On Neoclassical and Ecological Economics
Introduction
The idea that economics is a value-free science is outdated, to be generous. In my view, it never was value-free, because economic systems and policies always have and always will impact life. I understand why coming to this realization, as expressed, for example, in the sustainability movement and ecological economics, has taken time. I recognize that the free-market neoclassical economic paradigm, by virtue of its growth focus and associated incentives, has led to improved standards of living for a great many. There have been costs, however, that have not been properly accounted for and that have been accumulating. These costs are economic, ecological, social and psychological and impact even those who have become wealthier. Meanwhile, many have been left behind. And though it is unrealistic to say we can build political economic systems that provide justice, dignity and prosperity to every human being and safeguard each precious ecosystem, we owe it to the race to try. And we have been! We’ve evolved. The right of some humans to dominion over others was once accepted as a natural or ordained fact, and our political economic systems were built around that assumption. It was once legal to emit CFCs. We’ve come far. We have far to go. There is still great injustice. Our evolution continues. It is one of becoming more self-aware and thus more humane. The sustainability movement and ecological economics are manifestations of the evolution.
Reflections on neoclassical economics
I believe in free markets, and I believe that the neoclassical economic focus on growth has lifted the human race in many ways. I also believe that neoclassical economics has flaws that render it insufficient if not antithetical to sustainable human development in the 21st century and beyond. The assumptions underlying neoclassical economics permit injustice. The Invisible Hand both solves and creates problems, because humans are imperfect; even if acting in our own best interests is to the benefit of all, we are not entirely aware of what is in our own best interests. Growth too both solves and creates problems, because there are limits to growth (Meadows 2004). The idea that economics is value-free is lacking in self-awareness. At worst it reflects denial and exploitation. At best it reflects a need to see more evidence, via improved measurement and analytical techniques, of our economies’ impacts on life.
Capital markets participants, including asset managers, also often claim no responsibility. It is not their role to make judgments of right or wrong when selecting companies for investment. It might even be a violation of their fiduciary duty. Their clients have entrusted them with their savings and endowments with the primary goal of growing this money. The asset managers are at risk of not achieving this goal to the extent they are limiting their investment universe only to those companies doing all the right things by society and the environment. Politicians are also driven by the incentive to grow, and politicians make the rules of the political economy. The rules represent a high leverage point in any system, as described by Donella Meadows (Meadows, 1999). In a Machiavellian sense, the politicians determine the ends, which justify the means. The current rules allow economic actors to consider themselves value-free, to focus on profit first and foremost and to externalize as much cost as possible.
Growth in an of itself is not necessarily bad. Growth has become a problem in part because of how it is measured and in part because we are limited in both our knowledge and acknowledgement of the limits to growth. What is measured is done, and the strength of economies worldwide is summarized in a single metric, GDP. GDP growth is the goal of our global political economy, goals being another high leverage point (Meadows, 1999). This measure is limited, because it does not account for the externalities created by economic growth. These include waste, ecosystem degradation, displacement, impacts on social structures, impacts on physical and mental health, income inequality. It’s as though GDP counts all credits and less than all debits. And actually, some debits are counted on the credit side of the ledger, for example the time and money spent cleaning up an oil spill or keeping people in jail. GDP also excludes certain major sources of economic value-creation, including household labor, education, volunteer time, black markets and myriad ecosystem services. By not measuring these, it ensures that they are undervalued, underappreciated and often exploited. Neoclassical economics may be considered value-free only in this negative sense.
I see several reasons why GDP is used as the primary economic measure. One is that measuring and valuing externalities and things like household labor is more difficult than adding up consumer and business transactions. That is changing as we improve our measurement techniques, for example around environmental factors such as GHG emissions, soil quality, fish populations, etc. Still these are more difficult things to quantify, and humans tend to appreciate hard evidence. Another reason is that externalities are often slow-moving and difficult to perceive if one is not directly impacted. One may trust the IPCC’s evidence that the planet is warming, but a two-to-four-degree difference doesn’t seem like a lot and might even be desirable, depending on where one lives. And it sure isn’t changing most people’s day-to-day lives, which are filled with many more immediate concerns. Oil spills are tragic but eventually contained. However, the people of Flint and others unfortunately know too well the damage of externalities. Part of the issue is that damage can’t really be measured when what is damaged is invaluable. According to Pictet Asset Management, “In 2015, pollution killed nine million people—three times more than AIDS, tuberculosis and malaria combined (Pictet, 2018).”
