn around and sell marble to buy gold. The invisible hand works here; if marble is in short supply, those who have gold and want marble may have to offer more gold for their choice of building materials, but the marble quarries will be working overtime to balance things out.

Energy is different. Once you turn the energy content of a few million bushels of grain into a pyramid, say, by using the grain to feed workers who cut and haul the stones, that energy is gone, and you cannot turn the pyramid back into grain; all you can do is wait until the next harvest. If that harvest fails, and the stored energy in the granaries has already been turned into pyramids, neither the market economy of goods and services or the abstract system of distributing goods and services can make up for it. Nor, of course, can you send an extra ten thousand workers into the fields if you don't have the grain to keep them alive.

The peoples of agrarian civilizations generally understood this. It's part of the tragedy of the modern world that most people nowadays do not, even though our situation is not all that different from theirs. We're just as dependent on energy inputs from nature, though ours include vast quantities of prehistoric sunlight, in the form of fossil fuels, as well as current solar energy in various forms; we've built atop that foundation our own kind of markets to exchange goods and services; and our abstract system for managing the distribution of goods and services -- money -- is as heavily wrapped in mythology as anything in the archaic civilizations of the past.

The particular form taken by money in the modern world has certain effects, however, not found in ancient systems. In the old agrarian civilizations, wealth consisted primarily of farmland and its products. The amount of farmland in a kingdom might increase slightly through warfare or investment in canal systems, though it might equally decrease if a war went badly or canals got wrecked by sandstorms; everybody hoped when the seed grain went into the fields that the result would be a bumper crop, but no one imagined that the grain stockpiled in the granaries would somehow multiply itself over time. Nowadays, by contrast, it's assumed as a matter of course that money ought automatically to produce more money.

That habit of thought has its roots in the three centuries of explosive economic growth that followed the birth of the industrial age. In an expanding economy, the amount of money in circulation needs to expand fast enough to roughly match the expansion in the range of goods and services for sale; when this fails to occur, the shortfall drives up interest rates (the cost of using money) and can cause economic contractions. This was a serious and recurring problem in the late 19th century, and led the reformers of the Progressive era to reshape industrial economies in ways that permitted the money supply to expand over time to match the expectation of growth. Once again, the invisible hand was at work, with some help from legislators: a demand for more money eventually give rise to a system that produced more money.

It's been pointed out by a number of commentators in the peak oil blogosphere that the most popular method for expanding the money supply -- the transformation of borrowing at interest from an occasional bad habit of the imprudent to the foundation of modern economic life -- has outlived its usefulness once an expanding economy driven by increasing fossil fuel production gives way to a contracting economy limited by decreasing fossil fuel production. This is quite true in an abstract sense, but there's a trap in the way of putting that sensible realization into practice.

The arrival of geological limits to increasing fossil fuel production places a burden on the economy, because the cost in energy, labor, and materials (rather than money) to extract fossil fuels does not depend on market forces. On average, it goes up over time, as easily accessible reserves are depleted and have to be replaced by those more difficult and costly to extract. Improved efficiencies and new technologies can counter that to a limited extent, but both these face the familiar problem of diminishing returns as the laws of thermodynamics, and other physical laws, come into play.

As a society nears the geological limits to production, in other words, a steadily growing fraction of its total supply of energy, resources, and labor have to be devoted to the task of bringing in the energy that keeps the entire economy moving. This percentage may be small at first, but it's effectively a tax in kind on every productive economic activity, and as it grows it makes productive economic activity less profitable. The process by which money produces more money consumes next to no energy, by contrast, and so financial investments don't lose ground due to rising energy costs.

This makes financial investments, on average, relatively more profitable than investing in the kinds of economic activity that use energy to produce nonfinancial goods and services. The higher the burden imposed by energy costs, the more sweeping the disparity becomes; the result, of course, is that individuals trying to maximize their own economic gains move their money out of investments in the productive economy of goods and services, and into the paper economy of finance.

