It's Really Past Time for This
A Failed Theory
If you took economics in college then there is a very good likelihood that you learned using Paul Samuelson's Economics textbook, now in its 19th edition (along with new co-author William Nordhaus). And you learned the neoclassical theory of economics. I did and for most of my life I accepted that what Samuelson said was THE economics. Even as I took the course, however, I felt that something was missing, but I was too ignorant to put my finger on it. The one thing I did come away with was that it seemed economics as a field had missed some pretty basic physics in ignoring the role of energy in doing work, which is, after all, what economic production is all about. I hit on the idea of an “energy value” approach to costs and prices of goods and services, but I couldn't quite get it to reconcile with profits and rents. I played with it on and off again over the years, generally getting discouragement from my associates and friends who were more schooled in economics than was I. Eventually I started applying what I had been learning about systems science to the problem and at about the same time, Charlie Hall and his students at SUNY-ESF were organizing ideas that came to be biophysical economics. And as I dove into the literature that they were generating it struck me that my intuition about energy and money had been right.
But the incorporation of energy flow into economic theory could not be reconciled with the neoclassical theory with which I had been indoctrinated. Studies in ecological economics and biophysical economics made me realize the myriad problems with neoclassical theory based on systems thinking. Now numerous so-called ‘heterodox’ economic schools are starting to make inroads in their criticisms of the ‘orthodoxy’ of neoclassical economics.
Perhaps one of the most powerful criticism of neoclassical economics comes from Steve Keen, a former professor of economics at the University of Western Sydney. He is one of a handful of non-neoclassical economists who predicted the financial crises of late. His 2001, and now (2011) a revised and expanded edition, Debunking Economics: The Naked Emperor Dethroned? (Zed Books, London) is a tour-de-force that rips neoclassical economics apart at the seams. Keen takes on the orthodoxy on its own terms, that is he looks at every aspect of the basic theory that underlies all of the assumptions and results. That's right, you read correctly, a theory that precedes assumptions and results. In other words neoclassical economics was based on a “theory” that was pulled out of the ether and then neoclassical economists constructed an elaborate house of cards around it to prove that the theory was correct. That doesn't exactly sound like science does it?
Unlike sciences, such as physics, which the formerly political economists in the late 1800s wanted to be like, the neoclassical theory got started trying to emulate physics by proposing a model of the markets in which a general equilibrium state was the norm. A main motivation for this turned out to be the desire to use mathematics in the same way it was used in physics to derive various results and prove theorems. One of the main architects of this was Leon Walras a French economist who had started out to get an engineering degree, which probably explains his insistence on finding a model that was heavy in mathematics.
I have not studied enough details of neoclassical economics to count as an expert on the take down of the central model. I followed most of Keen's arguments and didn't spot any problems (except the one I will discuss below). So let me recommend his book to all who have this itching feeling that the economists who tell us what we should do, but fail to warn us when disaster (which according to their model shouldn't even happen) is impending, are basically blowing smoke.
What I have to contribute to this dismantling of the orthodox economics profession is a more systems-oriented set of arguments. These arguments align very well with biophysical economics, which is why I set off to learn what I could about the subject. By the way, Charlie Hall's and Kent Klitgaard's book, Energy and the Wealth of Nations: Understanding the Biophysical Economy (Springer), contains another set of direct attacks on neoclassical economics. Kent is an economist who has the background to know where the bodies are buried and digs them up in the book. Read that one too.
Here I will illustrate the problem with neoclassical economics with just four dumb problems that arise from adherence to neoclassical economics. There are many more, but this should serve to show how insane economics has gotten, and why it needs to be toppled as soon as possible. Unfortunately I will end by arguing why it won't be toppled and also explain why I think it really is too late to do so anyway. I am the cheerful one, aren't I.