Another reason GDP is used is that it has been successful. Take China. Measuring GDP growth rather than a metric that accounts for externalities has enabled China to become a world power in a short period of time, in part through industrialization and urbanization, like the US before it. Many in China have benefited. The median income has risen dramatically over the last two decades, lifting hundreds of millions out of poverty[1]. Had China (or the US or any other nation) been focused on a measure that accounted for externalities, growth would have been slower, and incomes would have risen less. It’s hard to argue. It’s also a fact that China has allocated hundreds of billions of dollars to cleaning up their polluted environments, including the smog hanging over their cities[2]. Whether it was worth taking the path of growth-at-any-expense-then-clean-up vs. slower, more mindful growth remains to be seen. In large part it is a question of timeframe. If fast results are the priority, accounting for externalities is often an impediment. If sustainable long-term growth is the priority, accounting for externalities means the difference between success and failure, because there are limits to growth.
This issue of timeframe is critical. It speaks to the political and economic structures in which GDP is so deeply embedded as the measure of value, and to the incentives that serve to maintain these structures. Capital markets fund a significant portion of economic activity. Capital markets players, such as asset managers, are paid based on the volume of activity they fund and/or the results of that activity, i.e. the performance of their investments. They are paid by individual and institutional investors seeking a return commensurate with the risk they are taking. In the vast majority of cases, performance is measured on an annual basis. Public companies report their results on a quarterly basis, and executive compensation is tied to the performance of their stocks, which gyrate based on quarterly results (and daily news). Given this structure, it is not difficult to understand why externalities have been largely ignored. Negative environmental and social impacts of businesses are typically felt over time horizons much longer than the periods over which corporate executives and asset managers are evaluated and paid. There is a tragedy of the commons at play. Why adopt best practices that eat into margins if one is not forced to? The competition won’t. Why spend money on climate change mitigation if one can’t see it or feel it and it’s not impacting one’s bottom line or compensation? Why invest in communities in the faraway places where one’s products are manufactured when one is not required to and, moreover, when that investment will reduce profits, thereby reducing returns to oneself, employees and investors? What is measured is done, and externalities are not yet properly accounted for.
GDP is the measure, and capital markets, for example the stock market, are dependent on growth. They are tied to GDP. As economic growth goes, so goes the stock market and the wealth of a great many individuals and institutions whose savings and endowments are invested in the stock market. A politician seeking election or reelection will do themselves irreparable harm to stand in the way of GDP growth. Internalizing externalities would add enormous costs to businesses and stunt growth, at least in the short term. And like asset managers, politicians are incentivized to focus on the short term. The frequency of election cycles discourages long-term thinking. Elections are funded by people and institutions of diverse interests that for all the reasons discussed above have difficulty looking beyond those interests to a common goal of long-term sustainable growth for entire political economic systems. This is due in part to a lack of awareness of our place within and impact on those systems.
Awareness needs to be raised, and it is, slowly. Our ability to measure the environmental and social impacts of businesses is improving. That impact is influencing asset managers’ investment decisions and being factored into corporate executive incentive structures. The US political system is lagging in terms of needed changes to its structure, and the current administration is taking steps back in terms of social and environmental justice, in my view. However, regulation related to environmental protection has been on the rise globally[3]. It is happening slowly, but we as a race are becoming more conscious. We are evolving from a linear to a systems mindset, from neoclassical to ecological economic thinking. A look at a few of the basic assumptions of neoclassical economics is informative.
· Producers seek to maximize profit. I believe this is true for the vast majority. The primary measure used to evaluate businesses in capital markets is profit. Profit is rewarded, so profit is sought. Profit is exaggerated, because externalities are not part of the calculation. However, the world is waking up to this misalignment. The EU directive on non-financial disclosure is one piece of evidence[4]. To the extent non-financial information is reported, it will be considered by executives and investors. If this information is linked to operational and financial performance, it will impact profits and stock prices. If it impacts profits and stock prices, it will influence executive compensation. If it influences executive compensation, executives will strive for performance on the triple bottom line, not just profit.
