The mystery of economic growth

[This blog is based on a letter I was invited to write by the President of The Institute of International and European Affairs (IIEA), Brendan Halligan, to its then newly appointed Chief Economist, Dan O’Brien.]

The origins of this note stem back to repeated requests from Brendan in 2011 to elaborate on ideas initially expressed in email correspondence, which followed a series of related events which I helped organise at the IIEA.

Any originality I can claim is only in the putting together of two areas of keen personal interest, energy and banking, while the real credit goes to the economists pioneering their respective fields. Although I am taking advantage of fortuitous timing. The exercise of preparing this note required reflecting on and documenting a personal journey of discovery over the past decade. The latter served as a useful reference to the several dozen important pieces of the puzzle, which I’ll attempt to summarise below.

The most significant aspect of the journey that must be highlighted is the ending of three secular debates that I’ve observed raging over the past decade, although their origins are much older.

For the purpose of this summary, they will be the starting point for what follows:

• Anthropogenic Climate Change: it is real and we are causing it [IPCC AR5, 2014]
• The end of cheap oil: conventional crude oil peaked in 2006 [IEA, 2011]
• Banks have the power to create and allocate credit and are not simply neutral intermediaries between savers and borrowers [Bank of England, 2014]

Modern society is as fraught with conflicts of secular dogma as was medieval society with religious dogma. To acquire a new world view, a change of paradigm, is comparable to a religious experience.

Professor Steve Cotgrove (1982)

However, accepting the above, the last point in particular, has profound implications for conventional neo-classical economic theory, and more importantly, its proponents. The vast majority of economists, certainly any in positions of authority with regard to setting economic policy, are orthodox neo-classical economists. What Professor Richard Werner, in the introduction to his ground-breaking book, New Paradigm in Macroeconomics (2005), describes as the dominant paradigm. It is dissatisfaction with both the explanatory and predictive power of this theory which has led to the formation of institutions such as INET and ISIPE.

I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world. In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not. Of course, from a longer view, macroeconomists let policy makers down much earlier, because they did not provide policymakers with rules to avoid the circumstances that led to the global financial meltdown.

Narayana Kocherlakota, President, Federal Reserve Bank of Minneapolis (2009)

This paper uses the lens of macro-economic history and builds on our earlier work to present a sharper picture of the role of credit in the business cycle. A primary challenge going forward is to redesign monetary and financial regimes to mitigate systemic crises (Turner 2009). Our results also add clarity at a time when it is still being argued that “[e]mpirically, the profession has not settled the question of how fast recovery occurs after financial recessions” (Brunnermeier and Sannikov 2012) and when, beyond academe, political debate rages over what the recovery “ought” to look like.

Jordà, Schularick, Taylor (2013)

The financial crisis presents both an ethical and an intellectual challenge to economics, and an opportunity to reform its study by grounding it more solidly in reality.

Colander et al (2009)

The End of Banking Fairy Tales

The publication last month (Mar 2014) by the Bank of England of their papers on money in the modern economy (McLeay et al. 2014b; McLeay et al. 2014a) finally consigns to the history books the notion that banks are neutral intermediaries in the economy, connecting borrowers with lenders. The power to create and allocate credit is arguably the greatest socially constructed power man has ever bestowed on another (Graeber 2011).

This admission by the Bank of England gives enormous credence to the work of Professors Richard Werner at the University of Southampton, and Steve Keen at the University of Western Sydney. Both of whom have laboured long and hard to disprove a fiction that economists and bankers have long upheld. They have also been ardent critics of neo-classical economic theory, Walrasian equilibrium theory in particular. Most importantly, both appear to have independently developed, although finding common source in the work of Minsky, disaggregated credit models for economic growth.

Werner argues in his disaggregated credit model that economic growth is driven by new credit creation, but only by that which is invested in increasing the productive capacity of the economy, i.e. new credit created for asset speculation only fuels asset price inflation and does not lead to long-term economic growth. The power to create and allocate credit, the defining characteristic of a bank, is a social good that should be regulated accordingly (Werner 1997; Werner 2005; Bezemer & Werner 2009; Werner 2012). Werner also argues that central bank intervention to control the quantity of money in circulation, Quantitative Easing (or its many other names (Werner 2010, p.9)), can only be effective if directed towards the productive economy, and the power to create and allocate credit is a social good that should not be held exclusively by private banks (Werner 1997; Werner 2005; Bezemer & Werner 2009; Werner 2012). The figures below show the correlation between GDP and credit created for increasing the productive capacity of the economy in Japan and the Czech Republic.

