Economyths - ten ways economics gets it wrong Part 8
In 2001, Harvard students performed a sit-in to demand a minimum hourly wage of $10.25 for the university's lowest-paid employees. Harvard Magazine formed a committee to debate the issue. One of the contributors was the economics professor Gregory Mankiw, author of million-selling textbooks including Principles of Economics. Given an opportunity to put principles into practice, Mankiw wrote: "Despite the students' good intentions, I cannot support their cause. If any inst.i.tution should think with its head as well as its heart, it is a university."25 To quote from his book: "The minimum wage is easily understood using the tools of supply and demand ... For workers with low levels of skill and experience, a high minimum wage forces the wage above the level that balances supply and demand."26 He concluded that giving janitors an extra buck or so an hour "would compromise the University's commitment to the creation and dissemination of knowledge." (As economist Gilles Raveaud points out, the conversation wasn't extended to cover how academic tenure fits in with supply and demand.27) Given that neocla.s.sical economics has been the dominant economic ideology since the late 1960s, it is no surprise that the inflation-adjusted minimum wage in the United States has declined over that period by about 25 per cent; or that wage inequality in general has exploded. While economics pretends to be an impartial science, it is in fact profoundly political. As the economist Joseph Stiglitz told Adbusters magazine: "Mankiw was on the Council of Economic Advisors under President Bush and ... they tried to push forward a particular ideological view that markets work perfectly."28 The problem is that, while market forces will automatically a.s.sign janitors or professors a wage of some sort, there is no guarantee that it will be appropriate or reasonable.
This matters because, as doc.u.mented by Richard Wilkinson and Kate Pickett in their book The Spirit Level, inequality is correlated, and not in a good way, with all kinds of other issues including community breakdown, mental and physical health problems, drug addiction, imprisonment rates, educational under-performance, teenage births, and so on.29 Those rich-but-unequal countries the US and the UK, whose cultures have been strongly shaped by neocla.s.sical thought, consistently top the charts on many of these areas, while more equal countries such as j.a.pan, Norway, and Sweden report fewer problems. Correlation is not the same as causation, but there is convincing empirical evidence that "The more equally wealth is distributed the better the health of the society," as the British Medical Journal reported.30 Of course, as doctors know, anything is fine in moderation. Some people will always earn more than others, and a degree of inequality fosters entrepreneurship, so long as it is seen as fair. But when inequality, which is a function of wage differentials rather than just minimum wages, becomes too extreme, it violates at a basic level our sense of fair play. This is why cooperative human societies, such as ones in which men hunt large game, often take care to ensure equitable distribution. "Without ever having heard calls for equality, these cultures are nevertheless keenly aware of the risk that inequity poses to the social fabric of their society," notes primatologist Frans de Waal, who sees the same behaviour in primates.31 From a global perspective, inequality fuels problems such as ethnic violence, because wealth in many developing countries is controlled by small but economically dominant ethnic groups, and terrorism.32 While neocla.s.sical theory owes much of its popularity, and funding, to corporate support, there is another const.i.tuency that has, perhaps paradoxically, benefited from the illusion of equality. That is the government.
Improving circulation.
Neocla.s.sical economists may be sworn enemies of government profligacy and red tape, but if there is one thing the two can agree on, it is the myth that we live in a free and fair world.
At Barack Obama's breakthrough speech during the 2004 Democratic convention, he began by admitting, as the mixed-race son of a father who "grew up herding goats, went to school in a tin-roof shack," that his presence on the stage was "pretty unlikely." In America, he went on, "you don't have to be rich to achieve your potential ... in no other country on earth, is my story even possible."