· Consumers seek to maximize utility. Utility means getting the best bang for the buck. It does not mean, in the minds of most consumers, consuming sustainably within the context of limits to growth. We believe we act rationally in our own best interests by focusing on price. But here there is a lack of self-awareness, because this behavior is irrational to the extent it ignores the non-financial impacts of our consumption on the systems in which we are embedded. It doesn’t make us terrible people. It’s not easy to sense or understand the externalities that occur, for example, across the world where much of our electronics and appliances are made. We have enough to worry about day-to-day! But part of the issue is information, and the human race has entered the golden age of information transfer. Mobile internet is reaching countless more millions of emerging market consumers every year. Detailed product information can be obtained with the scanning of QR codes and any number of apps. Supply chain transparency is increasing. People from China to Nigeria to Canada can share their stories on YouTube with virtually no barrier. Consumers have more information and are becoming more conscious in their consumption choices. Price will always be a critical factor in these decisions, but the more externalities are accounted for as costs, the more sustainable products will start to differentiate themselves in this regard as well. And perhaps as information transfer continues to shrink the globe, we will become more conscious of our place in global systems. Perhaps that will engender a greater sense of global community.
· All act in their own best interests, and society benefits. Donella Meadows describes the second highest leverage point in any system as, “The mindset or paradigm out of which the system—it’s goals, structures, delays, parameters—arises (Meadows, 1999).” The Invisible Hand is the mindset of neoclassical economics. It gives GDP as the measure of growth and the primary goal all its power. It allows people to believe that GDP growth is right, because it tells us that any negative consequences of growth will be dealt with by free markets through pricing and technological development. Maybe it’s true. Certainly, the Invisible Hand is at work in the sustainability movement. Humans are reacting to more information about the environmental and social impacts of our political economies and demanding that these impacts be priced in. Smart people all over the world are racing to develop the technology that may save us from environmental collapse. We are harnessing the sun! Renewable energy is now cheaper than fossil fuel energy in some places. This is human evolution and the Invisible Hand at its finest. But the markets are not entirely free. The Invisible Hand is both helped and hindered by other appendages of the political economic system. Subsidies, for example, are in direct opposition to it and often skew towards industries responsible for significant externalities. For example, according to the IMF, direct and indirect fossil fuel subsidies total about $5 trillion per year, or 6.5% of global GDP (Coady et al., 2015).
Perhaps the Invisible Hand is the solution. Perhaps the crisis of externalities has been caused by limitations to its proper function, including the use of subsidies. One could argue, if the playing field was level, we would be much farther along in the evolution from fossil fuels to renewables. Removing fossil fuel subsidies in any size, however, would create a great deal of disruption to the status quo. Fuel prices would increase dramatically. Industries would be upended overnight. Likely more people would lose jobs than gain them, at least in the short term. Growth would stall, and everyone compensated or seeking to get elected or reelected over the next couple of years would lose out. There may be benefits long-term, but not enough people in industry or in politics are incentivized to consider timeframes beyond a year or a few years at most. Incentives need to change. The metrics we use to evaluate the growth and health of economies and businesses need to change. Externalities need to be internalized. This would require command and control in the form of new accounting regulations related to non-financial disclosure but at the same time would free the Invisible Hand to further the technical advancements that are fueling the continued human evolution.
The principal is simple and humane. All costs need to be accounted for, including environmental and social costs. Corporates and consumers have resisted this in part out of greed, in part out of fear of disruption, in part out of just trying to live our lives day-to-day. One could argue it’s taken too long, but improving the means to measure these impacts has required time. Techniques are getting better every day. If people want evidence, we can now provide it. Not all the data is as straightforward as 2+2=4, but some of it is and that which is not is still evident to anyone with an open mind and no agenda, especially as externalities creep into our daily lives. As the means to measure impacts get better, externalities are accounted for as costs that impact earnings and stock prices. We are getting closer to knowing the true value of businesses. We are creating the incentives for businesses to be part of the evolution or be left behind. Most importantly, we are realizing our impact on the systems in which we are embedded. We are realizing our connections, as consumers and corporations, to our communities, including the global community. Many of us own things made in Asia. We are by definition part of the same system. Would we deny a connection? By realizing connections, we become more self-aware. We realize that we are part of a bigger Self and that the rational thing to do is to protect that Self. We allow the Invisible Hand to function on a higher plane.
