Damn good overview.
Steve
http://thearchdruidreport.blogspot.com/2009/10/why-markets-fail.html
<http://thearchdruidreport.blogspot.com/2009/10/why-markets-fail.html>
WEDNESDAY, OCTOBER 28, 2009
Why Markets Fail
<http://thearchdruidreport.blogspot.com/2009/10/why-markets-fail.html>
It's a safe bet that any public comment on the politics of peak oil,
unless it sticks closely to one of a very few widely accepted opinions,
will provide a good demonstration of the laws of thermodynamics by
turning plenty of energy into waste heat. Last week's /Archdruid
Report/ post was no exception. Between those who thought I was too hard
on Cuba, those who thought I was too soft on Cuba, those who insisted
America is already a fascist dictatorship, those who thought America
would be better off as a fascist dictatorship, and a variety of less
classifiable rants, I was well and truly denounced. My favorite for the
week was a bit of online splutter that, having exhausted its author's
apparently limited vocabulary of profanity, wound up with the nastiest
term he knew: "...you /American/!"
Those of my readers with a taste for wry humor may well have found all
this as entertaining as I did. Still, this week's essay will leave such
amusements behind, and return to the theme I've been developing in
recent posts, the reinvention of economics that will be necessary in an
age of hard ecological limits and deindustrial decline. Vegetarians and
animal rights activists take note: a certain number of sacred cows will
have to be slaughtered and dissected in the course of that inquiry, and
the process is unlikely to be either painless or clean.
Of the sanctified cattle facing a gruesome fate in the years ahead of
us, perhaps the most important is that blue-ribbon heifer of modern
economics, the belief in the infallibility of free markets. Back in
1776, Adam Smith's /The Wealth of Nations/ popularized the idea that
free market exchanges offered a more efficient way of managing economic
activity than custom or government regulation. The popularity of his
arguments has waxed and waned over the years; it may come as no surprise
that periods of general prosperity have seen the market's alleged wisdom
proclaimed to the skies, while periods of contraction have had the
reverse effect.
The economic orthodoxy that has been welded in place in the western
world since the 1950s, neoclassical economics, made a nuanced version of
Smith's theory central to its theories, arguing that aside from certain
exceptions much discussed in the technical literature, people making
rational decisions to maximize benefits to themselves will
simultaneously maximize the benefits to everyone. The neoclassical
synthesis has its virtues; you won't find neoclassical economists
claiming, as the free market fundamentalists of the Austrian school so
often do, that the market is always right, even when its vagaries cause
catastrophic human suffering. The concept of market failure is part of
the neoclassical vocabulary, and some useful work has been done under
the neoclassical umbrella to explain how it is that markets can fail to
respond to crucial human needs, as they routinely do.
Still, the great problem with neoclassical economics is the one has
already been discussed in these posts: its models have consistently
failed to foresee devastating economic disasters that many people
outside the economics profession could readily and accurately predict
years in advance. The implosion of the world economy in 2008 is only the
most recent case in point. One writer who surveyed the economics field
in the aftermath of the crash noted with some asperity that fewer than
two dozen economists anywhere in the world warned in advance of the
gargantuan bubble of securitized debt that exploded that year.
On the contrary, economists by the score lined up during the bubble
years to insist that the giddy financial innovations of the previous
decade had banished risk from the market and prosperity was assured into
the foreseeable future. They were of course quite wrong, and their
failure to see disaster as it loomed up in front of them compares very
poorly with the large number of people who used historical parallels to
recognize what was happening and make uncomfortably precise forecasts of
the results. (Keith Brand, who ran the lively HousingPanic blog straight
through the bubble, memorably summarized those predictions: "Dear God,
this is going to end so badly.")
I have discussed in several earlier posts some of the reasons why the
entire economics profession has been so prone to miss the obvious in
such cases. Here, though, I want to focus on a reason for failure that's
specific to neoclassical economics. Since most of the economists who
provide advice to governments come out of the neoclassical mainstream,
this is hardly irrelevant to our prospects for the future, especially --
as I intend to show -- because the same blind spot that left so many
pundits dining on a banquet of crow in recent months applies with even
greater force to the crucial fact of our time, the arrival of peak oil.
The point I want to make here is a little different from the most common
critique of neoclassical economics, though there is a connection. Many
social critics have commented on the ease with which the neoclassical
synthesis consistently ignores the interface between economic wealth and
power. Even when people rationally seek to maximize benefits to
themselves, after all, their options for doing so are very often tightly
constrained by economic systems that have been manipulated to maximize
the benefits going to someone else.
This is a pervasive problem in most human societies, and it's worth
noting that those societies that survive over the long term tend to be
the ones that work out ways to keep too much wealth from piling up
uselessly in the hands of those with more power than others. This is why
hunter-gatherers have customary rules for sharing out the meat from a
large kill, why chieftains in so many tribal societies maintain their
positions of influence by lavish generosity, and why those nations that
got through the last Great Depression intact did so by imposing sensible
checks and balances on concentrated wealth -- though most of those
checks and balances in the United States were scrapped several decades
ago, with utterly predictable results.