Four Dumb Problems
The first dumb idea that neoclassical economics proposed is that we human beings, singly and in aggregate, make rational purchasing decisions. We are described as Homo economicus a species that can readily calculate marginal utility and judge a price to pay (or extract). Now ordinary people know this is ridiculous. Yet the neoclassical economists have to have this kind of behavior or their theory falls apart. What makes this assumption (one that came after the theory!) insidious is that it puts an interpretation on Adam Smith's metaphor of the ‘invisible hand’ that leads to the ‘greed is good’ meme dominating our economic thinking. We are all rational utility maximizers looking out for our own interests and as if by magic this leads to the betterment of society, or at least to markets in equilibrium where prices are set by the balance of supply and demand.
The reality of human psychology is that we are anything but rational decision makers in most purchasing decisions. There are many reasons for this, but if you are interested in grappling with the foibles of humans as agents dig into the literature of the heuristics and biases research program. Daniel Kahneman won the Economics Prize in Honor of Alfred Nobel (the Nobel-like award for economics “science”) for demonstrating the irrationality of human decisions as compared with, for example, statistical rules. Of course humans are not emulating statistical reasoning (which would be required to be rational in the mathematical/logical sense). Rather they are following the rationale of biology. Our preferences and choices are guided by our underlying biological mandate. Unless, of course, we have access to higher order judgments that moderate that mandated drive. Most people don't, as it turns out.
So here we are with the beneficiaries of economics (mostly bankers, brokers, and their political hacks) praising greed and using the arguments of neoclassical economics to tell the rest of us that they are creating wealth (and jobs - big joke) and we should be happy that they are greedy. Go figure.
Markets Can Solve All
Another absolutely stupid belief promulgated by economists (and virtually every other breathing person that gets their misinformation from the media) is that the capitalist market system is absolutely the best thing since sliced bread. It will, eventually make us all wealthy if we just let it work unfettered.
Don't get me started on capitalism. I've laid down the challenge in a prior blog post Either Profits Go or We Go. But let's consider markets in general. I've written a good deal about this in various posts and my working papers on the Science of Systems. Markets are a form of logistical management of distribution. When they are small and semi-homogenous they work pretty well. Semi-homogenous refers to markets where all buyers and sellers have similar backgrounds and experiences so that they have a sense of the value (see below) of goods and services are. The information flow in such an arrangement suffers low distortion and there are repeaters distributed in the network that allow people to correct noisy messages. But when we get large market structures and highly heterogeneous participants (e.g. large corporations and many consumers) with very dissimilar backgrounds and knowledge, then information can easily be lost through noisy and unfiltered channels. No one can determine the real value of goods and services, so it becomes a matter of judging based on what others are doing — a fact that marketers and advertisers make great advantage of.
The neoclassical market is one that will always tend toward equilibrium because supply will eventually match demand at the right price. And since all participants are utility maximizers that simply has to happen. And, most important, there can be no regulation from exogenous factors, like a government to muck things up. Here we see the influence of using Smith's metaphor of an invisible hand taking on the role of ideology and driving beliefs that have no basis in reality. But the only way such a system could work is if every agent was indeed rational and had unfettered access to all relevant information without distortion, and was essentially omniscient! Every agent would need a complete model of the whole system in order for their judgments to be based on rational decisions. No such system exists in nature, I don't know why we should believe we have created one just because we think we have.
Then there is another kind of market that really isn't a market so much as a gambling casino, and that is the world of equity instruments. Starting out as a means to provide liquidity to investors in enterprises if they got into trouble and needed their investment withdrawn, the stock market, as one example, has turned into a den of speculators. The underlying value of an asset no longer has anything to do with the price of its paper. This happens because no one really knows what to base value on. Bubbles ensue and crashes follow. Even though everyone uses neoclassical economics as their excuse for playing the markets, the truth is neoclassical models don't really deal with finance and such phenomena. This is the reason that the economists didn't predict the crashes. They couldn't because their math didn't work that way. Still the ideology underlying the economic paradigm persists to our ruin.The Value of the Thing
According to Keen, classical economists distinguished between what they called the ‘use-value’ and the ‘exchange-value’ of a good or service. The latter kind of value assigned to a commodity was based on what effort or how much of the buyer's work reward would need to be given up to buy the commodity in an exchange. A commodity's use-value was somewhat hazy and thought to be subjective.
