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.

Strange Bright Banners

The transformation of money from a pragmatic measure of wealth to a metastatic abstraction that threatens to devour the economy of real wealth that created it – the theme of the last three posts here – has, as my readers have been quick to point out, political implications. The conventional wisdom these days ignores those implications; the consensus among alternative thinkers, which I suppose could be called the unconventional wisdom, deals with them in a stereotyped manner. I find it increasingly hard to accept either viewpoint.

The conventional wisdom, like most great fallacies, begins with a truth and stretches it until it becomes for all practical purposes a falsehood. The truth, one of the great achievements of the last three hundred years of thought, is the recognition that human life comprises a number of separate spheres that overlap solely in the life of the individual. Most of us have learned, for example, that when a religious leader makes statements concerning matters of scientific fact, those statements deserve no more (albeit no less) respect than those of any other interested layperson, and if the religious leader claims divine sanction for his opinions, he has overstepped the proper bounds of religion. (We are still in the process of learning that the reverse is also true, and a scientist who attempts to claim the prestige of science for an attack on religion is equally out of line.) Literature and the arts define another such sphere; so does politics; so does the realm of production and exchange of wealth summed up imperfectly in the word economics.

The separation of these spheres, important as it is, can never be total, because each human being participates in all of them and must balance their claims against one another. For this reason it’s entirely appropriate, say, for religious leaders to raise questions about the moral dimensions of the economy, or for a painter such as Picasso to deliver a devastating critique of a political act with his brush, and in the process create one of the great works of his career. In the same way, the political and economic spheres interpenetrate in significant ways, not least because money (the currency of economics) and power (the currency of politics) can often be traded in for one another. Thus it’s reasonable to discuss the ways that the distribution of wealth in a society intersects with its distribution of power.

This is what the conventional wisdom refuses to do. It’s acceptable nowadays to argue about whether government ought to regulate business, and in what minor ways; it’s very occasionally acceptable to talk about the corruption of government by business, though usually only when some egregious example of this standard practice is selected for pillorying in front of the public. It’s not acceptable anywhere in the American mainstream to talk about the extent to which the entire political process from top to bottom has been skewed by economic interests to the point of absurdity. The current “health care reform” farce is a case in point; most of the plans being discussed in Congress just now deal with the fact that half the American people can’t afford health insurance by forcing them to buy it anyway under penalty of law, funnelling tens of billions of dollars out of the pockets of struggling families – in the midst of a recession, no less – into the coffers of a health insurance industry that is already one of the most overfunded and corrupt institutions in American public life. (If this seems as wrongheaded to you as it does to me, dear reader, a letter to each of your congresspersons might be in order.)

It is to the credit of what I’ve called the unconventional wisdom, the consensus viewpoint of critics of the current system, that they recognize this overlap. What makes the unconventional wisdom problematic, here as elsewhere, is that so much of it redefines such overlaps in terms so extreme that a valid insight is once again falsified. It’s unquestionably true that business interests exert undue influence on the American political system, but this does not justify the wild claims so often made about the extent, centralization, and evil intentions of those interests and their influence.

Take the insistence, so often heard from radicals of the left and right alike, that America is a fascist state. If America were a fascist state, those on both sides of the political spectrum who currently exercise their freedom of speech to call it that would long since have been dragged from their beds in the middle of the night by uniformed thugs, never to be seen again – at least until their bones are pulled from a mass grave and identified by dental records decades from now. That is how things happen in a fascist state, and for today’s smug and pampered American radicals to wrap themselves in the mantle of victims of fascism, while relying on civil rights no fascist system grants its citizens, displays a profound disrespect for those who have actually suffered under totalitarian regimes.

To some extent this habit of flinging around extreme claims is simply the normal rhetorical extravagance of those who know they will not be held accountable for their words. Still, it is far from helpful to insist that because American democracy is troubled, corrupted by economic interests, and increasingly dysfunctional, it ought to be equated with the worst examples in our culture’s political demonology. It is even less helpful when this sort of thinking leads to the assumption that anything that replaces it must be better than the system we have now. That’s a common assumption in troubled times, but it’s also one to which history delivers a devastating reproof.

Imagine along these lines, dear reader, that sometime in the next year or so you start hearing media reports about a rising new figure in American politics. He’s young and charismatic, a military veteran who won the Distinguished Service Cross for bravery under fire, and heads a vigorous new third party that looks as though it might just be able to break the stranglehold of the established parties on the political system. Some of his ideas come straight from the fringes, and he’s been reported to have said very negative things about Arabs and Islam, but he’s nearly the only person in American public life willing to talk frankly about the difficulties Americans are facing in an era of economic collapse, and his party platform embodies many of the most innovative ideas of the left and right. Like him or not, he offers the one convincing alternative to business as usual in an increasingly troubled and corrupt system.

