The absurdity of modern economics

Any rational economics would be about how economic activity plays a part in the wider social system. Modern economics is doubly divorced from that. Firstly, it treats economics as an abstraction from social life, as though it could be judged solely on its own terms. And within that, economic activity is presented as revolving around money, rather than money being kept in its proper place as a means to our real social (or even economic) ends. Even if we accept the former abstraction, within economics itself one would expect the making, distribution, exchange and consumption of goods and services to predominate - that is after all how people actually live - but we have succeeded in making all that secondary to the circulation and augmentation of money itself.

This peculiar displacement and inversion that places money first and last - the perspective of the miser, that most wretched of human beings, who is, as someone-or-other once said, as much in need of what he has as of what he has not - is not the fault of economists, of course. Or at least they are no more than ghost-writers to the real culprit. This is after all a perfectly valid description of an advanced capitalist society, in which finance capital (and its unacknowledged bastard-and-then-master, fictional capital) has deposed real goods and services from the pinnacle of profitability to such as extent that the classic model of capitalist economic activity in which money is augmented through the creation and sale of goods and services - summarised by that nice Dr Marx as M-C-M1 - has started to run an increasingly poor second to the more direct creation of money through speculation, the creation of fictional capital and all the rest - M-M1.

It’s a distasteful state of affairs and creates the impression that economics has fallen into a sort of fantastic black hole, from which the introversion into which it has fallen ensures that it cannot escape. But even from the most radical point of view we can't just switch economics off. The economy is after all where we create all the means to our various ends, our economy is a capitalist economy, and so we must at least try to understand capitalism's view of itself. On the other hand, surely we are capable of constructing an economics that starts and ends with people, and so with goods and services. (Even this ignores the deeper significance of economic activity, of course - the way the very process of participating in economic activity shapes the way we experience existence, and the way we define what is real and what is not, what is normal and natural, what is right, wrong and indifferent. But at least it would wrench us away from this hypnotic fantasy that money must rule.)

An example of what I mean. In economic theory money is rightly assigned many functions. It is a store of value: people can use it to hold their savings. It is a medium of exchange, enabling us to buy and sell without having to wait for someone possessing exactly what we want and wanting exactly what we have. As an instrument for expressing the value (or at least the price) of goods and services, it’s a unit of account. Finally (as the list usually goes), money provides a standard of deferred payment (which is one important reason why we are always so concerned about inflation).

So far so ordinary. But since the creation of money by means of speculation, manipulation and downright fraud has come more to the fore (and nothing in recent economic policy has reversed this), this has made another, perhaps previously too obvious function of money more visible. For money is also a claim on goods and services. In a market that responds only to money, anyone with money has a right (or at least an access that will only be challenged in exceptional circumstances) to the goods and services created by society as a whole. As a result, those who specialise in creating money can corner a correspondingly volume goods and services (i.e., get rich) even though they create none themselves. Of course, financial activity does have its value - not only managing the supply and circulation of money and directing investment (though still conceived of in narrowly financial rather than social terms) but also rationalising and smoothing various aspects of markets themselves. But once financialisation gets out of hand and the generation of money through bubbles, absurd risk and outright crime starts to predominate over real economic activity - the creation of goods and services -then the financial sector starts to achieve stupid levels of wealth (i.e., a huge proportion of the money in circulation) even though it is adding very little of social value. On the other hand, as I have argued elsewhere, once finance capital starts to predominate, bubbles, speculation, crashes and monopolisation are inevitable - yet 'investment' banks, hedge funds and the rest are left in greater control over the real economy than ever.

Hence the significance of money's function as a claim to goods and service. It allows an otherwise parasitical class of financial specialists to distort and undermine the socially valuable part of the economy, not only making them richer and richer even though they produce very little of value themselves, but by this very process strengthening their position in the economy - and so society and politics - as a whole.

Our heroic bankers take on the evil dictators

According to the March 2011 edition of Private Banker International, 'at least $235 billion of illegal assets are held in offshore accounts opened by the wealthy, including those taking advantage of their government positions in the Middle East and North Africa. That is equivalent to 15 percent of the total $1.5 trillion held offshore by individuals from Arab and African states…', as 'over past decades these regimes have grown an entire ruling class consisting of family, friends, businesses, security forces and secret service that have transferred significant wealth out of their home countries.'