Obama's speech was certainly inspiring, and it made possible his later run for the White House. However, as Ron Haskins and Isabel Sawhill from the Brookings Inst.i.tution note: "Rags to riches in a generation is pretty much a myth: it happens very infrequently."33 Social mobility in the United States is actually lower than in its rich-country peers, and is declining with time. In 1980, the percentage of a son's income explained by his father's income was about 10 per cent. In 2000, that had increased to 33 per cent.34 A 2009 report from the Organisation for Economic Cooperation and Development said that such "intergenerational inequality" is higher in the US than other OECD countries.35 There appears to be a direct link between income inequality and social mobility - the steeper the hill, the harder it is to climb up. Obama is the exception that proves the rule, which is perhaps why he mentioned social equality in his inaugural speech: "The success of our economy has always depended not just on the size of our gross domestic product, but on the reach of our prosperity; on our ability to extend opportunity to every willing heart - not out of charity, but because it is the surest route to our common good."
The ingrained American belief in equality, coupled with a famed and powerful degree of optimism, have, paradoxically, allowed the country to drift towards a highly unequal state, with little resistance from the population. As Pareto knew, though, if social structures become too rigid, so that "the upper strata are full of decadent elements and the lower strata are full of elite elements," then eventually there will be a strong chance of "violent revolution."
In March 2009, when it was learned that giant insurer AIG was to pay out hundreds of millions in bonuses to its employees, there was a similar whiff of revolution in the air in the United States. AIG had just received a $170 billion bail-out, and posted a fourth-quarter loss in 2008 of $61.7 billion - the largest ever by a corporation. The country flipped into a state of rage when AIG decided to reward its employees as if nothing had changed. "The public is angry," wrote Susan Antilla for Bloomberg. "They are steaming, off-with-their-heads mad at AIG and other financial companies for the greed and cheating that pushed us into a financial meltdown ... Americans want to see heads roll."36 AIG employees received death threats, and were warned to avoid wearing the company logo and to travel in pairs. One banker said: "At this point, it's like the French Revolution - the mob has got the banks' heads in the guillotine."37 The one argument heard that these ma.s.sive financial-sector bonuses were actually worth it (as opposed to contractually necessary) was the law of supply and demand, aka the law of the status quo. If AIG didn't pay them, the employees would just go somewhere else, because they were in demand from similar companies. As one compensation consultant told the New York Times: "The word on the street is that AIG employees are being heavily recruited."38 Presumably that's a different street than the one they were supposed to walk down in pairs.
The case of AIG and its peers is a graphic demonstration that supply and demand together don't form a law, and aren't the sole factors that should determine income, if only because they fail to take into account basic human needs for fairness and justice. Although there is no single formula to create an equal society, some of the tools available are progressive taxation, wage controls, alternative company structures, and social policy. Neocla.s.sical economists may see such measures as distortions to the free market, but they are as nothing compared to the AIG-like distortions produced by free markets.
Progressive taxation This approach has been adopted by Nordic countries such as Denmark, which has a top tax rate of 63 per cent. Obviously such an eye-watering rate wouldn't play well in countries such as the United States - it's hard to see "Tax the Rich!" and "Redistribute the Wealth!" becoming popular political slogans anytime soon. Even there, though, Warren Buffett and Bill Gates have spoken out in favour of estate taxes on the wealthy. As Buffett explains, they might help compensate for the fact that he pays tax at a lower rate than his secretary.
Wage controls At one end of the income scale, workers need protection in terms of a minimum wage. At the other end, we need protection from the workers. In 2009, President Obama imposed a $500,000 salary cap on bailed-out bank bosses. This was obviously justified by the fact that they were now glorified civil servants, but it opens up the question of whether caps are appropriate in other circ.u.mstances (personally, I'm not convinced that anyone on this planet should be paid more than $500,000). Alternatively, shareholders could stop tolerating bloated pay packages when there is little or no correlation with performance. This appears to be the practice in j.a.pan, where tax rates are low but so is pay inequality.
Company structure The excesses of CEO compensation are also helping to fuel interest in alternative structures such as non-profits, employee-owned companies, and the cooperative movement. The non-profit sector in the US is already huge, and includes vital inst.i.tutions such as universities, hospitals, and electric utilities. According to political economist Gar Alperovitz, non-profit electricity companies are on average 11 per cent cheaper than profit-making companies, and are more likely to adopt sustainable technology.39 Social policy One of the most important drivers of social inequality is a country's education system, including access to childcare. In unequal countries such as the UK or US, there is a huge difference in quality between the best and the worst schools. Rich families can buy their children a good education, either by sending them to a private school or moving to the catchment area of one of the better state-funded schools. Both of these options are expensive because there is compet.i.tion from other families.
