Why Markets Fail

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.