Bizarrely, the same article (aptly entitled 'Private banking’s ticking bomb'), having noted that 'The family of deposed Egyptian president Hosni Mubarak is estimated to have as much as $70 billion of assets. Tunisia’s ex-president Ben Ali is said to have up to $10 billion and Libyan leader Muammar Gadaffi and his family have an estimated $20 billion offshore', suggests that 'One big problem comes from trying to assess which assets originating from the region are legitimate and which are suspect'.

Really? How could any of these groups conceivably have acquired such staggering sums by legal means?

Equally bizarrely, a leading baker is quoted as saying that 'Your private bankers should be close enough to their clients to have alarm bells start to ring if what they are being offered, say £5 million, looks unusual in size and timing”. Well, they scored well on that one too: what 'timing' could possibly explain away wealth on such a gargantuan scale? Gadaffi has been in power for 42 years so, with $20 billion between them, his family must have deposited an average of $500,000,000 each year for decades on end. That’s the £5 million deposit our eager banker suggests might be a tell-tale sign of corrupt dealing every 5 days. But only when the people of Libya say that enough is enough do the Gadaffis' bankers wonder whether there might be something doubtful about this.

So when the previous article in the same journal celebrates how heroically Swiss bankers shut down the tyrants' assets in record time, we are entitled to ask, how did you manage not to notice the staggering scale of looting while it was happening?

Incidentally, the reported figures surely understate the problem. As reported, the amounts stolen by Ben Ali, Mubarak and the Gadaffis come to $100 billion. If the total of illegal assets is only $235 billion, then these three groups account for 40% of the total. Surely that cannot be correct - not with all the other dictators, their families and their cronies, all the corrupt generals and arms dealers, and all the rest. What if this little groups represents only 5% of the whole - which I find quite believable, given the nature of these regimes - then the offshore stolen money comes to $2 trillion - that’s $2,000,000,000,000, or a little under $6,000 for every single Arab man, woman and child.

Perhaps our upright bankers can redeem themselves a little and tell us how much Mugabe and his grubby pals have stashed away? Or exactly how many of the 400,000 millionaires in the Middle East and North Africa did not acquire their riches by raping their countries? Given that 'Banks in Europe, the US, Switzerland and most other developed countries have to do background checks on so-called PEPs (politically exposed persons)', they surely know more than they are telling.

Conversely, what do they plan doing about it? Or do they just smugly assume that the new regimes will be as corrupt as their predecessors and be happy to let bygones be bygones? Perhaps the millions of poor in Arab countries can help them make up their minds, or at the very least make sure they not only get the money back but also demand that these shabby crooks (and no, I don't mean the dictators this time) are made to pay for the part they played in robbing some of the poorest people on earth.

Shakespeare on bubbles

Banquo
The earth hath bubbles, as the water has,
And these are of them.Whither are they vanish'd?

Macbeth
Into the air; and what seem'd corporal melted
As breath into the wind.
Would they had stay'd!

Banquo
Were such things here as we do speak about?
Or have we eaten on the insane root
That takes the reason prisoner?

Macbeth, Act 1 Sc.3

The witches of investment banking and market ideology provided the insane root with which our masters - and our systems - were poisoned, and the rest is as malevolent and illusory as any witch could devise.

National budgets and global economies

George Osborne delivers his first budget and insists that it is fair. I’m not sure what he means by this, but it is hard to see how it can be. Regardless of what Mr Osborne wants, he simply lacks the political levers needed to control the economy or to decide who bears the burden of the recovery. Of the three key controls, he has access to (and by no means full control over) just one: the UK public sector, including the livelihoods of millions who not only did not cause this recession but also are the main victims.

As for the other two areas - the private sector and the global economy - what can he say? But, being a mainstream politician who therefore cannot confess that the social system he works in is profoundly dysfunctional, he has no power over the UK private sector, especially the banks. I know from my one personal experience that the banks are doing very well at the moment, thank you, and despite a piffling bank tax, will do even better in future. But George cannot do anything about them, because they are his mates in the City – not exactly the Tories’ targets of choice - and because faith in the beneficence of untrammeled markets and big business is in the very the bedrock of Tory thought. Indeed, I suspect that most Tories cannot imagine what taking the City to task would even mean (and I doubt that many Labour or Liberal politicians would do any better).