A UK study headed by Alan Milburn showed that parents send their children to good schools not just for academic reasons, but also so they can learn soft skills such as social confidence. Elite universities like Harvard or Oxford are valued for the quality of the education, but also because they allow access to powerful social networks (in 2007, 47 per cent of Harvard graduates went into finance or consulting).40 Inequality therefore gets frozen in - those born into poor families stay poor, and those born into rich families stay rich. General access to high-quality education and childcare is required to keep things fluid.
Tipping point.
While there are many routes to a more equal society, an absolute prerequisite is an economic theory and worldview that acknowledges the huge discrepancies in power and influence that are present in the real world, and that points to ways of righting the balance. As with models of irrational behaviour, this is hard to accomplish in the cla.s.sical framework, which is based on the reductionist, symmetrical methods of cla.s.sical physics and a.s.sumes that the playing field is already level. It does come easily in the complexity approach, whose agent-based models naturally tend to reproduce the power-law distributions of wealth distribution or company size; or with feminist economics, which is concerned with differences in power. Neither of these is featured in basic textbooks, which tend to focus on neocla.s.sical theory.41 Just showing that the "law of supply and demand" is not based on physics, or science of any type, will be enough to change the debate over things like minimum wage. As Charles Darwin observed: "To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact."42 The best test for theoretical ideas is to compare them with empirical data, of which there is now plenty. Today, most economic transactions leave an electronic record. Credit rating agencies and other companies buy this information and use it to build sophisticated models of consumer behaviour. The information can also be used to test economic hypotheses. Consider, for example, Milton Friedman's prediction that free markets would tend to drive out businesses that discriminate on the basis of race or gender. An early study of new car dealerships in the United States by law professor Ian Ayres in 1991 showed that: "White women had to pay 40 per cent higher markups than white men; black men had to pay more than twice the markup, and black women had to pay more than three times the markup of white male testers."43 Minorities were also targeted by predatory lenders during the US subprime mortgage scandal.44 Studies of gender discrimination in the labour market show that women are over-represented in the poorest-paying jobs, under-represented in the highest-paying jobs, and are usually paid less than men for doing the same job.45 The outrage over bail-outs has since largely dissipated, and the bankers have kept their heads on and are back to their old tricks of awarding themselves huge bonuses with only muted complaint from the public. This is good for governments and the elites in power, who - while they might occasionally exploit resentment for short-term political gain - naturally prefer the workforce to be content with its place in the order of things. So far there is little sign that the American dream/fantasy of financial success has lost its hypnotic power. But if Pareto were around today - sitting in a comfortable chair with a cat on his lap and a gla.s.s of the finest brandy, watching Bloomberg on TV - I'm sure he would be monitoring the situation with interest. As he knew, ideologies are what the elites use to justify their inherently unstable position. It is ironic that the concept of Pareto optimality is now part of that ideology.
As discussed in Chapter 4, complex adaptive systems often tend to evolve towards a critical state - the slope of the sandpile increases until it approaches chaos. The same deregulatory ideology that allowed this instability to develop in the stockmarkets may also be pushing society towards an unstable tipping point. Markets crash, but societies can too.
To delay the day of reckoning, governments in the US and elsewhere don't actually need to reduce inequality - they only need to perpetuate the illusion that (a) everyone's situation is improving, and (b) everyone has a shot at the prize. Above all, they need to keep the economy growing. As Henry Wallich, former governor of the Federal Reserve, said: "Growth is a subst.i.tute for equality of income. So long as there is growth there is hope, and that makes large income differentials tolerable."46 As shown in the next chapter, though, that solution may be leading to a different kind of credit crunch.
CHAPTER 8.
THE OVER-SIZED ECONOMY.
Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist.
Kenneth Boulding, ecological economist (1910-93).
If the climate were a bank, they would already have saved it.
Hugo Chavez, president of Venezuela (2009).