Figure 1 Explaining Growth: driven by credit creation for GDP transactions (CR), not interest rates or fiscal policy; Werner (2010, p.32)

Figure 2 lagged real-sector bank credit constraints and nominal output growth in the Czech Republic, 1995-2007 (Bezemer & Werner 2009, p.26)

Keen cites Minsky: if we are to fully comprehend how market economies really behave, “it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself.” (Minsky, 1982a, p. 5) Keen goes on to state that general equilibrium theory is not such a theory. By combining a Graziani model of a pure credit economy with a Goodwin growth cycle model of Minsky’s Financial Instability Hypothesis (FIH), Keen was able to recreate the Great Depression and the Great Recession in his modelling environment (Keen 2013), shown in Figures 3 and 4 below.

Elsewhere, Keen (2011a) argues that in a credit-based economy, there are three sources of aggregate demand, and three ways in which this demand is expended:

1. Demand from income earned by selling goods and services, which primarily finances consumption;
2. Demand from rising entrepreneurial debt, which primarily finances investment; and
3. Demand from rising Ponzi debt, which primarily finances the purchase of existing assets.

“Schumpeter’s and Minsky’s perspectives thus enable us to integrate credit, asset markets and disequilibrium analysis into an alternative macroeconomics. In a credit economy, aggregate demand is the sum of income plus the change in debt, and this demand is expended on both goods and services and purchases of existing assets. Debt therefore has both positive and negative connotations for the economy: it finances the expansion of economic activity via innovation and investment, but it can also cause asset bubbles and eventually, an economic crisis if too much of this debt is directed to Ponzi finance.”

Income + Change in Debt = Output (GDP) + Net Asset Sales (Keen 2011b, p.30)[1]

Figure 3 Cycles in real output diminish, followed by a sudden change to declining output

Figure 4 Apparent economic tranquility gives way to a deflationary collapse. (Keen 2013, p.229)

Keen’s work is compelling, not only because of its explanatory power, but also by virtue of its rigorous employment of the Scientific Method, an inductive problem solving approach. Werner makes the point that this is contrary to the deductive approach used for the development of much neo-classical economic theory.

Adair Turner, directly influenced by the work of Werner and Minsky (Credit creation and social optimality ECOBATE 2011), has picked up this issue with both hands and run with it. He is bringing this message to the mainstream and hopefully will be instrumental in driving the reform that this realisation makes essential: credit creation and allocation is a social good that must be regulated accordingly; and for economic growth, it has to be directed towards real entrepreneurial activity (Schumpeter) which increases the productive capacity of the economy (Macroeconomic Policy and Economic Stability INET Hong Kong 2013).

While such a policy can be adopted to prevent future credit crises, we must also contend with the challenge of emerging from our most recent credit crisis, the very task set by the EC which prompts this note. Koo’s work on Japan and Balance Sheet Recessions is instructive in this regard (Koo 2011; Eggertsson & Krugman 2012). Koo argues that in the wake of a nation-wide asset price bubble collapse, a large portion of the private sector switches from profit maximisation to debt minimisation, and this change in dynamic has a depressing effect on aggregate demand: The first casualty of this shift to debt minimization is monetary policy. Koo argues that it is essential that the drop in aggregate demand in the private sector must be filled by government spending during a balance-sheet recession, deficit bedamned (not quite, he argues that the counterfactual would show that it costs a lot less than austerity in the long run).

Koo pays special attention to the peculiar pro-cyclical situation in the EC, where investors can chase higher bond yields without exchange rate risk. Koo recommends preventing non-nationals from buying government bonds to avoid this problem:

‘Ending the eurozone’s crisis will require a two-pronged approach. First, international bodies like the EU and ECB need to declare that member countries experiencing balance sheet recessions must implement and maintain fiscal stimulus to support the economy until private sector balance sheets are repaired. Second, eurozone member nations must declare that in ten years they will prohibit the sale of government debt to anyone other than their own nationals.’ (Koo, 2011, p.31)

Figure 5 Ireland in Balance Sheet Recession: Massive Increase in Private Savings after the Bubble (Koo 2011, p.29)

Koo goes on to argue that ‘how the money is spent is largely irrelevant during a balance sheet recession: the important thing is that the money be spent.’(ibid, p.33) Werner and Keen would qualify this, that it must be spent on increasing the productive capacity of the economy. I will argue further below, that this needs to be qualified further still, as increasing the productive capacity of the economy can only be done through improving energy efficiency.