But even that is a relatively small problem. The real reason why the private sector is free from political action is not that it is sacrosanct but that it invulnerable. Capital will simply go somewhere else. The reason it is free to do this is not that this is some sort of natural phenomenon – the mysterious workings of the market – but because we lack a political system with the span of control, the competence and the willingness to take action on a global scale. There are no true global or inter-governmental political institutions, and such economic institutions as do exist at that level – the WTO, IMF, etc. – have effective power only over the weak (and therefore, like the poor in this country, the very people who require support, not budget cuts), and remain committed to the market ideology that got us into this mess in the first place.

At the moment this gap can be filled only when the politicians of all the major economies can agree on a common policy. But that is extremely unlikely, because the very mobility of capital that allows banks and others to flout local economic controls also creates a bidding war between struggling national economies that forces national politicians to make their own economies as attractive as possible to global capital.

Tough luck, George. But you can do something about it. You can start to admit that the global economy requires direction, not only to escape from the present recession but also avoid future problems with the environment, with global development, and so on. Secondly, you can agree that that direction must be active - not just ‘market forces’ and more than regulation but positive organisation (or at least active alignment) of its basic forces with the world’s basic needs. And finally, you can start to campaign for the truly global political system, without which any aspirations to a coherent economic system are completely forlorn.

You won’t, of course, and neither will your Liberal or Labour counterparts. Because you are, after all, a mainstream politician for whom the present system is so all-encompassing that you cannot even imagine what it is. Asking you to grasp the nature of global society is like asking a fish to point at the sea it is swimming in – obviously everywhere, but so pervasive that it cannot be conceived by any run-of-the-mill fish like you. So we all limp along, with little hope for anything but the weasel words of a well-intentioned bloke who is unable to solve the problem he is confronted with, but too immodest to concede that there is nothing he can - or will - do.

Are Boomers to blame?

An interesting article over at the Burning Platform site - a nicely expressed summary of the widespread sense in the USA that our current crisis is caused by Boomer fecklessness, corporate greed and other cultural and psychological failings. This is the comment I posted:

Nice article but still just a footnote to the culture-wars debate. No real analysis of capitalism as an economic system, so not likely to get to the real nub of the matter. Just as your car is ultimately driven by its underlying engineering and your driving style only affects what it is capable of in relatively small ways, so the basic rules of a capitalist system are clear and simple and all this anger about corporate greed and reckless Boomers is secondary. So are complaints about CEOs offshoring America’s jobs: if you don’t get the basic fact that globalisation is the natural expression of capitalism and completely indifferent to American interests then you are just going to be reduced to another branch of the Tea Party any day now. A capitalist economy pursues the maximum possible ROI – and that is necessarily greater than any sustainable return from the real economy. So this structural requirement for ever-increasing profit will soon cease to be met by any conceivable real economy, especially in peace-time, and the unreal economy, where imaginary values can be made to look real just long enough to cash the cheques, will start to take over. But even the financial sector is only the pure form of capitalism: _all_ sectors of a capitalist economy – including the real economy – will eventually be forced to resort to the same tricks – short-termism, unsustainable debt, insane risks, creative accounting, illusory economics, perpetual motion machines, ridiculous leverage, subsidies to the biggest and richest companies, the constant destruction of (and forced demand for more) goods and services to fight imaginary security threats, and finally just plain dishonesty. Where else are the profits in a mature, free and open economy going to come from? Well, you could try being less mature, free and open, but I don’t think that’s a policy direction any of the subscribers to this site would like much – being cheap labour and having a security-obsessed state isn’t much of a future. None of which has anything to do with Boomers or greed or other cultural or psychological explanations. They are the symptoms – along with environmental devastation, the looting of developing countries, the appalling levels of poverty within America itself, the absurd dishonesty of so much of the media and government, and much else. But they are not the disease.

Not, I suspect, very congenial to most of the readers on that site, nor likely to be responded to, but what the hell.

Was it caused by fractional reserve banking? Not really.

