Economic Growth Enigma: Money or Energy

Professor Robert Ayres will be joining The Sustainable Development, Economy and Society Master Class at the ISG in Paris this year as a guest speaker on Thursday at 14:00.  You will find a short bio note summarizing some of the high points of his career and prolific  output just below. In his presentation  and in  the following question period Ayres will be looking at some important aspects of the future of the planet, which holds out some interesting clues for the future career and expertise choices of young people looking at a future business career.  As he rakes through the smoldering coals of a world soon to be  saddled with post-peak oil prices that will never again come back to “normal”, he may have a few clues for your future.

Economic Growth Enigma: Money or Energy

Let me start by drawing your attention to seven undoubted facts and leads to four propositions for specific ways to deal with the consequences of these facts, including job creation and climate change.

 Key Facts

The first fact is that the others are inter-related, whence the order of presentation is unimportant. We list them in the order of presentation.

The second undoubted fact (which is a consequence of the laws of thermodynamics) is that physical materials are not created or consumed, but are moved and transformed by human actions. The transformations start with “raw” materials from nature, add value at each stage of transformation, until they finally become products. All products eventually become wastes to be discarded and disposed of. The first two industrial revolutions in the 18^th and 19^th centuries, were based largely on transformation technologies introduced to exploit pockets of high quality natural resources, notably fossil fuels (coal and petroleum) but also metals and other minerals. To simplify the following discussion, we use the term “exergy” (which literally means useful energy) as a proxy for all useful natural resources

The third key fact is that the finite stores of high quality (low entropy) exergy resources in the earth are unevenly distributed. They are fast (now) being exhausted, while the renewable resources (like sunlight and wind) are generally much lower in quality and much more costly to exploit. Moreover, the Greenhouse Gases (GHGs) from fossil fuel combustion are accumulating in the atmosphere and driving climate change rapidly toward irreversible economic and social disaster. (The vast majority of the scientific community agrees with the above assessment, even though most governments and industry leaders ignore it). In the absence of renewable exergy sources, more and more economic activity and a rising share of GDP, will be required to provide useful energy for the economy. It follows that the price of energy (especially fossil fuels such as oil) will rise over time.

The fourth key fact is that – conventional economic theory to the contrary -- the global economy is not driven simply by capital accumulation and human labor. The economy cannot function without a continuous (and ever-increasing) supply of exergy resources, both in the form of materials embodied in capital stock and as an “activator” for both human labor and the machines that augment (and increasingly replace) human labor. Without energy from food (Calories) human muscles and brains cannot do useful work. Machines, which have replaced most kinds of human (and animal) labor, cannot function without exergy that is mostly derived from fossil fuels. The world is truly “hooked” on oil (George Bush’s words), if only because liquid fuels from petroleum are essential for every sort of internal combustion engine, and combustion engines power almost every sort of vehicle in the transport system, not to mention off-road construction machinery and farm machinery. Coal and gas are also primary fuels for the electric power sector. Energy (exergy) matters in economics far more than most economists seem to think. Without a supply of energy (in the form of “useful work”) there can be no production. Exergy is as much a “factor of production” as labor or capital – or finance.

The fifth key fact is that the existing laissez-faire global economic system is functioning very badly.  The existing economic (and financial) system is based on transactions between individuals and firms that can adversely affect people and companies that were not involved in the transaction and that had no say in the decisions. The word for third-party effects in economics is “externalities”. Externalities can create environmental problems (e.g. pollution). Pollution is a consequence of the crude and inefficient processes that convert resource inputs to useful goods and services. But other externalities result from an unstable and out-of-control financial system and an ineffective political system. Such financial externalities (problems) have a centuries-long history, but they got a lot worse with the financial crisis that began in 2007.  Almost nothing has been done to prevent a recurrence. This malfunction has many aspects. The ones most obvious to the politicians and the public are the sovereign debt crisis, economic stagnation and unemployment. But the one that is potentially most important – climate change – gets far too little attention.