It is such thinking that leads Adair Turner to the conclusion that ‘We should therefore cease treating overt money finance [OMF] as a taboo subject.’ (Turner 2013, p.41) Although he also notes: ‘Within the Eurozone political construct, the case for keeping OMF in the taboo box remains strong’ (ibid, p. 38)

The End of Cheap Oil

Certain theories in physical science are so pervasively accepted as to be called laws, such as the law of gravity. First among them are Newton’s laws of motion and the conservation of energy, and Lavoisier’s law of conservation of mass, which Einstein brought together in his famous theory of relativity and E = mc² formula.

Second among them are the laws of thermodynamics, the second of which states that in a closed system, entropy always increases. We never observe the broken pieces of the vase assembling themselves from the floor back onto the table, only the reverse. Thus we take low entropy fossil fuels and, in the process of extracting useful energy, we produce high entropy carbon dioxide in the atmosphere.

It is such laws that underpin the science of climate change. The particular problem solving methodology, the Scientific Method, underpins the modern industrial age, and arguably defines progress. The scientific definition of energy is the ability to do work (measured in joules). The rate at which work is done defines power (measured in watts). The chart below demonstrates the sources and uses of energy in Ireland in 2012 (SEAI 2013, p.5). The average human needs about 2000 Calories per day, which is equivalent to about 100 watts (think of a human’s average power requirement to get up and move around, think, etc, as the same as that of an old 100 watt light bulb, with an efficiency not much dissimilar).

Figure 6 Overall Energy Flow in Ireland – 2012 (SEAI, ktoe: kilo tonne oil equivalent)

However, on a per-capita basis, each person in this country requires an additional 3,800 watts of power to enjoy the energy services that make our lives profoundly different from the 1 billion people in the world who have no access to modern energy. That’s nearly 40 times more than we need just to live. Yet, it only costs about 5% of GDP. Ireland enjoys a GDP of ~€160 bn because of the access it has to physical power, both the energy and the technology to transform it. It is a simple physical fact that without it, the economy would look like that of the many countries which don’t enjoy such access (IMF 2011).

Curiously, there is an almost perfect correlation between GDP and electrical power consumption. Yet attempts to develop a theory of causation appear to exist only on the fringes of economics, promoted by physical scientists or hybrid physicist-economists (Lindenberger & Kümmel 2011; Ayres et al. 2013; Warr & Ayres 2010; Ayres & Voudouris 2014; Ozturk 2010), with the notable exception of Georgescu-Roegen: The Entropy Law and the Economic Process (1971). While our political class appear acutely aware of the importance of energy. Simply consider the impact of Churchill’s decision to convert the British Navy from coal to oil (Yergin 2012; Barr 2011), not to mention more controversial recent examples (Friedrichs 2010; Klare 2009; Commission on Energy & Geopolitics 2014).

So, while it is a truism to say that without physical power, there is no economy, there is nothing in the canon of mainstream economic theory to account for its role in the economy. Conventional economic theory assumes output contribution is equivalent to input cost share with perfect substitutability. If that were the case, debates about solving climate change by eliminating the use of fossil fuels, oil in particular, would be moot, rather than very divisive, which unfortunately they are (Moe 2010).

Lindenberger et al argue that such assumptions do not stand up to empirical evidence. Recalling one of the comments at our meeting regarding standard economic growth theory, it uses a modified Cobb-Douglas production function, the Solow-Swan exogenous growth model, and attempts to explain economic growth through the accumulation of labour and capital and the ‘unknown quantity’, Total Factor Productivity, or ‘Factor-X’ as Brendan recalled it.

A theory that is forced to place the vast majority of its explanative power into something that it cannot explain is hardly credible. Yet it’s taught in every undergraduate economics programme.