Almost a year ago, I wrote an entry in my parallel environmental blog entitled Why capitalism must expand - whatever the environmental consequences. Rather surprisingly, yesterday I received a comment, from Jerry Fox, an American engineer and blogger. His comment ran as follows:

Capitalism supported by fractional reserve banking and the artificial support of governmental bailouts does require constant expansion both to pay off the inherent interest and to delay the inflationary effects of the money supply. I hope that you are not trying to lump the great system of free enterprise which has helped to make America the envy of the world, being linked to a Constitutionally maintained money supply, to this travesty that has come to be called "Capitalism". Under the former, there is no need for constant expansion to support a healthy thriving economy along with proper concern for any environmental issues.

I repeat Jerry’s comment here because it is equally relevant to a point I have recently been considering. There is a striking difference between the diagnoses and remedies offered by American and non-American bloggers and other commentators, which, quite by chance, Jerry’s comments expresses very well.

Here is my reply, which is equally relevant to this blog:

Thanks for your comment, Jerry. I sympathise strongly with the view that fractional reserve banking has played a terrible role in the current crisis, and my impression from tracking a number of American blogs is that this is widely held to blame for the crisis as a whole. However, I remain sceptical of the idea that this is a distinct phenomenon from capitalism proper, for two reasons.

Firstly, fractional reserve banking has been a feature of financial capitalism ever since the first capitalist banks came into existence – far earlier than the fist Europeans arrived in the Americas, let alone anything specific to the US economy or constitution. It is simply a matter of risk management: although I don’t have enough reserves to cover all my commitments, I take a chance that all the chickens won’t come home to roost at the same time. And by and large this has proved a good and familiar bet – to the point where one of Shakespeare’s best known tragedies, The Merchant of Venice, which was first performed around 1596-1597, depends entirely on a situation in which this bet on fractional reserves fails.

And it was essentially the recurring failure of this bet that led to regulations specifying exactly how much reserves were required for various kinds of transaction. In other words, there was no pure capitalist system with non-fractional reserves, which was then polluted by the creation of fractional reserve banking. Rather, capitalism was always a system of fractional reserve banking, which governments, sick the regular crises, eventually normalised with formal requirements for banking licenses, specified capital requirements, the 1933 Glass-Steagal Act, and so on.

As I understand it, the issue with the recent collapses was two-fold. When markets have been massively aligned (as they were, for many reasons, over the last few years), a boom that had looked fantastic turned into a bust proved that it was all just a fantasy, because everything went up and down at once. But even more importantly, the problem with many speculations (it’s hard to describe credit default swaps as investments) was that they were not required to be backed by any reserves at all. I have seen of what would have been a large enough reserve to cover most defaults and so forestall this crisis, and none of them were very different from the standard fractional reserve requirements for more conventional loans and obligations.

You can blame a number of technical features for this – the rise of ‘mark to market’ accounting, for example. In my own view, a more profound explanation lies in the process of systematic deregulation. This seems to have been a pretty universal phenomenon – certainly rife in London, where the absence of effective capital requirements made it the most popular financial centre in the world. Other centres tended to be more reserved (as it were) than London and the various US exchanges, but unfortunately they are collectively large enough to push the planet into a financial nosedive.

So fractional reserve banking played a role in the current crisis, but primarily because it did not extend to the specific types of transaction that actually brought the system down. Not much to do with the corruption of free enterprise or Constitutionally-protected monetary system.

James Hansen and the inexorable slide toward nuclear power.

On his Storms of My Grandchildren site, James Hansen talks about how intolerable coal-powered power stations are in any realistic future, and claims that:

in most countries, phase-out of coal emissions requires also a carbon-free source of baseload electric power that is competitive in price with coal. Until we have another way to meet 21st century energy needs while eliminating coal and carbon emissions, nuclear power appears to be the only option.

From this he infers that even nuclear power would be the lesser of these two evils, concluding that

The (“3rd generation”) nuclear technology ready to replace the aging 2nd generation reactors in the United States and other counties is inherently safer than existing nuclear power, which already has an exemplary safety record – however, it still burns less than one percent of the nuclear fuel and leaves a long-lived nuclear waste pile. Hansen recommends initiating urgent development of a fourth-generation nuclear power plant. These “fast” nuclear reactors utilize more than 99 percent of the fuel and can “burn” nuclear waste, thus solving the nuclear waste problem that concerns so many.