The sixth key fact, following from the fifth, is that economic growth has become even more imperative today than it was in the past. This is because it is seen as the only way to escape from the sovereign debt burden, while continuing to enjoy social and medical entitlements that politicians promised but which are unfunded. A slow-growth or no-growth economy may be a long-term imperative, but in the short-term it is a recipe for social disaster. But, despite the misplaced faith in the regenerative power of pain (“the urge to purge”) by many economic and political conservatives, austerity as a response to the debt crisis has not brought forth a flood of private sector investment and is not generating growth or jobs. On the contrary it is making government deficits – hence the current economic situation and unemployment -- worse. So another policy approach to growth is badly needed.

The seventh (and final) fact is that the negative externalities caused by purely financial activities – such as asset “bubbles”, credit collapse, debt default, austerity and its economic-social consequences – have vastly increased  in scale and scope since the days of Adam Smith and his successors, who were obsessed with trade. The negative externalities caused by financial excesses are growing faster than ordinary economic activities.  The world is becoming more crowded; population has more than tripled since 1940. It is rapidly urbanizing; production is increasingly mechanized and automated. Economic-financial activity is far more global and more complex. Negative externalities from bubbles already outweigh the efficiency gains from business mergers and mega-finance. In fact, they constitute a real challenge to the future of capitalism.

Propositions

Our first policy proposition is that economic policy is currently mis-focused on increasing labor productivity. This is, in practice, a policy encouraging the replacement of high-cost labor by machines and it is promoted by direct or indirect subsidies for natural resource extraction. We argue that a much better policy would be to increase natural resource productivity, by taxing exergy extraction and use, to shift the balance between resource costs and labor costs. In principle, taxes on labor should be cut while taxes on natural resource use should be increased.

A second and closely related policy proposition is that exergy waste must be actively discouraged by government, either by taxation or by regulation, including (or by) elimination of existing regulations, especially in the electric power sector, that discourage improving efficiency. A policy of encouraging exergy efficiency is needed for multiple reasons: (1) To cut the adverse environmental (and human health) consequences and costs of pollution; (2) To cut the buildup of “greenhouse gases” (GHGs) in the atmosphere; and (3) To increase economic efficiency – and accelerate economic growth -- by increasing exergy efficiency (and resource productivity).

A third policy proposition concerns income and economic inequality. Here a brief digression is needed. Compensating for inherent financial instability requires constant “tweaking” by regulators. One type of tweak (cheap money) tends to create asset “bubbles” and the collapse of every major bubble causes a depression or recession and creates the conditions for another bubble. The bursting of (many) bubbles causes heavy losses to people not directly responsible for the creation of the bubble. Another kind of “tweak” (after a bubble bursts) is that weak banks are absorbed by stronger (larger) banks, with explicit government support. This, in turn, exacerbates the “too big to fail” (TBTF) phenomenon. TBTF financial institutions can (and do) maximize their own profits by gambling with depositor’s money, in the knowledge that they will be “bailed out” by the tax-payers if (when) things go wrong. This process invariably shifts wealth and power from the poor and middle classes to the rich, a process that tends to be self-re-enforcing through the influence of special-interest lobbies on the political process.  Hence, government policy needs to focus explicitly on avoiding the circumstances that lead to financial bubbles. It also needs to  compensate for income inequality and its economic-social consequences. Direct taxes on high personal incomes may help, but changes in bank regulations to discourage excessive risk-taking by TBTF institutions (gambling), and policies to ensure transparency and accountability for all significant domestic and international financial flows into (and out of) “tax havens” will be needed also.

The fourth policy proposition is “intensive decarbonization”. It follows from all the others. Governments have just one hope of escaping from the grip of financial bubbles, global debt and economic stagnation. Global leaders must recognize that cheap fossil fuels, especially liquid fuels, are approaching inevitable exhaustion, later if not sooner. They need to recognize that delay is exacerbating the increasingly obvious and costly consequences of climate change. The time has come to break the “addiction” to carbon-based fossil fuels in general, and to oil in particular. As mentioned earlier, government should increasingly use tax policy to enhance the long-term trend of rising real prices in the production and use of fossil fuels.