Economists are taught that economic growth should be maximised. However, ecologists and environmentalists believe you can have too much of a good thing. The models used by economists don't properly take into account a few details - such as melting icebergs, shrinking resource stocks, or the opinions on all this of future generations. In fact, the real credit crunch is not the one involving banks, but the one involving the environment. For centuries we have been depleting forests, oceans, fuel sources, and other species, and the bill is about to become due. This chapter shows how economists' cherished belief in economic growth is colliding with the reality that we are just one part of a larger ecosystem. It explores new economic approaches that aim to resolve the conflict and bring our financial system into balance with the rest of the world.
In November 2006, before the credit crunch got into full swing, another economic crisis had already begun to unfold. This crisis was not heralded on the front covers of the Wall Street Journal or the Financial Times. Pundits did not appear on financial TV shows to ruminate on its causes. Politicians did not exploit it to stir up envy or lambast their rivals. It went completely unnoticed by economists. However, its repercussions are potentially even more serious than the market crash.
The crisis began in America, where large numbers of agricultural workers suddenly stopped working. It wasn't that they went on strike, or demanded higher pay; they just left their jobs and didn't come back - even if it meant certain death. Some farmers said it was like ma.s.s suicide.
Businesses went bust or closed down; entire industries, such as Californian almond farming, were under threat. The crisis did not stay contained in the US, but propagated around the world as quickly as the credit crunch. By early 2007, farmers in Canada, the UK, mainland Europe, South and Central America, and Asia were all reporting the same problem. But no one could figure out what was causing it. Why would these workers, who had served us so diligently for thousands of years, who had been celebrated throughout the ages in poems and myths for their industriousness and productivity, suddenly and collectively lose interest in living?
Were they suffering from a mysterious disease that affects their minds? Was it because, in their jobs, they are exposed to large amounts of chemical toxins? Could it be stress from over-work, or the constant need to travel around in search of the next job? Was it a result of climate change, or radiation from mobile phone masts, or working with genetically modified crops? Were there not enough flowers?
Scientists could not answer these questions - they had no idea why the bees were dying. But they did come up with a name: colony collapse disorder (CCD). And some believe it is a harbinger of things to come. As insect biologist E.O. Wilson said, the honeybee is nature's "workhorse - and we took it for granted. We've hung our own future on a thread."1
The Delphic bee.
Bees and humans share a long history together. We started gathering honey in the wild around 10,000 years ago, and have kept bee colonies for at least 5,000 years. Bees and honey also feature prominently in our mythology. According to Homer, the G.o.d Apollo's gift of prophecy was granted to him from three bee maidens: "There are three holy ones, sisters born ... From their home they fly now here, now there, feeding on honeycomb and bringing all things to pa.s.s. And when they are inspired through eating yellow honey, they are willing to speak the truth." The oracle at Delphi was often called the Delphic bee. The Greeks a.s.sociated honey with eloquence and the power of speech; Pythagoras was said to have been fed it as an infant, and the favourite food of the Pythagoreans was bread and honey.
Today, bees outnumber us on the planet by hundreds of times. They play a vital role in the world economy by pollinating crops including alfalfa (used for cattle feed), apples, almonds, citrus fruits, broccoli, carrots, onions, and melons. Without them, large parts of our agricultural supply chain would fall apart. So if these winged prophets are trying to tell us something, then maybe we should listen.
Honey bees were brought to North America in the early 17th century by Dutch or British colonists, and reached a peak population of 5.9 million colonies in 1947. By 2006, that number had declined to around 2.4 million, and the wild population was down by 90 per cent. According to congressional testimony, CCD has since knocked out a further 25 per cent of the remaining colonies.2 Similar die-offs have happened in the past, but they have been smaller, and the bees have died in the hives rather than just flying away as with CCD.
The cause of the phenomenon is still being debated. Possible culprits include parasites, fungal diseases, and acc.u.mulated exposure to toxic chemicals such as pesticides. Another contributor is environmental stress: many of the colonies affected belong to large commercial operations, which regularly transport the bees around the country to pollinate crops. Climate change may also play a role, by changing the blooming times of crops. It has even been proposed that electromagnetic radiation from phone masts or power transmission cables is interfering with the bees' delicate navigational systems.