Political incentives also need to change if we are to progress. Campaign finance for congressional elections is a primary issue. It gums the works of the Invisible Hand. Winning campaigns is largely dependent on money, and so congresspersons are largely dependent on donors. Indeed, according to Lawrence Lessig in Republic, Lost (2011), congresspersons spend 30-70% of their time raising money. Large donors make a big difference, and so their interests are prioritized. Given this, and given two-year election cycles, how can we expect congress to focus on long-term issues?
What if all donations were anonymous and capped at a reasonable number, say $1000? What if the primary way congress sought capital was by each having a YouTube channel, social media presence and a website that contained the following: their principals, their views on different issues clearly spelled out, their backgrounds, voting history, a track record (provided by a third party) of the effectiveness of the policies they have voted for, their affiliations, a blog on what they are working on currently. Allow people to vote, through the websites with a single click, on the bills going through congress. These votes would not have an impact on passage, but they would make it evident whether congresspersons are representing their constituents in general or only special interests. What I’m getting at here is transparency. Require them to put themselves out there. Show data on the financial, social and environmental impacts of the policies they have drafted or supported. Create a bonus pool out of a portion of all donations and give them bonuses for positive impacts, bonuses that vest over multiple years and have clawbacks should the performance decline over the period. Part of the issue, according to Lessig, is that congresspersons are underpaid and so incentivized to supplement their incomes. So, what would be the performance measures? Perhaps things that most human beings agree are important, measures of income inequality, education and prosperity. Replace GDP with GPI, or use them side-by-side, and link political compensation to both. Make it so that the number of people positively impacted by policy matters. Change the goals of the political economy so that they account for externalities, and watch behavior change throughout the system. Watch government funds get funneled to projects with longer-term, more equitable goals than pleasing certain donors. We don’t need to plan the economy, increase regulation, increase the size of the government or look more closely over the shoulder of every person and business. We just need to change a couple of rules and goals using common sense, some data on externalities and some heart as the justification.
To me, it’s a matter of time. Change is hard, and people and institutions will always resist, especially when they benefit from the status quo. It’s sad that we have allowed ourselves and our businesses to ignore externalities and common sense to the point of near and present danger. But perhaps it’s natural.
Conclusion: reflections on psychology and evolution
Transpersonal psychologist Stanislov Grof described the life of individuals as occurring in three major phases. The first, with respect to individuals, occurs in the womb and for a short time thereafter and is characterized by a feeling of unity with the mother. Throughout the second, which comprises the majority of our lives, we are striving to establish our individual identities. This is a very difficult process, and we are plagued with insecurity along the way even to the point of self-destructive behaviors; but it is all quite natural and necessary to our process of self-realization. In the third phase we come to understand that this process has actually been one of Self-realization, the realization that we are individuals in a greater whole, connected rather than entirely separate. In many ways, this third phase is a return to the first.
This theory can be applied to humanity as a whole, and it is my hope and belief that humanity is in the third phase or entering it. The sustainability movement is the evidence. For millennia we were one with the earth. We understood that to hurt it was to hurt ourselves. Then we grew up and sought to make our mark, forgetting our connections and exploiting the earth. Now, in large part through growing pains, many have realized that exploitation cannot continue, because it is suicide. More than averting disaster, this process of Self-realization has the potential to lead humanity to a higher plane of existence. That is my belief. Sooner or later, we will wake up in critical mass to the idea that we need to tweak the goals of our system in order to continue our evolution.
References
1. Meadows, Meadows, Randers (2004). Limits to Growth: The 30 Year Update. Chelsea Green Publishing.
2. Meadows, Donella (1999). Leverage Points: Places to Intervene in a System. The Sustainability Institute
3. Pictet Asset Management (2018). Global Environmental Opportunities: transforming sustainable investment. Pictet Asset Management.
4. Coady, et al. (2015). How Large Are Global Energy Subsidies? International Monetary Fund
5. Lessig, Lawrence (2011). Republic, Lost. Twelve.
6. The World Bank: https://data.worldbank.org/country/china
8. Generation Asset Management. 2017 Sustainability Trends Report.
[1] The World Bank: https://data.worldbank.org/country/china
[2] Reuters: https://www.reuters.com/article/us-china-energy-renewables/china-to-plow-361-billion-into-renewable-fuel-by-2020-idUSKBN14P06P
[3] Generation Asset Management: 2017 Sustainability Trends Report
[4] https://ec.europa.eu/info/business-economy-euro/company-reporting-and-auditing/company-reporting/non-financial-reporting_en