The Bubble Economy: Is there a way out?

The United States may not be the most admired country in the world today, as once it was. Bubble Economy book cover - top halfBut the economic decline of the US is still capable of doing much harm outside its borders as well as internally. Part of the underlying  problem is an extremely unrepresentative  government system of the US.  Congress is currently  dominated by entrenched special interests – “big money” —  that want to preserve the status quo. This reality makes it very difficult for the executive branch  to function day-to-day, still less respond creatively  to new challenges.

There is a weak economic  recovery under way. It is weak because most OECD  governments have been persuaded by conservative economists that government debt is now much too high and that government deficits have to be cut by cutting welfare spending.  As a direct consequence of austerity policies, unemployment is still too high, especially when under-employment and “drop outs” are taken into account. Youth unemployment is bad in the US, worse in Europe (except Germany) and truly terrible in the Mediterranean countries (Greece, Italy, Spain, Portugal).  Meanwhile, economic inequality has been growing , most workers (except the top 10 percent) have static or declining incomes,  but corporate profits have soared.  Corporations, especially the “tech” companies of Silicon Valley, are sitting on vast hoards of money, stashed mostly in off-shore banks to avoid taxes.

Neo-Keynesian economists, like Paul Krugman,  have been saying for years that austerity is a bad idea. They advocate more “stimulus” spending,  even at the expense of increasing the government  deficits. The problem with that approach, of course, is that there is no visible end to it.  Bigger deficits would (will) unquestionably increase the government debt burdens still more in the short run. The problem is that it is not clear why or how growth could cut those deficits in the future.

Limits of neo-classical economic theory

In short, the current neo-classical economic theory of growth has no good answers to the growth dilemma.  Political leaders have to promise more jobs but they have no tools (or ideas) for making it happen. The standard theory of growth, associated with the name of Robert Solow but now taught in every leading university, does not explain past growth, except in general terms of steadily increasing  “factor productivity”. Nobody knows exactly what this means, except  that capital and labor become more productive in some unexplained way, presumably related to the (automatic) accumulation of knowledge.  Mainstream economists assume  that  economic growth will continue in the future – after the present crisis – along the same trajectory  as in the past.

I think this is doubtful for at least two reasons. In the first place oil prices may rise, despite the appearance of plenty. This is because costs of maintaining  the old “legacy” fields (especially in the Middle East), are rising fast. Outside North America production is not increasing. I come back to this point later.

The other reason for skepticism about economic recovery ever getting back to “trend” is that the new technologies creating financial fortunes are not creating many jobs, at least in the US or Europe. In fact, some of those technologies (e.g. robotics, driverless cars) are destroying jobs. Meanwhile, there is evidence of “secular stagnation”. Meaning that the old Keynesian device of stimulating growth by deficit spending, is no longer working. This is probably because so many markets.  Spending on smart-phones, i-pads , games consoles and the like does not create enough new jobs to compensate for declining markets in second homes and third cars.

Meanwhile, low interest rates and anemic growth also mean that long-term investors, like pension funds and insurance companies (with $80 trillion in assets worldwide), need higher returns than they get from government bonds. Long-term Investors are forced to go for riskier bets, such as REITs (real-estate investment trusts) and hedge funds.  US-based hedge funds now manage over $2.5 trillion (up from $1.9 trillion in 2008), thanks to a history of outsized returns. Those returns were based on the use of leverage to exploit market imperfections, as well as underlying economic growth. But hedge fund returns are now declining. This is partly because the industry is so competitive that hedge funds are beginning to bet against each other; it is a zero-sum game. In any case,  they are not growing fast enough now to pay for their high management fees.

The elephant in the room

The “elephant in the room” is energy. Actually, I mean, useful energy,  such as flowing  water and fossil fuels. Economic growth since the 18th century (or longer) has been based on declining energy prices, thanks to the discovery of huge resources of fossil fuels,  first coal, and later petroleum and now gas.  The technologies – especially for electric power generation and  transportation — that were developed to exploit those resources are the pillars of today’s economy.  The existing material and financial wealth of the OECD countries, especially the US, is the happy result of resource discoveries and associated technologies.