The most likely scenario is that CCD has no single cause but is the c.u.mulative result of many small stresses. Trying to a.n.a.lyse the collapse of a species is a little like trying to a.n.a.lyse the cause of a stockmarket crash - everyone has their own theory, but none of them quite add up on their own. As E.O. Wilson puts it: "We are flying blind in many aspects of preserving the environment, and that's why we are so surprised when a species like the honeybee starts to crash."3 While scientists are at a loss to explain the behaviour of bees, most economic models go a step further by eliminating them from consideration altogether. Bees play a pivotal and irreplaceable role in the world economy - in the US, the value of their services is estimated at $15 billion annually. However, they don't respond well to the usual range of economic incentives. Even though, in many respects, they appear to be quite intelligent - as shown, for example, by the intricate design of their hives, or the complex dance they perform to communicate the location of pollen sources - they seem to have no grasp of basic economic principles. The law of supply and demand eludes them altogether. They just don't get it. Maybe that's why they're so unmotivated.
In fact, this seems to be a property of the entire natural world. Take fish. Around 500 years ago, fishermen from Portugal and Spain started travelling to the Grand Banks off the coast of Newfoundland, Canada, to catch cod. Everything went swimmingly for hundreds of years. Cod became a staple food in Europe and North America, and in 1968 the total catch from the Grand Banks was 810,000 tons. Then the fish population began to decline. Scientists were brought in to determine the maximum allowable catch; but their models proved disastrously wrong, and in 1992 the most famous fishery in the world suddenly collapsed altogether, with the loss of 40,000 jobs.4 It still hasn't recovered - for some reason, the remaining fish don't seem to be able to reproduce at the same rate.
Once again, the law of supply and demand was flouted. The demand for fish was increasing - one author described the situation as "senseless, wild over fishing" - but the supply did not respond accordingly, or even adjust in a smooth manner.5 It just suddenly disappeared. Other fisheries around the world have similarly collapsed. It makes you wonder what critical but economically-illiterate species will be next to throw in the towel without warning.
Could it be us?
The carbon question.
The idea that the human race is approaching some kind of critical limit is probably premature. But if we take economics to be the study of "household rule," then we have certainly failed to keep our house - this planet - in order, and it's fair to say that as a species we are economically illiterate.
When neocla.s.sical economics was founded in the late 19th century, honey bees were still buzzing cheerfully about their work, and there were still plenty of fish in the sea. World population was only about a billion people, 15 per cent its current size. But even then, there were concerns that we were approaching fundamental limits of natural resources.
William Stanley Jevons first gained fame as an economist with his 1865 work The Coal Question, which drew attention to the fact that Britain's coal was running out. Britain had become the dominant world power by exploiting coal-based steam engine technology to drive its mines, factories, railways, and ships.6 As Jevons put it, coal "is the material energy of the country - the universal aid - the factor in everything we do. With coal almost any feat is possible or easy; without it we are thrown back into the laborious poverty of early times." The only problem with this "miraculous" substance, formed from plant matter hundreds of millions of years old, was its limited supply. Britain's growing economy meant that the demand for coal was increasing exponentially. The country was therefore effectively accelerating towards a stop sign. Coal would never run out completely, but it would become near-impossible to extract what was left. "In the increasing depth and difficulty of coal mining we shall meet that vague, but inevitable boundary that will stop our progress."
Jevons reviewed a number of alternatives including wind, tidal, and solar power, but no suitable subst.i.tute for coal was available. Furthermore, technological innovation would only have the effect of lowering costs, thus increasing consumption even further. This phenomenon, sometimes known as the Jevons Paradox, was demonstrated by the fact that while steam-engine technology had continuously been improved by inventions such as the governor, any savings due to efficiency were more than offset by higher use.