In my last presentation at the biophysical economics conference last June I presented an evolutionary model of the exchange calculus developed in early Homo species. This calculus is based on the energy requirements of living. The use-value of a thing is actually based on either how much energy will be conserved in doing necessary work, such as a bow and arrow reduces the energy expenditure needed to hunt for food (energy). The energy return on energy invested in making the bow and arrow is very high. But there is a caveat of sorts. Suppose one member of the tribe gets really good at making bows and arrows which are of high quality in terms of the efficacy of their use. Suppose also that other hunters are less proficient in making these implements. Then a trade can be made, hunting accouterments for meat. The bow and arrow maker becomes a specialist and helps the hunter be more efficient in exchange for surplus meat that the hunter can now produce by being more efficient. Here the exchange-value and use-value are equated. Both parties have a deep understanding of what advantage there is for this trade — they have visibility into what work is accomplished by the other and can find an exchange rate (say x arrows for ten day's worth of meat) that is equitable. This same calculus prevailed well into the agricultural revolution where most people were farmers or the makers and purveyors of farming equipment.
But by the time Adam Smith and David Ricardo were making their observations of economic mechanics, society had become much more highly specialized in jobs (in fact one of Smith's best arguments involved the specialization of workers in a pin factory leading to greater productivity overall). And the work done in those various jobs was not as easily judged by others. The prevailing hierarchical (and class) structure emerged from the process whereby those who had some resources to organize a production facility hired workers whom they paid subsistence wages, extracting more work than those wages would have been worth if everyone, especially the workers, had access to information about the amount of energy involved on either side. The excess production value over costs in wages (and materials) is the basis of profits.
The exchange calculus could no longer function in that no one could say the true value (use and exchange) of a thing. Money was now in wide use and could act as an exchange medium (information used to direct the flow of energy through all of the work processes) but had no intrinsic value (the creation of money is yet a whole other story!) Thus people assessed value based on what has come to be known as “what the market will bear.” In other words, if an employer offers to pay a wage that is just at subsistence and others seem willing to take that wage, then it must be the right wage. Or if a vendor is selling a good at a named price and others are buying that good at that price then it must be the right one. Further distortions come into play if a good, for example, is in short supply and many people have decided that they really need to have it, then they can bid up the price.
Now comes along the neoclassical theory that amplifies this notion and treats value as a purely subjective aspect. At the same time these economists expect that the agents doing the buying and selling are being rational about assessing that value. They assume something called utility to skirt the problem of sorting out any real intrinsic values.
I go back to the original exchange calculus to argue that indeed commodities have a value based on the energy consumed versus energy obtained (or conserved) in living. We go to our jobs, expend energy on behalf of an employer who sells our labor for a price and out of that exchange pays our wages. Then we use that money to buy food, water, shelter, clothing, etc. with a little (maybe) left over for recreation or savings. This is still the bulk of our exchanges and still forms the basis of value.
But a new distortion emerged out of the rise of civilizations to act as governance systems over the obtaining and distribution of resources, mostly food, but metals and other extracted commodities. That is those at top of the hierarchy sought to be compensated more for their work than the actual energy value of the work would warrant. The logic is straightforward. If the work I do is more important than the work you do, then I should get paid more. There is some merit to this proposition if the governor is doing a good job and through amplification of their mental work generating energy value for the greater society. In a sense the have a claim on the surpluses their work generates for all of society so why shouldn't they get some luxuries (especially if the surplus is great)?
There are two problems that derive. The first problem is that those at the top always seem to want more. Isn't there a wisdom that suggests that they should moderate their hedonistic desires so as to not promote the idea of driving for more surplus? The second problem is that this hedonism trickles down the hierarchy leading to demands for even more surplus so that others further down can enjoy some benefits above and beyond subsistence. Today's middle class (what is left of it) is a testament to the fact that people foolishly let their desires for more stuff drive their choices in life. At first it started as just wanting more conveniences to make life easier. A washing machine in every home. But gradually it morphed into not just extended needs, but wants that were interpreted as needs. A TV in every room in the house.