Ironically, this happens just as a perpetually expanding money supply driven by mass borrowing at interest has become an anachronism unsuited to the new economic reality of energy contraction. It also guarantees that any attempt to limit the financial sphere of the economy will face mass opposition, not only from financiers, but from millions of ordinary citizens whose dream of a comfortable retirement depends on the hope that financial investments will outperform the faltering economy of goods and services. Meanwhile, just as the economy most needs massive reinvestment in productive capacity to retool itself for the very different world defined by contracting energy supplies, investment money seeking higher returns flees the productive economy for the realm of abstract paper wealth.

Nor will this effect be countered, as suggested by the well-intentioned people mentioned toward the beginning of this essay, by a flood of investment money going into energy production and bringing the cost of energy back down. Producing energy takes energy, and thus is just as subject to rising energy costs as any other productive activity; even as the price of oil goes up, the costs of extracting it or making some substitute for it rise in tandem and make investments in oil production or replacement no more lucrative than any other part of the productive economy. Oil that has already been extracted from the ground may be a good investment, and financial paper speculating on the future price of oil will likely be an excellent one, but neither of these help increase the supply of oil, or any oil substitute, flowing into the economy.

One intriguing detail of this scenario is that it has already affected the first major oil producer to reach peak oil -- yes, that would be the United States. It's unlikely to be accidental that in the wake of its own 1972 production peak, the American economy has followed exactly this trajectory of massive disinvestment in the productive economy and massive expansion of the paper economy of finance. Plenty of other factors played a role in that process, no doubt, but I suspect that the unsteady but inexorable rise in energy costs over the last forty years or so may have had much more to do with the gutting of the American economy than most people suspect.

If this is correct, now that petroleum production has encountered the same limits globally that put it into a decline here in the United States, the same pattern of disinvestment in the production of goods and services coupled with metastatic expansion of the financial sector may show up on a much broader scale. There are limits to how far it can go, of course, not least because financiers and retirees alike are fond of consumer goods now and then, but those limits have not been reached yet, not by a long shot. It's all too easy to foresee a future in which industry, agriculture, and every other sector of the economy that produces goods and services suffer from chronic underinvestment, energy costs continue rising, and collapsing infrastructure becomes a dominant factor in daily life, while the Wall Street Journal (printed in Shanghai by then) announces the emergence of the first half dozen quadrillionaires in the derivatives-of-derivatives-of-derivatives market.

Perhaps the most important limit in the way of such a rush toward economic absurdity is the simple fact that not every economy uses the individual decisions of investors pursuing private gain to allocate investment capital. It may not be accidental that quite a few of the world's most successful economies just now, with China well in the lead, make their investment decisions based at least in part on political, military, and strategic grounds, while the nation that preens itself most proudly on its market economy -- yes, that would be the United States again -- is lurching from one economic debacle to another.

It is unfortunately also the case that many of the nations that have extracted their investment decisions from the hands of a self-terminating market system are not exactly noted for their delicate care for human rights. If that proves to be the wave of the future -- and it may be worth noting that Oswald Spengler, among others, predicted that outcome -- then the invisible hand may end up giving us all the finger.

Wednesday, November 04, 2009

Harnessing Hippogriffs

One of the more interesting aspects of writing these essays is that I can never predict in advance what will get me a flurry of outraged responses each week. It’s a fair bet that something always does; the collective conversation of the modern industrial world has become so overheated in the last decade or so that it’s difficult to say much of anything without getting somebody in a swivet; still, what it is that sets off the swiveteers routinely catches me by surprise.

Last week was no exception. Of all the things in that essay that might plausibly have launched the usual cries of outrage, the one that did so was an offhand reference to the free market fundamentalists of the Austrian school, many of whom insist that the proper solution to every economic problem is to let the market have its way. As it happens, in making that comment I was thinking specifically of Michael Shedlock aka Mish, whose blog is one of the handful I read daily.