Geologists at the time estimated that Britain had coal reserves of about 90 billion tons. Jevons argued that, if the exponential growth trend continued, the reserves would be severely depleted within half a century. The result would be that Britain would lose its dominant position in the world economy to low-cost producers like the United States. Labour and capital would emigrate, and "all notions of manufacturing and maritime supremacy must then be relinquished."
The Coal Question was very influential, and was cited in Parliament. As it turned out, coal production did peak 48 years later, though at 292 million tons it was about half what Jevons had estimated. Total production has since dwindled to about 20 million tons, and in 2003 the UK imported more coal than it produced for the first time.7 Of course, this isn't a problem, because unknown to Jevons, it turned out that coal did have a viable subst.i.tute. Britain has shaken off its reliance on solar energy stored in British coal, and is now reliant on solar energy stored in North Sea oil fields, which saw their peak production in 1999 and are now in decline.
So what about the oil question? Oil is clearly as important now as coal was in 19th-century Britain, and it too is a limited resource. Will market forces help us calibrate the correct price for this vital commodity - or are we instead accelerating towards another "vague, but inevitable boundary"?
Closed economy.
People have been worried about "peak oil" for almost as long as we have been pumping it out of the ground. However, the fact that past predictions of supply exhaustion have been wrong does not inoculate us from it ever happening at all. It seems reasonable to suppose that we are approaching the later stages of our long relationship with carbon fuels; and as Jevons knew, our energy supplies are vital for our long-term future.8 Weirdly, though, mainstream economic theory has almost as little to say about oil as it does about fish, or bees, or anything outside the human sphere. That is one reason why prices for these things don't reflect their real worth. And it is also what supports the myth that the economy can grow forever.
Neocla.s.sical economics represents a mathematical model of human behaviour. As the systems scientist John D. Sterman observes: "The most important a.s.sumptions of a model are not in the equations, but what's not in them; not in the doc.u.mentation, but unstated; not in the variables on the computer screen, but in the blank s.p.a.ces around them."9 One of the things missing from neocla.s.sical economics - and it's a big one - is the rest of the planet. It completely neglects the fact that the human economy is embedded in the biosphere, which consists of living things (including bees and wheat), the products of living things (including honey and oil), and necessary resources for living things (like fresh water).
Traditionally, economists had recognised three factors of production - land, labour, and capital. In neocla.s.sical economics, though, only labour and capital have played an important role. Natural resources were either excluded from the list or paid lip-service to. In 1974, one "laureate" economist even said that "The world can, in effect, get along without natural resources" because human ingenuity and technology can always provide a subst.i.tute.10 Jevons' concerns about exponential growth in a world with limits were lost in the mix.
When natural resources were considered, they were a.s.sumed to be essentially infinite. "Minerals are inexhaustible and will never be depleted," wrote energy economist Morris Adelman in 1993. "A stream of investment creates additions to proved reserves, a very large in-ground inventory, constantly renewed as it is extracted.... How much was in the ground at the start and how much will be left at the end are unknown and irrelevant."11 Even in Mankiw's current textbook Principles of Economics, as Gilles Raveaud points out, natural resources and energy are left out of the chapter on economic growth. As a result, "they cannot become a problem - for economists, that is."12 Underlying this omission is a kind of denial. In his book Beyond Growth, the ecological economist Herman Daly relates a story about his work on a 1992 World Bank report whose topic was "Development and the Environment." An early draft contained a diagram of the relationship between the economy and the environment. It consisted only of "a square labelled 'economy,' with an arrow coming in labelled 'inputs' and an arrow going out labelled 'outputs' - nothing more." Daly suggested they should at least add a larger box around the one for the economy, to represent the environment. The following draft included the large box, but there was no label. Daly pointed out that "the larger box had to be labelled 'environment' or else it was merely decorative." In the next draft, the entire diagram was left out.13 It is as if economics has become so disembodied and detached from reality that it thinks it can do without the physical world.
The reason for this peculiar att.i.tude is rooted in the idea, derived from the work of Jevons et al., that the economy is a beautifully tuned machine-a closed system that operates according to perfectly calibrated laws. The machine will of course need fuel to keep it running, and oil to keep it lubricated, but these are freely available on the open market from a range of suppliers. The stock of these things in the ground is of no more concern to an economist than the stock of fuel is to the owner of a Lamborghini. They just know it's there.
