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.

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.