This doesn't seem to me to follow. Why is he so confident that these fourth-generation nuclear power plants are any less pie-in-the-sky than carbon capture? It's the first time I have heard anyone suggest that the problems of safety and spent nuclear fuel could be a thing of the past. I would very much like to hear Hansen's reasoning. Not that I would like CCS any more than him, but it doesn't make much sense to be asked to choose between two mirages.

But there's a more important assumption in Hansen's commentary. He argues that, if we are to avoid both fossil fuels and nuclear power, then we need 'a carbon-free source of baseload electric power that is competitive in price with coal'. It is certainly a most attractive option. However, my reading of the technical literature leads me to two conclusions. One, such an option will not exist for many years to come. And two, we can't afford to wait that long.

So how is it Professor Hansen can claim that the solution needs to be 'competitive in price with coal'? Given the magnitude of the potential problem - a series of disasters and creeping destruction that will dwarf any previous human experience short of, perhaps, a re-run of the global plague in the 14th century, surely this is like saying that we should have decided our strategy for the Second World War on the basis of whether it would have been as painless as peace.

Plainly this would be nonsense, and as in the case of WW2, there is little doubt what the consequences of continuing prevarication will be. Add to this the impact of ever-expanding resource depletion, ecosystems collapse and 40% more people by 2050, and waiting for another cheap energy source to come along sounds like madness. It would be nice if we were in a position to choose between cheap, friendly, familiar options, but we aren't. Meanwhile, our social, political and economic system is awash with people and interests for which an effective solution would be anathema, if not fatal.

Of course, we are not at war, and such metaphors are as likely to be misleading as helpful. But to pretend that we can reach Professor Hansen's own goals without paying a price and making preparations comparable to a war strikes me as unwarranted optimism, if not self-deception.

Consumerism, 1932

I re-read Aldous Huxley's Brave New World, and what do I find?

In the nurseries, … the voices were adapting future demand to future industrial supply. ‘I do love flying’, they whispered, ‘I do love flying, I do love having new clothes, I do love…’

£10 to the first person who can explain why this isn't true

http://www.theonion.com/content/news/u_s_economy_grinds_to_halt_as

Fair value? Can free markets ever value the environment?

A basic problem with markets that absolutely must be answered if we are to create an environmentally rational economy is that of deciding how to value things. Valuation failures were a key cause of the recent financial crisis, which stemmed at least in part from the policy of allowing companies to claim that their value was whatever the market would currently bear, including any number of imponderable items that had yet to demonstrate any real value, such as future prices, hypothetical values and debatable projections derived from complex financial models. As part of the general indifference to risk exhibited by regulators and accounting authorities during the last decade or so, this so-called ‘mark-to-market’ or ‘fair value’ approach accounting has been a part of US GAAP since the early 1990s and seems to have all but replaced any notion of intrinsic value. And as if all that were not enough, ‘fair value’ accounting was also central to the Enron scandal.

Mark-to-market is obviously important when it came to buying and selling stocks and shares, but it goes far beyond that. The value of company assets that can be offered as collateral is also the basis for loans, derivatives and other direct and indirect funding. So when a bull market lasts for years on end and prices kept going up regardless of any material value of the companies themselves, smart operators are provided with an environment that favours both massive speculation and spectacular frauds. From the point of view of mark-to-market accounting, a bull market amounts to a universal pyramid scheme: whatever the value of an asset or liability today, we can usually assume that it will be worth more tomorrow, so we can borrow today as though we are more wealthy than we really are.

However, when the dislocations and fantasies this situation naturally engenders go too far, the market will be seized by the bears, and the rapid falls in mark-to-market valuations that follow will mean that previous loans, bonds, asset and liability prices, interest rates and pretty much every other number the markets use will start to go the wrong way for everyone – again regardless of the underlying strengths and weaknesses of individual companies. In a bear market, mark-to-market put the pyramid onto its head, and you would be stupid to lend today, as the collateral that guarantees your loans will almost certainly be worth less – maybe a lot less – tomorrow than it is today. In extremis, markets for many items disappear altogether and the financial sector ground to a halt.