Within this closed economic system, according to theory, the "law of supply and demand" correctly allocates resources to each of the machine's parts. However, while this "law" may be of some fuzzy use within the human economy, it breaks down completely at the boundaries of our economy with the natural world. The economy has no way to measure exactly how many fish are in the sea, or how much oil is in the ground. The costs of supply measure only the costs of extraction, which depend on a large number of factors, and do not smoothly adjust to give a measure of scarcity. Fishermen did not stop fishing the Grand Banks because it was too expensive - they stopped because one year there were no fish.
In fact, as Daly noted: "resource prices are to a large extent arbitrary - a fact that is seldom recognized."14 The supposedly sensitive price signals of the free market turn out to be not just mildly paradoxical in their behaviour, but completely distorted. A good ill.u.s.tration is provided by the price perambulations in the commodities market in 2008.
Super spike.
One of the irritating features of the "law of supply and demand" is that, when you really need it, it gives confusing answers. The more a CEO gets paid, the more he or she is in demand; but the more we need and use a valuable resource, the cheaper it may become. Or worse still, the price may just oscillate wildly for no apparent reason - as in 2008, when the price of crude oil increased by a factor three in a matter of months, before taking an equally sudden plunge.
At their peak, gasoline prices exceeded $4 a gallon in the United States, thus exacerbating the recessionary effects of the subprime mortgage crisis. The oil price increase also fed directly into higher prices for basic food supplies around the world. Some called it the worst food price inflation in history. It wasn't that people were finding it hard to fill their tanks - they were finding it hard to fill their stomachs.
As shown in Figure 17, the price of wheat also more than doubled in the twelve months from March 2007 to March 2008. Prices of bread, pasta, and tortillas all soared. There were a number of factors behind this increase, including poor harvests, increased demand from countries like China and India, and speculation; however, the oil shock contributed by pushing up fertiliser and transportation costs. Oil and wheat are now also linked, because when oil is expensive, farmers are motivated to use land to grow biofuels for energy instead of wheat for food.
The people most exposed to the price shock were those in developing countries who spend as much as 75 per cent of their income on food. Sudden spikes are especially damaging because these people have little access to short-term credit that would see them through. Countries including Mexico, Egypt, Indonesia, Pakistan, Cameroon, and Haiti experienced violent food riots. The director general of the International Food Policy Research Inst.i.tute, Joachim von Braun, called the crisis "a serious security issue."15 The World Bank warned that 100 million people were threatened with starvation.
Figure 17. Solid line shows the price of wheat, dashed line shows the price of oil, both normalised to a value of 100 at the start of 2000.16 It wasn't all doom and gloom, though. Some people did very well out of the price shock. One trader working for Citigroup was awarded a bonus of $100 million for his prescient timing of the oil market.17 Citigroup is now part-owned by the US government after being rescued in November 2008, and the $100 million bonus was described by a White House spokesman as "out of whack." The 100 million people threatened with starvation may have agreed.
Nor did the commodities price shock have much to do with impending shortages - the world didn't suddenly run out of oil in the spring of 2008. As with the subprime mortgage crisis, the main cause or enabling factor for the surge in prices can be traced back to the dismantling of economic safeguards.
People involved in the commodities business have always been able to enter into futures contracts, in which they agree to buy or sell a certain amount of a commodity in the future for a set price. This gives some protection against future price swings. The Commodity Futures Trading Commission (CFTC) in the US put limits on this kind of speculative trade. However, in the 1990s, a subsidiary of Goldman Sachs asked for an exemption so that it could hedge the risk of oil price fluctuations. The CFTC agreed, and extended the exemption to other banks.