Figure 7 US GDP 1900-2000, Actual vs. 3-factor Cobb-Douglas function

Having developed a modified production function which both incorporates energy and permits output elasticities to be set empirically, Lindenberger et al argue that ‘energy and its conversion into physical work accounts for most of the growth that mainstream economics attributes to “technological progress” and related concepts. It decisively determines the economic state of nations.’ (2011, p.6015) Ayres & Warr make the distinction between useful and non-useful energy, of which only the useful component is productive. Thus, ‘with this formulation the efficiency of converting energy inputs into useful work is a key driver of growth.’ (Ayres et al. 2013, p.83). They conclude ‘the primary drivers of growth are capital deepening, and the increasing supply of energy or “useful work”.’ (ibid)

The ecologist and mathematician Alfred Lotka (Lotka-Volterra model) proposed a modification to Darwin’s theory of evolution. He proposed that ‘natural selection’ is best understood as a struggle among organisms for energy. Thus he suggested that ‘fittest’ in the general Darwinian sense can be refined and specified more precisely as an ability to capture and use energy at a rate and efficiency more effective than another. The work presented above suggests we might understand productivity in a similar sense, so that we can refine our understanding of Total Factor Productivity to one of physical power output and energy efficiency (which specifies the amount of gross input energy required).

Because of its incommensurability, the pioneering work introduced above is likely to be dismissed by proponents of the dominant paradigm. However, the role of triple digit price oil on recent economic performance should still feature more prominently in the discourse on the Great Recession, particularly in light of experience from the Seventies’ oil shocks. The run up in the oil price to its peak in the summer of 2008 has caught the attention of several macroeconomists who study the role of oil in the economy, some since those oil shocks (Hamilton 2009; Hamilton 2011; Serletis & Elder 2011; Kilian & Vigfusson 2012).

Notably, the IMF attempted to put the issue on the political agenda in 2011 when it published research, now three years ago, in Chapter 3 of its April World Economic Outlook: Oil Scarcity, Growth, and Global Imbalances (IMF 2011). Michael Kumhof, the economist at the IMF who built and operates the Dynamic Stochastic General Equilibrium (DSGE) model (2010), incorporated the work of Lindenberger et al into his to look at the macroeconomic impact of sustained high oil prices. Kumhof has presented in Dublin twice, most recently at the IIEA (video, slides).

Jeff Rubin, former Chief Economist at CIBC, is the author of ‘The End of Growth’ (2012). I’d recommend watching the interview with him at this link for an introduction to his thesis: Jeffrey Rubin On Why High Oil Prices Stop Growth. He spoke in Cork at the ASPO6 conference I organised in 2007.

Clearly such a thesis would not be palatable to the EC, nor indeed the wider European and global society. The UK ERC’s exhaustive analysis of the subject of oil depletion is worthy of study (Miller et al. 2009), although, the IEA’s admission of a peak in 2006 is the crucial point. The outstanding question is what impact that will have on the long-term growth prospects for Europe, which the work of Lindenberger et al suggest, and as Rubin argues, could spell the end of economic growth as we’ve come to know it.

Figure 8 World crude oil production (in million barrels per day), from (Kumhof & Muir 2014, p.2)

The end of growth?

In attempting to synthesise a theory of economic growth which properly accounts for both the role of credit and physical power (energy sources and the technologies to harness them – efficiency), it’s important to understand the primacy of energy in the equation. Credit is a social construct, we can, and have, created as much as we want of it, within the parameters of that construct (note Soros’ theory of reflexivity). As Keen and Werner argue, the rate of economic growth will be determined by the rate of new credit creation applied to increasing the productive capacity of the economy. Increasing the productive capacity of the economy requires increasing the physical power supply to the economy, assuming no proportional increase in efficiency. Thus, if this theory is correct, new credit will only drive economic growth when physical power is not the limiting factor. If available low-entropy energy is the limiting factor, then that investment must be directed towards increased energy efficiency.

Per the law of conservation of energy, it is neither created nor destroyed, simply converted from one form to another, with increasing entropy. To use a finance analogy, as a global society, we need to transition from powering that society on our savings (fossil fuels are millions of years of sunlight accumulated into a very low-entropy form) to doing it on our current income, the constant flow of energy from the sun (relatively higher entropy). To extend the analogy, credit allocation determines the direction and pace of the economy, but only when there’s an engine and fuel being supplied to it to provide power.