The key problem this presents if markets are to be part of the solution of our environmental problems is that the scope, scale and urgency of those problems mean we cannot allow the kind of fragility and flakiness market economies have exhibited to determine how we invest in the environment. Leaving aside the question of speculators actively manipulating environment-related markets (e.g., greenhouse gas cap-and-trade, offsets, and so on – see the final section of this), we cannot accept the risk of being plunged into years of environmental inactivity or retrenchment simply because markets were unable to value these investments appropriately.

But is there any alternative as far as markets are concerned? Is there any definition of value markets can work with that will always reflect the intrinsic social value of taking action to protect the environment? Are there any accounting principles, valuation methods or other general policies, methods or tools that will ensure that environmental investments are not caught up in speculative frenzies and then dumped as unceremoniously as the global financial system was in 2008-9?

Probably not, or at least not ones that are capable of controlling markets without considerable active intervention and constraint – which is to say, undermines their very nature as markets. After all, how are markets to price things other than in money? How am I to judge a given transaction other than in terms of the profit it offers me (which means strictly in terms of money)? And once all value is reduced to money and the only goal is more money, what other valuation method is there apart from what the market says? In other words, regardless of whether valuing assets and companies in terms of their market price is sensible, it represents what market-based investors wanted to know about a stock, because it predicted what they most wanted to know about their ultimate concern, namely profitability.

In short, the markets know the price of everything and the value of nothing. As this is Oscar Wilde’s definition of a cynic, that seems appropriate enough – the attitude of markets (and perhaps business in general) to the environment is cynical at heart, for the only question they are capable of posing is, How do we make money out of this? Not exactly a responsible attitude.

Actually there is a limit to how far this is true. In a market who basic function is to direct investment in the real economy, prices will still be determined by prices, but these prices will be linked to the material consequences of making real investments - in houses, in MP3 players, in clothes, in a million other goods and services. And that of course is what the economy is for – to ensure that society works. True, the answer is still expressed indirectly, in terms of money, prices and profits, but at least the link to real, non-financial value is there.

Or so it should be, in a socially rational economy. But when the central function of markets is perverted into speculation, and the key question is not how to distribute wealth in society but how to make a quick killing by exploiting changes in price.

But is this a real problem, or merely a theoretical stick with which to beat the markets? Unfortunately it is very, very real. For example, by 2008 the average barrel of oil was being traded 27 times before it was actually delivered for use in the real economy. This certainly contributed to the otherwise inexplicable massive price spike of that year, and is hard to account for in terms of buying oil for use in the real economy. Or again, the Tabb Group consultancy has estimated that mroe than 60% of trades in the US stock markets are controlled by automated systems that are designed to take advantage of tiny price difference within miliseconds of their arising - not really an issue for investors in the real economy. More generally, it has been estimated that perhaps 85% of stock exchange activity is speculative, with only a small minority representing genuine investment.

And so on. All in all, the speculators are clearly in charge, and as a number of scandals and exposés have demonstrated, the manipulation of prices is a fundamental of stock markets.

This is perhaps the fundamental problem of using markets to manage the environment: that markets recognise only prices, and no price generated by a pure market can reflect socially rational value (including environmentally rational values) unless forced to do so – which is the very antithesis of a market price. Markets are like severely autistic children: it’s not hard to get through to them - it’s impossible. You can constrain them with regulations and rules, but once the market has taken over control of prices, it is hard to see why just this sort of bubble should not develop.

So can markets play any part in managing the environment? Perhaps in limited ways. But the tendency to break the link with real environmental goals and consequences seems to be intrinsic to any system that measures success strictly in terms of prices and profits. If it doesn’t do that, is it a market? If it does, how can we ever trust it not to undermine every strategy for managing the environment?

The problem isn't Peak Oil. It's just plain OIL

It seems to be very hard for some people to 'get' what the problem with fossil fuels really is. Daniel Yergin, Mr Peak-Oil-What-Peak-Oil? in person, is apparently in Davos for the annual jamboree in which all those clever people who got us in the current mess celebrate how clever they are.