The net effect of this deregulation, as with subprime mortgages, was the creation of another casino, except that everyone was betting on oil and other commodities instead of houses. Goldman Sachs and other banks persuaded large inst.i.tutional investors like pension funds and sovereign wealth funds to invest in commodity futures. Such funds tend to be long-term buy-and-hold investors, so the effect was to drive prices consistently higher. Between 2003 and 2008, the value of speculative oil future contracts grew by a factor of more than 20, until they added up to the equivalent of more than a billion barrels. A Goldman a.n.a.lyst whom the New York Times called an "oracle of oil" predicted a "super spike" in oil prices to $200 a barrel, and let it be known that he owned two hybrid cars.18 This fuelled interest even further. (Hint to investors: when Goldman Sachs comes over all green, check your investment portfolio.) The most telling moment of the crisis came in May 2008, when the CFTC investigated the reasons for the commodity price spike and concluded that prices were "being driven by powerful fundamental economic forces and the laws of supply and demand."19 Nothing, it seems, is beyond the explanatory abilities of the invisible hand. People around the world were dying of starvation as a direct result of the spike, but according to the CFTC there was nothing to investigate.
A year later, when prices had sunk back to a fraction of their peak, and with a new chairman working under the Obama administration, the CFTC changed its position and was once again considering caps on speculative activity. The truth is that markets or mainstream economic theory cannot tell us the correct price for oil, taking into account its future scarcity, any more than they know how to price a vanishing population of cod, or any other species or vital resource.
Selling futures.
Just as the price mechanism fails to calibrate the economy to its available natural resources - the inputs - so it fails to account for that arrow going in the other direction - the effects of pollution. Things like air or forests or oceans are not in the model, so whether we damage them or not doesn't register. Electricity from coal, with its high carbon emissions, is the same as electricity from solar power. The only time pollution does matter, according to the orthodox model, is when we pay people to clean it up, because that is a human activity that is part of the economy.
Pollution does not fit easily with the framework of "supply and demand" because while there is plenty of supply, there is not much demand - we just dump it where we can. Pollution and environmental damage therefore tend to be concentrated in poorer areas, such as developing countries. (As Larry Summers, who at the time was president of the World Bank, pointed out in a 1991 memo: "the economic logic behind dumping a load of toxic waste in the lowest-wage country is impeccable and we should face up to that."20) This acts as a hidden transfer of wealth from poor countries to rich countries.21 Other soft targets include common areas, such as the atmosphere or oceans.
The environment's ability to absorb pollutants may actually turn out to be a stronger constraint on the economy than energy supplies. According to one estimate, to avoid dangerously destabilising the climate system in the foreseeable future, we need to limit total c.u.mulative CO2 emissions to 1 trillion tonnes of carbon.22 Since the start of the industrial revolution we have emitted about half a trillion already, and at current rates we will spew out the next half trillion within 40 years. The amount of carbon in fossil fuel reserves exceeds that amount by several times, which implies we'll have to leave some in the ground.
Finally, another thing missing from neocla.s.sical economics - and again it's a big one - is the future. Because neocla.s.sical economics a.s.sumes that the economy is at or near equilibrium, it ignores the effect of time and concentrates on maximising utility in the short term. When future events are incorporated they are a.s.signed a discount rate, so they become less important the further away they are, and dwindle to insignificance after a few decades.23 But with non-renewable stocks, time does matter, because in the future there will be less of them. For "supply and demand" to be meaningful we should consider the demand of future generations, but there is no pricing mechanism in the market that will take this into account.
It is sometimes argued that this is not a concern because, when a resource such as oil runs out or needs to be replaced, then either a suitable alternative is found or human ingenuity invents one. The former Saudi oil minister Sheikh Yamani is famously attributed as saying, during the 1970s oil shock, that "The stone age didn't end because we ran out of stones." But Yamani was an oil salesman, and they aren't in the business of encouraging conservation. Alternatives do exist to fossil fuels, such as nuclear energy, solar power, new biofuels created from synthetic biology, and so on, but it is an open question whether any of these will be a subst.i.tute for the "miraculous" powers of the black stuff.
To summarise, mainstream economics - the kind taught in universities to undergraduate students, and the kind that dominates government policy and business strategy - does not take into account the true value of natural resources; the effects of pollution; or the rights of future generations. These oversights are reflected in the way that economic growth is measured using the gross domestic product.
Appropriate measures.