In order for that transition to happen smoothly, the physical power we derive from fossil fuels has to be replaced with low-carbon renewables. Recalling Figure 6 above, Ireland’s average power consumption is 17,550 MW. Installed electricity power generation is 7,165 MW of conventional and 2,000 MW of renewables (EirGrid 2014). The renewable figure needs to double to reach our 40% target for renewable electricity by 2020. As typical capacity factors on renewable technologies are a third (or less) of their rated output, Ireland would require 17,550 turbines with nameplate capacity of 3MW (52,650 MW) to generate our current level of power consumption, a 25 fold increase over current levels (a very simplified calculation, large efficiency gains can be made by powering transport electrically). In light of the current protests against development of wind farms in Ireland, the scale of the challenge comes into acute perspective.

Thus, with the advent of a peaking in global conventional oil supply, and any future growth in liquid fuels coming from environmentally unfriendly non-conventionals, such as Canadian tar sands and fracking, we may be entering into a period of energy constrained economic growth (McGlade & Ekins 2014). The transition to electric vehicles is being spurred by rising oil prices and climate change policies, increasing the rate of penetration to off-set higher oil prices suggests a need for innovative policy instruments to accelerate the transition.

Having already introduced two sets of unorthodox economists attempting to introduce a new economic paradigm, I will conclude by introducing a third. As was pointed out in our discussion, there’s more to life than GDP. The discourse on alternatives to the ‘growth fetish’ stem all the way back to the Club of Rome’s Limits to Growth, first published by Meadows et al in 1972 (2004), and many non-orthodox economists denounce it in no uncertain terms (Jackson 2009), particularly those within the environmental and ecological economic domain, led by economists such as Professor Herman Daly (Daly & Farley 2010; Daly & Townsend 1993). They argue that a sustainable economy is one that doesn’t grow, but exists in dynamic equilibrium, living within the limits set by the natural carrying capacity of the ecosystem, governed by the laws of thermodynamics.

Figure 9 foreword by Herman Daly extracted from (Czech 2013)

By proposing that we give up ambitions for economic growth, either for ecological reasons or because they are imposed by energy limits, I haven’t forgotten your point about debt sustainability (see my note to Prof FitzGerald at the ESRI below), nor have I forgotten about the several billion other people on this planet with very legitimate ambitions to live the lifestyle we enjoy every day. The idea that we might choose to destroy our ecosystem so that we might repay our debts has a curious resonance in a country that has experienced the record levels of emigration and economic hardship seen in Ireland since the banking crisis. History is replete with such tales (Diamond 2013).

Given the theories on credit creation presented above, the obligation to repay loans which had no social benefit, indeed, quite the contrary, simply inflated assets prices and concentrated wealth, needs to be legitimately questioned. Indeed, there are those who question whether or not a credit-based fiat money system is socially optimal at all (Benes & Kumhof 2012), specifically because of its requirement for perpetual economic growth (Lietaer et al. 2012).

However, in the absence of economic growth, the focus of public attention would undoubtedly switch to the thorny and politically uncomfortable topic of distribution – the heart of the real challenge we face.

Political Economy of Economic Theory – Is a new paradigm possible?

Thomas Kuhn (1962) argued in his account of the growth of scientific knowledge that researchers operate within generally accepted ‘paradigms’. The process of shifting to a new, more advanced paradigm is not necessarily smooth, as the old paradigm is supported by those who have made a career out of its propagation. Lakatos (1970) argued that defenders of the ‘old paradigm’ (defined by him as a research programme) would adopt ‘immunisation’ strategies, such as the introduction of ad hoc assumptions, to try to ‘protect’ their ‘core’ beliefs against contrary empirical evidence — a practice already condemned by Karl Popper (1968) as unscientific. As the number of inexplicable facts rises (‘anomalies’, in Kuhn’s terminology), the call for a new paradigm should become louder. The new paradigm must be able to explain at least as much as the previous approach and in addition also account for the many ‘anomalies’ of the old paradigm, thereby encompassing it. A new paradigm must rise to the challenge of explaining at least the seven central empirical puzzles in macro- and monetary economics… (1) The apparent velocity decline; (2) the identification problem of money, and (3) of what makes banks special (while incorporating this feature appropriately into a macroeconomic model); (4) why there are recurring banking crises; (5) the ineffectiveness of over a decade of interest rate reductions in stimulating growth in Japan (and a growing number of other countries), and, more generally, the link between interest rates and growth; (6) the success of the German and East Asian economic models, despite widespread government intervention and use of non-market mechanisms; and (7) the ineffectiveness of supply-side re- forms (deregulation, liberalization, privatization) in enhancing economic performance in Japan and other countries.