What actually allowed society to pursue this amount of wealth production and distribution was something hiding in plain sight. The age of fossil fuels provided extraodinary amounts of energy to drive a growiing economic engine. Our attention was drawn to our remarkablly clever inventions that allowed us to use this energy. Indeed they were some pretty clever machines. And they did allow the emergence in the western world of a wealthy middle class. Energy was so abundant that it was taken for granted almost as much as water and air. And economists treated it thusly, not even a factor of production (land, capital, and labor). And that was a major (horrendous) oversight.
So here we are today gauging the price of everything and knowing the value of nothing.The Economy Must Grow
And that leads me to the fourth dumb idea that neoclassical economics advocates promote as a good thing — a good economy is a growing economy. It is so blatantly dumb, as in completely ignoring the laws of nature, that the fact that this idea is widely accepted by the majority of people in this world is one of the main reasons I concluded that humans are just not sapient enough to manage our cleverness. You don't even need systems science to see how incredibly dumb this is. There are no natural systems that are closed to mass inflows that can grow forever. It boggles my mind how so many presumably smart people can believe that the economy must grow in order to be healthy.
I know the arguments. 1) The economy must produce more wealth so that everyone can prosper (the rising tide metaphor). The trouble is that the top 10% of income earners are taking more than 50% of the supposed growth surplus. It is more like the tide is raising a few luxury yachts while the dinghies are anchored to the bottom and the water is rising around them and flooding them. There are more hungry people in the world today than ever before even while a few nations have been growing. Something hasn't quite worked out according to plan. 2) The economy must produce more jobs for people to earn a living. This is because the population keeps growing and is not likely to stop doing so until a major calamity hits. This is one of those areas where people really do get foolish vis-a-vis letting their biological mandate cloud their thinking. Reproductive rights are cherished by almost everyone, regardless of the consequences. Once again I rest my case regarding insufficient sapience. Stop growing the population and you can stop creating useless jobs. 3) We humans are exceptional and deserve to reap all the reward we can from nature. I doubt I need dwell on that particularly stupid thought.
Not everyone believes that growth (especially in the totally bogus value of gross domestic product - GDP) is a necessary condition for a healthy economy. Herman Daly, father of ecological economics, and his associates promote the idea of a steady state economy (also: Steady State Economy).
Even so the prevailing belief is in growth. Just listen to any MSM report on economic activity. The talking heads only understand one story line - growth is good. The one I really get a kick out of is “sustainable growth.” If ever there was a dumber oxymoron than “military intelligence” it would be this one. It is simply staggering to think that educated people could hold those two concepts in their minds so joined.
Why Understanding Energy Flow is Essential to Understanding Economics - The Brief Version
Keen's book is a worthy read. And, as I said above, I can't find fault with his arguments as far as they go. Unfortunately he missed the real elephant in the room by ignoring the true role of energy in the economy. Most economists treat energy (e.g. fossil fuels) as just another kind of commodity. There is some logic in that, for example food commodities are really energy. But energy is fundamentally different from material commodities like metals and water. Energy flows through the economy and us and is used up in the process. It is converted from a high potential flow that can drive work processes to a low potential form that is non-recoverable, that is waste heat. Materials can, in principle and with enough energy to process them, be recycled through the economy. We do a pretty good job with some of the metals like aluminum. But energy is on a one-way trip through economic activity. Which means we have to constantly extract and convert the high potential sources to keep things moving.
Two of the heterodox schools of economics that Keen failed to critique are the ecological and the biophysical economics disciplines. Both come from essentially the same background in systems ecology (Howard T. Odum's thinking). Ecological economics has gone toward the effort to pricing ecological services, trying to integrate the finite resource and pollution issues into a more traditional economics framework. Whereas biophysical economics is based on energy flow dynamics and seeks to completely redefine economics as a biophysically-based science (a real science!)