Mr Yergin thinks Peak Oil is a long way off. A lot of other people in Davos would agree, I suspect, though whether this is a matter of superior knowledge, judgement or self-interest I would not like to say.

But what does it matter how far away Peak Oil is? Assume that it is close, or has even arrived. The contradiction between falling supply and massively accelerating growth (courtesy of China, India, etc.) will create an equally massive economic crisis. But what if we assume that Peak Oil is far off, as Yergin argues. What then? We syphon billions of barrels of the stuff up the surface and burn it into CO2? Yes, that's exactly what we do.

As various people have now noted, we cannot afford to burn more than a small fraction of even the fossil fuels at our disposal now, let alone any additional future supplies - not because of its economic price but because of its environmental consequences.

So, Peak Oil is a huge problem. But so is the oil continuing to flow.

To put the matter in a nutshell, the problem is not Peak Oil. It's just plain Oil. A uniquely valuable and important commodity, but one for which we haven't even begun to really pay.

Economy versus environment (Part 94)

Q: What would actually happen if any significant proportion of the population suddenly took it into their head to reduce their environmental impact? A: The economy would collapse.

If you look at the recent recession, it is striking how much damage was done by relatively small changes in GDP. Of the highly developed nations, the UK (among the OECD countries, a middling performer) was so badly hit that it has experienced a loss of a little over 2.5% since the end of 2007. What? 2.5% in two years? A bit over 1% a year? What’s the big deal? Yes, I know, losing 1/80th of my income would not be a good thing in a year, but how can this be enough to do so much damage to an economy?

So what would happen if, say, 20% of the population managed to knock 50% off their environmental impact? Surely that would be an excellent start. Well, from an environmental point of view, perhaps. But if that translated into a 10% fall in consumer spending, where would that leave the economy? Consumer spending represents about 56% of German GDP, 58% of Japan’s GDP, 64% of the UK’s and 72% of the US’s (here). So a 50% fall in spending by 20% of all individuals would cut these economies by somewhere between 5.6% and 7.2% of GDP. In other words, even such a small change by a small minority would reek more economic havoc than the current recession!

So, we all get the environmental bug, and the economy folds. And with it go (as the current recession has also shown) investment in green technology and solutions of all kinds. Not everything, but far too much to support the real greening of industry. On the contrary, investors would be heading for the safe, short-term returns. And governments everywhere would be trying to compensate for the shortfall with new spending – and so shoring up the very economic activity those who had cut their impact had hoped to eliminate.

This isn’t a criticism of taking action, of course. But it is the old revision-versus-revolution problem. If you want only that the system work a bit more benignly, you need only revise the system so that it loses its more unpleasant foibles. But if the problem you are worried about is inherent in the system itself, revision isn’t the answer. The only way to fix systematic problems is to change the system in systematic ways.

That in turn is a political issue. Our politicians are of course firmly committed to growth, but that is not an irreversible condition. But two things are fundamental.

1. We must develop a credible explanation of this most fatal link between economy and environment, and make it as central a plank of future political discourse and policy-making as growth and consumerism have been since the 1970s.
2. We must define a programme for migrating our existing economy to a sustainable form. This cannot wait for 'the market' or the actions of private corporations, whose interests will never be to change themselves while there is still money to be made. Governments and local organisations must start to plan the elimination of environmentally destructive economic activity, undo the vicious circle of capital expansion that drives consumerism, obsession economic growth and the disregard of the poor and weak.

What makes an economy healthy?

A persistent theme in economic reasoning is to fail to define what is meant by 'the economy', and in particular its conception of economic health. Here are four possible definitions of economic health, of which only the first (and until the recent boom, the second) seems to be taken at all seriously by politicians:

1. Monetary measures of economic activity such as GDP or profitability. This is essentially a financial view of the economy.
2. Then there is the definition of economic health based on the so-called real economy. This involves measuring how well we are achieving the creation of the right mix of goods and services to maintain the economic system itself - as measured by growth, profitability, government income from taxation, employment levels, international competitive position, and so on.
3. Then there are measures of how well the economy contributes to creating a healthy society. This would include measures of human well-being, social solidarity, and so on.
4. Finally (so far), there are measures of how well the economy contributes to creating a sustainable society. This takes into account society's position in the natural world.