Mish is among the most thoughtful and articulate proponents of the Austrian school in today's blogosphere, and he has an excellent eye for the economic news that matters – which is by and large exactly the economic news that the rest of the media avoids covering. Very nearly the only thing on his blog that makes me roll my eyes is his repeated insistence that the market is always right and government regulation is always wrong; no matter how berserk the market gets, its vagaries are for the best, and any problems should be corrected by privatizing even more government functions. Now of course Mish is hardly an official spokesperson for the Austrian school, as if there were such a thing, but he's not exactly alone in his insistence, either.

Enough people in the peak oil scene share similar views that it's probably necessary to say something about the free market and its potential for solving or creating problems during the twilight years of industrialism ahead of us. Any such comments need to be prefaced, though, by a reminder that a spectrum consists of something other than its two endpoints. Just as a great many people on the left have picked up the dubious habit of using labels such as "fascism" for any political system to the right of Hillary Clinton, a great many people on the right seem to have convinced themselves that any form of economic regulation at all is tantamount to some sort of neo-Marxist hobgoblin – a "socialist-communist-ecologist" system, to use a phrase that actually appeared in one of the comments fielded by last week's post.

Now it bears remembering that drowning is not the only alternative to dying of dehydration; there's a middle ground that is noticeably more pleasant than either. The same principle also applies in economics. The experiment of having government own all the means of production in an industrial society, along the lines proposed by Marx, received a thorough test at the hands of the Communist bloc and failed abjectly. At the same time, the experiment of having government keep its hands off the economy altogether in an industrial society, along the lines proposed by a great many free-market proponents these days, received an equally thorough test, and failed just as dismally. The test took place a little earlier; in America, it ran from the end of the Civil War into the first decade of the twentieth century, and the result was a catastrophic sequence of booms and busts, the transfer of most of the nation's wealth to a tiny minority of wealthy people, the bitter impoverishment of nearly everyone else, and a level of social unrest that included two presidential assassinations and so many bomb attacks on the rich and their families that bomb-throwing anarchists became a regular theme of music-hall songs.

Now it's always possible for theorists to contrast a Utopian portrait of a free-market economy against the gritty and unwelcome realities of extreme socialism, just as it's possible for people on the other side of the spectrum to contrast a Utopian portrait of a socialist economy against the equally gritty and unwelcome realities of unfettered capitalism. Both make great rhetorical strategies, since the human mind is easily misled by binary logic: if A is evil, it seems wholly reasonable to claim that the opposite of A must be good. The real world does not work that way, but this is hardly the only case in which rhetoric ignores reality.

The problem with the rhetoric, however, may be stated a bit more precisely: however pleasant they look on paper, free markets do not exist. Strictly speaking, they are as mythical as hippogriffs.

It occurs to me that some of my readers may not be as familiar with hippogriffs as they ought to be. (Tut, tut – what do they teach children these days?) For those who lack so basic an element in their education, a hippogriff is the offspring of a gryphon and a mare; it has the head, body, hind legs, and tail of a horse, and the forelimbs and wings of a giant eagle. Hippogriffs are said to be the strongest and swiftest of all flying creatures, which is why Astolpho rode one to the terrestrial paradise to recover Orlando's lost wits in Orlando Furioso, and why Juss rode one to the summit of Koshtra Pivrarcha to rescue Goldry Bluszco in The Worm Ouroboros. They are splendid creatures, no question; their only disadvantage, really, is the minor point that they don't happen to exist, and drawing up plans to use them as a new, energy-efficient means of air transport in the face of peak oil, for instance, will inevitably come to grief on that annoying little detail.

Free markets are subject to essentially the same little problem. There have been many examples of market economies in history that were not controlled by governments, but there have been no examples of market economies that were not controlled, and if one were to be set up, it would remain a free market for maybe a week at most. Adam Smith explained why in memorable language in The Wealth of Nations: "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or some contrivance to raise prices." When a market is not controlled by government edicts, religious taboos, social customs, or some other outside force, it will quickly be controlled by combinations of individuals whose wealth and strategic position in the market enable them to maximize the economic benefits accruing to them, by squeezing out rivals, manipulating prices, buying up their suppliers, bribing government officials, and the like: that is to say, behaving the way capitalists behave whenever they are left to their own devices. This is what created the profoundly dysfunctional economy of Gilded Age America, and it also played a very large role in setting up the current debacle.