Government should accompany this policy by encouraging the attractiveness of investment in exergy based on non-fossil fuels, making, for instance, renewable fuels increasingly profitable in comparison with fossil fuels.

It is not necessary for governments to “pick winners” at this stage nor to finance them. What is necessary is to create a financial “incubator” within which the inventors and innovators can perform their wonders without requiring direct subsidies from the taxpayer (although some subsidies may be justified on a benefit cost basis). Financial innovation is needed to direct private investment toward decarbonization and exergy independence, essentially what President Jimmy Carter tried unsuccessfully to initiate in the 1970s.

Some current financial techniques, such as securities responsive to long-term investor needs, securitization, derivatives; can be used to market securities based on non-fossil fuels and exergy efficiency. In principle, we think the financial system (with some government encouragement) can create non-fossil fuel energy-based securities that would finance the long-term investment needs of insurance companies, pension funds and university endowments. The customers would be the same institutions that so eagerly bought the (fraudulently) AAA-rated securities based on sub-prime mortgages before 2007.

Skeptics are not in short supply. “Austerians” will argue, among other things, that the debt crisis is really the most important challenge facing the world economy and that the only solution is to liquidate all the unprofitable investments: Don’t bail out the losers. Let the free market work its magic. (Look how well that worked in 1929!) And it’s OK to cut taxes on the rich who are the “job creators”. Others will deny there is a climate crisis, so nothing should stop us from exploiting that ocean of oil (and gas) locked in shale that can and will be extracted profitably for decades to come.

Some others will argue that renewables like wind power, rooftop PV (photo voltaic), solar concentrators, tidal power, or oil from algae, are not profitable now – that they need to be subsidized – to succeed in the market-place. Others will argue that the economy doesn’t really depend much on energy, because energy costs represent such a small share of GDP. It follows from that assertion that economic growth can continue indefinitely and that our grand-children will be a lot richer than we are.  It also follows from that line of argument that we don’t need to change anything, because “the economy wants to grow” and it will grow automatically.  That argument is wrong.

We say that these skeptics are wrong and they are betting on the wrong horses. If so, the odds favoring unconventional investments in non-fossil fuels and exergy efficiency are better than the market “thinks”. We think this is a good time to make such long-term bets on economic and job growth while avoiding catastrophic climate change.

To implement such an approach, we propose a practical dialogue between the distinguished academic experts on exergy  and the long-term investment community, such as insurance companies and pension funds; to devise special financial securities and investment techniques to encourage investment in non-fossil fuel-based exergy production and use.

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About the author

Robert Underwood Ayres is an American-born physicist and economist whose ’s career has focused on the application of physical ideas, especially the laws of thermodynamics, to economics; a long-standing pioneering interest in material flows and transformations (Industrial Ecology or Industrial Metabolism); and most recently to challenging held ideas on the economic theory of growth.

Trained as a physicist at the University of Chicago, University of Maryland, and Kings College at the University of London (PhD in Mathematical Physics), Ayres has dedicated his entire professional life to advancing the environment, technology and resource end of the sustainability agenda. His major research interests include technological change, environmental economics, “industrial metabolism” and “eco-restructuring”. At various times he has acted as a consultant to the White House, National Goals Commission, Office of Management and Budget, Transport Canada, OECD, Statistics Canada, and numerous UN agencies. He set up and ran for several years the innovative program on Technology, Economy and Society at IIASA, the International Institute for Applied Systems Analysis in Laxenburg Austria, and retains his long term affiliation with that institution.

Presently: Visiting Professor Chalmers University Gothenburg (Sweden) and Emeritus Professor of Economics and Political Science and Technology Management at the European Business School, INSEAD in Fontainebleau France.

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