from Werner (2012)

Thomas Kuhn famously described a paradigm as a coherent pattern of research organized around commonly shared theoretical propositions and models, and a paradigm shift or ‘revolution’ as the emergence of an alternative framework of common and shared analysis. A paradigm is, however, sufficiently open-ended ‘to leave all sorts of problems for the redefined group of practitioners to resolve’

(Kuhn, 1962, p. 10) from Helm (2005)

‘a new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.’

Max Planck (quoted by Kuhn)

To Werner’s seven anomalies above, I would add the role of energy in the economy. I came to economics late in life and have learned most of what I know through the eyes of critics of neo-classical theory. Scientists are trained sceptics, theories are only as good as the empirical evidence that supports them, and the brief discussion above highlights several instances where neo-classical economic theory can neither explain nor predict many observed economic phenomenon – the most dramatic example of which being the recent Great Recession, which prompts this work.

Professor James Watson, who shared the Nobel Prize with Crick in 1962 for elucidating the double-helix structure of DNA, has lectured on how the discovery was made. He describes in detail the work of several notable scientists which had just become available before their discovery and how, when they looked at it together, it was obvious what the structure had to be. In contrast, when Einstein published his theory of relativity in 1915, it was sufficiently ground breaking that it took some time for its implications to become socialised among his peers and suitable tests designed. The theory predicted that light would bend as it travels around the sun. When it was proven in 1919 during a solar eclipse, his theory found much wider acceptance. So it should be with Werner and Keen’s warnings of a financial crisis, predicted by their theories (Bezemer 2009).

It was not until the Second World War that Einstein’s theory found its first practical application, sadly, and much to his dismay, when America chose to put it to use in Japan. It also underpinned the expansion of a civilian energy programme, which subsidised the proliferation of atomic weapons. Watson and Crick’s discovery is of such magnitude that we are only now beginning to enjoy, after many years of labour, its fruit in the development of pioneering medical treatments. Although its application in food production remains controversial and bioterrorism is an emerging concern.

There is nothing new to be discovered in physics now. All that remains is more and more precise measurement.

Lord Kelvin, 1900

Some people will be very disappointed if there is not an ultimate theory that can be formulated as a finite number of principles. I used to belong to that camp, but I have changed my mind. I’m now glad that our search for understanding will never come to an end, and that we will always have the challenge of new discovery. Without it, we would stagnate.

Professor Steven Hawkins, 2002 (Godel and the End of the Universe)

It’s remarkable to contrast the explosion of scientific discoveries in the early 21st century with the complacency emerging towards the end of the 20th, best expressed by Lord Kelvin above. Fukuyama appeared to express a similar sentiment in the political domain after the collapse of Communism (Fukuyama 1992). The classic archetype of Kuhn’s theory of scientific revolutions is the one created by the emergence of a solar-centric cosmology attempting to replace the long-held and Catholic Church-endorsed geocentric theory. It’s important to have epistemic theories for the socialisation and social construction of science, and the political economy of ideas (Bénabou et al. 2013). However, the track record suggests it’s a multi-generational process to replace paradigms, particularly when the stakes are high. What stakes are higher than the promise of continued economic growth or the existential threat of climate change, two seemingly unstoppable forces pitted against one another?

In the economic domain, we have very serious challenges to resolve, but little time within which to resolve them. In order for over 6 billion, and growing, people on this planet to enjoy the quality of life and energy services that we in Europe take for granted, while not frying our planet in the process from climate change, it is going to require a profound change in how we source and use energy. The IEA estimates the cost at $500bn a year from 2020 until 2030, double the current spend, which needs to double again after 2030, just to keep us under 2 degrees Celsius warming – the internationally agreed target (Fulton & Capalino 2014). We should note that these projections were prepared using conventional neo-classical economic models.