There's a rich irony here, in that the market economy portrayed in textbooks – in which buyers and sellers are numerous and independent enough that free competition regulates their interactions – is exactly the sort of commons that so many free market proponents insist should be eliminated wholesale in favor of private ownership. All commons systems, as Garrett Hardin pointed out in a famous essay a while back, are hideously vulnerable to abuse unless they are managed in ways that prevent individuals from exploiting the commons for their own private benefit. This year's Nobel laureate in economics, Elinor Ostrom, won her award for demonstrating that it's entirely possible to manage a commons so that Hardin's "tragedy of the commons" does not happen, and she's quite right – there have been many examples of successfully managed commons in history. Strip away the management that keeps it from being abused, however, and the free market, like any other commons, rapidly destroys itself.

This does not mean that the best, or for that matter the only, alternative to the unchecked rule of corporate robber barons is Marxist-style state ownership of the economy; once again, dying from heatstroke is not the only alternative to dying from hypothermia. It means, rather, that something between these two extremes might be worth trying, especially if it can be shown by historical evidence to work tolerably well in practice. Of course this is what history shows; broadly speaking, economies that leave the means of production in private hands, but use appropriate regulation to harness their energies to the public good, consistently produce more prosperity for more people than either unfettered capitalism or extreme socialism.

This being said, the midpoint between these extremes may not lie where today's conventional wisdom tends to place it. Consider an example from the not too distant past: a large industrial nation with a capitalist economy, but remarkably tough regulations restricting the growth of private fortunes and the abuses to which capitalist economies are so often prone. The wealthiest people in that nation paid more than two-thirds of their annual income in tax, and monopolistic practices on the part of corporations faced harsh and frequently applied judicial penalties. The financial sector was particularly tightly leashed: interest rates on savings were fixed by the government, usury laws put very low caps on the upper end of interest rates for loans, and hard legal barriers prevented banks from expanding out of local markets or crossing the firewall between consumer banking and the riskier world of corporate investment. Consumer credit was difficult enough to get, as a result, that most people did without it most of the time, using layaway plans and Christmas Club savings programs to afford large purchases.

According to the standard rhetoric of free market proponents these days, so rigidly controlled an economy ought by definition to be hopelessly stagnant and unproductive. This shows the separation of rhetoric from reality, however, for the nation I have just described was the United States during the presidency of Dwight D. Eisenhower: that is, during one of the most sustained periods of prosperity, innovation, economic development and international influence this nation has ever seen. Now of course there were other factors behind America's 1950s success, just as there were other factors behind the decline since then; still, it's worth noting that as the economic regulations of the 1950s have been dismantled – in every case, under the pretext of boosting American prosperity – the prosperity of most Americans has gone down, not up.

It makes a good measure of how far we have come as a nation – and not in a useful direction – that the economic policies of one of the most successful 20th century Republican administrations would be rejected by most of today's Democrats as too far to the left. A case could be made, in fact, that far and away the most sensible thing the US Congress could do today, in the face of an economy that has very nearly choked to death on its own bubbles, is to reenact the economic legislation in place in the 1950s, line for line. (When you're hiking in the woods, and discover that you've taken a trail that leads someplace you don't want to go, your best bet is normally to turn around and go back to the last place where you were still going in the right direction.)

Yet there's an interesting point that also ought to be made about the economic regulation of the 1950s. Outside of antitrust legislation, not that much of it applied to the economy of goods and services on any level, whether that of Mom and Pop grocery stores or big industrial conglomerates. The bulk of it, and very nearly all the strictest elements of it, focused on the financial industry. More broadly speaking, instead of regulating the production and consumption of goods and services, the economic policies of the Eisenhower era focused on regulating money: on ensuring that too much of it did not end up concentrated unproductively in too few hands, and on controlling its propensity to multiply as enthusiastically as rabbits on Viagra. The relative success of these measures points toward a distinction already made in these posts, and to practical steps that will be explored in next week's post.