But the age of fossil fuel-driven economic growth is almost certainly ending, if not already over. China is now the biggest carbon emitter, but the air pollution from burning coal is choking its cities, and the annual (unpaid) health and environmental cost of that air pollution alone is estimated by the World Bank at 9% of the Chinese GDP. That does not include the Chinese contribution to long term climate change.  Even the 7% growth rate China expects to achieve in the coming year (2015) cannot compensate for that cost.

The standard neoclassical theory  of economics  is deficient  because it neglects the essential role of  cheap (useful) energy as a driver of economic growth. The highest quality  supplies of these natural resources are now approaching  exhaustion, as indicated by the increase in the price of crude oil since  the 1980s. Many politicians and energy companies are making huge bets on “fracking” shale for oil and gas. But the technology is complex, high pressure water (plus chemical additives) is needed, and shale-gas wells don’t  produce for long.  Output per well declines at something like 60% per year,  so hundreds of thousands of wells are needed to provide the same output as a much smaller number of Texas or Saudi-Arabian oil wells in previous decades.

The energy returns on energy investments (EROI) that were over 100:1 in the 1930s are now down to about 20:1 globally and the “new” resources such as deep ocean drilling, Canadian tar sands and shale “fracking” exhibit EROIs less than 10:1 and closer to 4:1 in some cases. (Only the oil companies have exact figures). This means that oil and gas prices will almost certainly rise from current levels (near $100/bbl for oil) if there is any further supply problem in the Middle East. They will rise faster when (or if) economic growth accelerates again.

The other reason for doubting that fossil fuels can power the future global economy is climate change. Some people (such as Republicans and Polish coal miners) want to believe that climate change is a hoax or just a natural phenomenon.  The UN’s  International Panel on Climate Change (IPCC), consisting of reputable climate scientists  says otherwise. It is now far beyond reasonable doubt that human activity, mainly the combustion of carbon-based fuels, is the chief culprit. Global temperatures are rising, storms and floods are more frequent and more violent , glaciers are melting and the sea-level is rising. The visible effects of climate change are still modest in most countries, but the process, beyond a certain point, will be irreversible, at least on the time scale less than millennia.

So the world is confronted by a treble challenge: (1) the end of ultra-cheap fossil energy will drive increasing energy prices (consuming en ever greater share of economic surplus) and constituting a drag on growth, (2) climate change that threatens the very habitability of the Earth, starting with low-lying coastal areas and (3) high unemployment combined with underfunded pension funds, due to slow economic growth in the OECD countries. Yet faster economic growth, with business-as-usual, will entail still greater energy consumption. This  implies even more combustion of fossil fuels and the consequent environmental problems.

Is there any escape from this trap?

The short answer is yes.  The key to accelerating economic growth is to increase end-use efficiency while investing massively in low-carbon or non-carbon technologies. The global economy needs to replace most of its internal combustion engines by electric motors.  Governments (like the German government) could do this by subsidizing so-called “renewables” like solar power, wind power, geothermal power and so on.  Of course, government  subsidies  would increase their  deficits, which would be politically difficult at present. However  the private sector has the cash to make those investments now.

The costs of renewables have been declining fairly rapidly, as the technology improves, and economies of scale could accelerate this trend. Meanwhile the price of oil and natural gas will not decline and can may rise.

There is a profitable “gap” to be exploited by the finance  industry. What is needed is a method of “securitizing” investments in a variety of renewables, in a way analogous to the way mortgage-based bonds were securitized in the 1980s.  Investment banks like Goldman-Sachs should be able to figure out how to do this. Whoever does it will make a lot of money and do the world a favor at the same time. It will be a triple-win—a “trifecta”.

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The above builds on materials and analysis that are set out in detail in Ayres’ latest book, The Bubble Economy: Is Sustainable Growth Possible? By Robert U. Ayres. MIT Press, 388pp. ISBN 9780262027434 Published 27 June 2014

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About the author:

ayres bw smallRobert Ayres’s career has focused on the application of physical ideas, especially the laws of thermodynamics, to economics; a long-standing pioneering interest in material flows and transformations (Industrial Ecology or Industrial Metabolism); and most recently to challenging held ideas on the economic theory of growth.

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