Meanwhile, our policy advisors and political leaders, grappling with a political body looking for a way out of the current economic malaise, are using economic theories that appear at best flawed, and at worst, dangerous. The public discourse, for the first time since the Great Depression, is only beginning to question again who gets to create and allocate credit, who gets access to energy (which sources?) and physical power (which technologies?), and our perverse obsession with economic growth at the seeming expense of social wellbeing, despite the overwhelming empirical evidence that they must be questioned. They are simply accepted norms, which only now, in the wake of the crisis, do we become aware again that they should be questioned. The stakes are undoubtedly very high indeed.

It’s unfortunate that it requires a catastrophe of the magnitude of the financial crisis to create the space for such questions to get the chance to be aired (Homer-Dixon 2008). Thankfully, organisations like INET appear determined not to let a good crisis go to waste.

But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation; a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts.

(J. M. Keynes, 1936, p. 33)

While I can happily offer economic theories that appear to offer better insight into the nature of the world in which we live, I have very little to say about managing the political economy of ideas so that such a better understanding might be more widely shared, and put to use in a timeframe commensurate with the challenges we face. I must leave that to leaders such as Adair Turner and Michael Kumhof.

To conclude, I believe a fruitful line of further enquiry would be to integrate a compatible form[2] of Lindenberger and Ayres production functions with Keen’s monetary Minsky model, to form an Integrated Assessment Model (Weitzman 2009, p.15). This should point to the role of credit, physical power, and energy efficiency, as determinants of economic growth.

In the absence of such study, I will venture to speculate, on the grounds argued above, that the only legitimate reason to create credit is to invest it in increasing energy efficiency. However, in light of those same arguments, such study could also highlight the significant challenge of achieving economic growth in the face of peak oil and addressing climate change. The question of whether or not we really need or want perpetual economic growth, which presents yet further challenges to both conventional political and economic wisdom, may simply be overtaken by the physical reality of declining oil production and catastrophic climate change. The consequence of which leads one inevitably to question the wisdom of operating a credit-based money system which requires constant economic growth, and more importantly, is highly unstable in an economy not growing fast enough.

Figure 10 Author’s model for powering economic growth in a constrained physical system

Using that age-old analogy of the economy as an engine, just as an engine needs oil and air to create forward movement, so too the economy needs physical power and credit. We’ve got an engine that’s designed to run on $20/barrel oil when there’s none left, and we’ve flooded it with enormous amounts of misallocated credit. We need a new clean engine.

It ain’t what you don’t know that gets you into trouble.
It’s what you know for sure that just ain’t so.

Mark Twain

References

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Ayres, R.U. et al., 2013. The underestimated contribution of energy to economic growth. Structural Change and Economic Dynamics, 27, pp.79–88. Available at: http://linkinghub.elsevier.com/retrieve/pii/S0954349X13000593 [Accessed April 14, 2014].

Benes, J. & Kumhof, M., 2012. The Chicago Plan Revisited, Available at: https://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf.

Bernardo, G. & Campiglio, E., 2013. A Simple Model of Income, Aggregate Demand, and the Process of Credit Creation by Private Banks, Available at: http://www.levyinstitute.org/pubs/wp_777.pdf.

Bezemer, D.J., 2009. “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models, Available at: http://mpra.ub.uni-muenchen.de/15892/.

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Colander, D. et al., 2009. The Financial Crisis and the Systemic Failure of the Economics Profession. Critical Review: A Journal of Politics and Society, 21(2-3), pp.249–267. Available at: http://www.tandfonline.com/doi/abs/10.1080/08913810902934109 [Accessed March 28, 2014].

Commission on Energy & Geopolitics, 2014. Oil Security 2025, Available at: http://secureenergy.org/sites/default/files/Oil_Security_2025_0.pdf.

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[1] Prof Keen’s latest thinking (Keen et al. n.d.) updates this model, c.f. (Bernardo & Campiglio 2013, p.9; Kakarot-handtke 2014)

[2] There are commensurability challenges to integrating equilibrium and dis-equilibrium theories. See Hawkins reference above for similar challenges in the physical sciences.