Systems science is inherent in biophysical economics, which is why that is where my attention is drawn. We have to understand the economy as a complex, adaptive and evolvable system, the dynamics of which are governed by the laws of energy flow and work. We needed to understand this many years ago, unfortunately. Had economics been peopled by scientists it is likely that as the sciences of thermodynamics and non-linear dynamics as well as psychology and neurobiology developed economics would have followed. But the tradition was peopled with those who wished to look like scientist but were driven by an ideological framework, essentially a religious belief system.
Now I fear that it is too late. In order to formulate and affect meaningful policies in the governance of the economy (and it does need governance) you need time. You need a good theoretical framework, and you need lots of data-driven models to verify the theory. And time is something we just don't have much of anymore. Given the intransigence of the ideas foisted by neoclassical economics in our society (and those ideas are appealing to the ignorant masses) I simply cannot envision any message that will open people's eyes to reality and move them to actions. It is basically the same story with anthropogenic global warming.
The fundamental problem is that we are working down our stock of fossil energy at an incredible rate. Fossil fuels account for over 80% of the energy driving our economy. We have probably reached or might have even passed the peak of extraction, meaning that over the next several decades we will have less and less fossil fuels to power society. But it is even worse than that. The energy cost of extracting those fuels is climbing exponentially. The extraction of tar sands, tight oil and gas, and deeper coal veins takes far more energy than was the case historically. That means there is less net energy for doing economic work in each time period going forward.
And, in spite of the neoclassical belief in substitution effects resulting from high prices, we really don't have substitute sources of high power energy needed to run our current developed world economies, let alone bring the developing economies up to some &ldauo;reasonable” standard of living. At best we might be able to position ourselves to live off of real-time solar inputs if we invest heavily in wind, solar, and hydro power generation now before the fossil fuels become useless. But we would have to substantially diminish our consumption of energy on the lifestyle side — much more so than most people will be willing to do voluntarily.
So while those few of us who are capable can continue to seek understanding of our situation, at least for scientific sake, I just don't see that understanding having any impact on how the world is run by the idiots in charge. They do not want to know.
Why We are Stuck with Stupidity
This seems terribly stupid to anyone who is able to think about these issues. All of the facts are right in front of everyone's eyes, yet no one sees.
Recall above I said that the reason no one knows what anything is worth (and therefore what price is reasonable) is that society got increasingly complex and people started specializing and not understanding what work was involved in any other economic processes. They were forced to follow the herd (let the market set the prices) in making decisions about how much to pay or receive. They also were reduced to following the herd in deciding what they should want to buy. Well that is the problem here as well. The complexity of our social system is such that no person can do a reasonable job of understanding all of variables and processes in play. Our brains evolved a capacity to inadvertently (unknowingly) create complexity by solving local problems. But we did not evolve the capacity to determine whether or not those perceived problems should be solved, or solved by expedient means. The better part of wisdom must surely involve critically grasping the longer-term consequences of expediency for hedonic reasons.
In other words we lack the wisdom, singly or collectively, to manage our affairs appropriately in a complex world. Without wisdom we can be clever but still stupid. Just a cursory look around at various institutions that we have developed over the millennia that are now dysfunctional, failing, or failed. Education, banking, government, corporations, the list is long. And those failings can be directly attributed to the people who took leadership positions within their frameworks. Very few of them appear to be very wise (Nelson Mandela, in my opinion, being the one lone exception).
I wish I could say that the days of neoclassical economics domination are waning and that a new theory such as biophysical economics will rise and that we will be able to fix everything as a result, but I can't. Nevertheless I think that neoclassical economics and its proponents should be dismantled. The theory is corrupt and reinforcing bad thinking in nearly everybody. The people who push it are intellectually dishonest at best and possibly criminally malicious at worst. But it is also the case that the citizens who continue to swallow their BS because it sounds good are partially culpable as well. We are a minimally sapient species. We are too influenced by ideological thinking. Most of us don't comprehend the facts or the principles that operate on reality. So what hope exists? Evolution in the long run, I think.