By neglecting and even arguing against these necessary redistributive
processes, neoclassical economics has helped feed economic disparities,
and these in turn have played a major role in driving cycles of boom and
bust. It's no accident that the most devastating speculative bubbles
happen in places and times when the distribution of wealth is unusually
lopsided, as it was in America, for example, in the 1920s and the period
from 1990 to 2008. The connection here is simple: when wealth is widely
distributed, more of it circulates in the productive economy of wages
and consumer purchases; when wealth is concentrated in the hands of a
few, more of it moves into the investment economy where the well-to-do
keep their wealth, and a buildup of capital in the investment economy is
one of the necessary preconditions for a speculative binge.
More broadly, concentrations of wealth can be cashed in for political
influence, and political influence can be used to limit the economic
choices available to others. Individuals can and do rationally choose to
maximize the benefits available to them by exercising influence in this
way, but the results can impose destructive inefficiencies on the whole
economy. In effect, political manipulation of the economy by the rich
for private gain does an end run around normal economic processes by way
of the world of politics; what starts in the economic sphere, as a
concentration of wealth, and ends there, as a distortion of the economic
opportunities available to others, ducks through the political sphere in
between.
A similar end run drives speculative bubbles, although here the
noneconomic sphere involved is that of crowd psychology rather than
politics. Very often, the choices made by participants in a bubble are
not rational decisions that weigh costs against benefits; it's not
accidental that the first, and still one of the best, analyses of
speculative binges and panics is titled /Extraordinary Popular Delusions
and the Madness of Crowds/. Here again, a speculative bubble starts in
the economic sphere, as a buildup of excessive wealth in the hands of
investors, which drives the price of some favored class of assets out of
its normal relationship with the rest of the economy, and it ends in the
economic sphere, with the crater left by the assets in question as their
price plunges roughly as far below the mean as it rose above it,
dragging the rest of the economy with it. It's the middle of the
trajectory that passes through a particular form of crowd psychology,
and since this is outside the economic sphere, neoclassical economics
can't deal with it.
This would be no problem if neoclassical economists by and large
recognized these limitations. Unfortunately a great many of them do not,
and the result is the classic type of myopia in which theory trumps
reality. Since neoclassical theory claims that economic decisions are
made by individuals acting freely and rationally to maximize the
benefits accruing to them, it's seemingly all too easy for economists to
believe that any economic decision, no matter how harshly constrained by
political power or wildly distorted by the delusional psychology of a
bubble in full roar, must be a free and rational decision that will
allow individuals to maximize their own benefits and benefit society as
a whole.
Now of course, as mentioned in an earlier post, those who practice this
sort of purblind thinking often find it very lucrative to do so.
Economists who urged more free trade on the Third World at a time when
"free trade" distorted by inequalities of power between nations was
beggaring the Third World, like economists who urged people to buy
houses at a time when houses were preposterously overpriced and facing
an imminent price collapse, not uncommonly prospered by giving such
appallingly bad advice. Still, it seems unreasonable to claim that all
economists are motivated by greed, when the potent force of a
fundamentally flawed economic paradigm also pushes them in the same
direction.
That same pressure, with the same financial incentives to back it up,
also drives the equally bad advice so many neoclassical economists are
offering governments and businesses about the future of fossil fuels.
The geological and thermodynamic limits to energy growth, like political
power and the mob psychology of bubbles, lie outside the economic
sphere. The interaction of economic processes with energy resources
creates another end run: extraction of fossil fuels to run the world's
economies, an economic process, drives the depletion of oil and other
fossil fuel reserves, a noneconomic process, and this promises to flow
back into the economic sphere in the extended downward spiral of
contraction and impoverishment I've called the Long Descent.
Here again, neoclassical economics is poorly equipped to deal with the
reality of noneconomic constraints on economic processes. It thus comes
as no surprise that when an economist enters the peak oil debate, it is
almost always to claim that there is nothing to worry about, because the
market will solve any shortfall that happens to emerge. As shortfalls
emerge, expect to hear the claim -- already floated by a few economists
-- that declining production is simply a sign that the demand for fossil
fuel energy has decreased. No doubt when people are starving in the
streets, we will hear claims that this is simply because the demand for
food has dropped.
There are promising signs that the grip of neoclassical theory on modern
economics is beginning to weaken. A recent conference on biophysical
economics -- a field which embraces the heretical concept that the laws
of nature trump the laws of money -- attracted many attendees and, in a
shift of nearly seismic proportions, managed to get coverage in the New
York Times. Other alternative viewpoints in economics are beginning to
be heard, as they usually are in times of financial woe. Still, what's
needed now is something even more sweeping: an economics of whole
systems, perhaps modeled on ecology, in which the entire world of
noneconomic factors that influence economic processes is explicitly
included in theories and practical analyses. Until that emerges, the
advice governments and businesses receive from their paid economists may
well continue to make matters worse rather than better.
Posted by John Michael Greer
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