Would you vote for him? Millions of Germans did; replace the Distinguished Service Cross with the Iron Cross and Arabs with Jews, and the parallel should be self-explanatory. That parallel is anything but unique, for that matter; swap out a few details and you have the early careers of Mussolini, Salazar, Peron, or any number of other dictators of the same era. One of the problems with the continual use of fascism as a bogeyman by political extremists is that it becomes far too easy to forget how promising fascism looked in the 1920s and 1930s to many good people disgusted with the failings of their democratic governments. It’s not the “cornpone Hitler” James Howard Kunstler has predicted that we have to fear, much less the imaginary conspiracies that occupy so much space in today’s alternative discourse, but a suave, articulate, and charismatic figure who harnesses the widespread assumption that anything must be better than what we have today, and replaces a dysfunctional democracy with an all too functional tyranny.

Such a figure, it bears remembering, could as easily emerge from the left as from the right. One popular DVD that circulated widely in the peak oil scene a few years back was called The Power of Community, a documentary about how Cuba survived its own equivalent of peak oil when Soviet fuel subsidies stopped at the end of the Cold War. It’s a worthwhile case study of how a society can weather an extreme energy shortage, but it finessed one of the key points that enabled the Cuban response, namely, that Cuba is a dictatorship. To impose the draconian restrictions on energy use that got his country through its “Special Period,” Castro did not have to mobilize public opinion, placate powerful special interests, and shepherd legislation through a fractious Congress riven by ideological splits and determined to defend its prerogatives; he simply had to impose them, and those who disagreed were welcome to spend the next few years discussing the matter at length behind bars with their fellow political prisoners.

A great deal of the American left seems to have seen nothing wrong in this curious definition of “community.” This in itself is troubling, as is the enthusiastic reception of David Korten’s The Great Turning, among the most antidemocratic books of recent years, by the same circles. Korten argues that certain people – essentially, those who share his background and values – are at a superior “developmental stage” to others and are therefore better suited to rule, and the only way to survive the spiralling crises of the present and near future is to take power away from the “developmentally inferior” people who now hold it and give it to the gifted few. The idea that these few might need to be subject to checks and balances to keep them from abusing their power, it hardly need be said, finds no place in Korten’s book – a point that has done uncomfortably little to decrease its popularity.

It’s from sources like these that a neofascism of the left could quite readily emerge on American soil. Of course a neofascism of the right is equally possible, and the most dangerous possibility of all – because the most likely to slip past social critics unnoticed – might well be a movement that places itself in the abandoned middle ground of American politics. There is a great deal of empty space where common sense and compromise once bridged the gap between the major parties, and those parties themselves have become increasingly detached from the values and needs of the people they claim to represent. That space could offer an unparalleled opportunity to an astute and ambitious demagogue. It’s not exactly comforting that Nick Griffin, the head of Britain’s neofascist British Nationalist Party, is now using images of Churchill and the Battle of Britain in place of the Nazi regalia his followers once sported; Griffin is no fool, and where he goes, others will likely follow.

The crucial point that has to be recognized, and is too little recognized just now, is that it’s quite possible to replace a bad system with one that is much, much worse. Historians generally agree that the Weimar Republic was a failure, but I know of none who would suggest that the regime that followed it was an improvement. In the same way, those philosophes who criticized the Ancien Regime in its last years were quite correct to point out that the French monarchy and government were dysfunctional, corrupt, and wildly inefficient. Still, their guiding assumption – that what replaced it could only be better – was brutally betrayed by the Terror, the imperial tyranny of Napoleon, and a quarter century of bloody warfare, leading to no better end than the devastation of France and the restoration of an even more feckless monarch than the one they hoped to see overthrown.

The collapse of American democracy, or what is left of it, into one or another form of autocracy may be a foregone conclusion at this point. Certainly Oswald Spengler, whose ideas continue to land solid hits on a future his critics just as consistently miss, considered it that. He argued that the great struggle of the century or two ahead of his time would pit failing democracies corrupted by wealth in a long but ultimately losing struggle against the rising force of what he called Caesarism – the rise of charismatic leaders who would finish destroying crumbling democratic institutions and rule by a combination of force of personality and raw physical violence. The first round in that struggle began during Spengler’s own lifetime, though he did not live to see the first generation of Caesars fall; it seems unwise to dismiss the possibility of an imminent second round out of hand.

Still, the last word in all this probably belongs to an unlikely but eloquent spokesman, whose name I do not know. He was an elderly man, a Navy veteran with grandchildren, waiting for his laundry to finish at a laundromat here in Cumberland when I arrived there this morning on the same errand. Passing the time as the dryers tumbled, we talked about the weather and the misbehavior of politicians downriver in Washington DC. Then he shook his head and said, “I feel sorry for my grandkids. Me, I’ve had a good life, and my sons all did pretty well, but my grandkids and other people’s kids, they’ll never have what we had.”

For more than two centuries, the glue that has held American society together has been the hope – often falsified, but more often fulfilled – that each generation, no matter how difficult its own life might be, could hope for better things for its children. That faith is breaking apart where it has not already shattered. In its wake, strange bright banners are all too likely to be unfurled, and I suspect that a great many people who imagine themselves immune from the temptation of simple answers will end up marching beneath those banners toward some terrible destiny.