Note that, in Definitions 3 and 4, I say that these measures 'would' be used. It's not that such measures don't exist - on the contrary, we seem to be awash with studies of human happiness these days (a great deal of it summarised in The Spirit Level, by Richard Wilkinson and Kate Pickett 2009). However, such measures have no impact on actual economic management, so they hardly count (yet).

Definitions 1 and 2 - the 'financial' and 'real' economy definitions - look very similar, in that the definition of health itself remains much the same, with only the diagnostic differing much. Yet the differences are fundamental, for when economic health is measured and managed exclusively in terms of money (GDP, profit, and so on), booms will always turn pathological. And that is exactly what we got, of course, as soon as the momentum was dominated by those with no other grasp of the economy than as a device for making money - the investment bankers, the corporations whose profits come primarily from treasury operations, and so on. And of course, our economically naive politicians followed suit - endlessly grovelling to these alleged Masters of the Universe -and so, of course, ensuring that they would indeed be the true masters of our economy.

All the same, measuring economic health in terms of the second, 'real' economy definition of economic health means limiting ourselves to another strictly economic definition. This one is taken from a previous age when the link between the economy and society was not taken for granted and even economists did no believe quite so slavishly in markets, or even profitability, as a measure of economic health. This post-War era was was killed by globalisation, though the final coup de grâce was administered by Thatcher, Reagan, the Chicago School of economics and the Washington Consensus adopted by the IMF, World Trade Organization, World Bank and many national governments.

The strength of the 'real economy' definition of economic health is that it does at least tether the economy to society. Of course, business itself was constantly bucking against it, but fortunately the post-War social consensus was that society needed to be actively managed and the economy was not the same as business. When that ceased to be true - when national economies suddenly found themselves confronted with global competition and national businesses were allowed to shift capital and operations offshore - and big business discovered that it held all the important cards, the post-War social consensus promptly collapsed. The financialisation of the economy followed all but automatically, and the rest is history.

Hence also the weakness of the second, 'real economy' definition of economic health - that it ties the economy to society but does not define it in terms of what it does for society. So although politicians and economists regularly insist on the social connection, this is seldom more than verbal reassurance. Conversely, little attention was paid to what would happen if national economies were internationalised while there was no global consensus, let alone global political apparatus, for managing an increasingly global economy. As usual, the economists (a body of intellectuals blessed with 20:20 hindsight) completely failed to predict what happened next.

So as soon as the circulation of capital and resources starts to enter new circuits, the entire political class was thrown into disarray, excepting only those for whom it was axiomatic that markets should be allowed to determine everything (Thatcher and Reagan) and those for whom capitalism had always been suspect (socialists, etc.). The immediate effects were that everything was sacrificed in the name of an extremely narrow definition of economic health (implicitly Definition 1, of course) - the privatisation and marketisation of the public sector, tax breaks and subsidies for fabulously wealthy corporations and individuals and, far from the economy serving society, coming to see society as being reduced to an appendage to the economy. Happy days indeed.

It was twenty years before the new market/Washington consensus was able to dominate the entire political spectrum (at least as far as parliamentary politics was concerned), but there was never much doubt that it would.

So the second definition of political health was always unstable. As for the third - the creation and maintenance of a healthy society - it never really got a grip on economics. At a rhetorical level, of course, it was always argued, even by the most extreme market enthusiasts, that the full marketisation of the economy would benefit us all. But that merely meant that connection was assumed - the same as definition number two. On the other hand, the actual method chosen to hand it over - handing over society's key assets to big business, deregulating markets, and so on - not only assumed that Definition 3 could be achieved by equating it with Definition 2 but all but made it inevitable that the economy itself would quickly lapse into Definition 1 - the source of our current woes.

But even if Definition 3 could have been enforced by political control over the economy - a doubtful proposition, given the lack of clear understanding by mainstream politicians and economists of how capitalism really works - it is now clear that this would not have been enough. For centuries we have paid little attention to society's impact on nature, even though it has sometimes reached the point where a civilisation has effectively committed environmental suicide.

Nor was this simply a matter of ignorance. We have had the materials for a true environmental science for as long as there has been a science of any kind. Liebig and others were already explaining how we were constantly undermining the natural basis for society in the middle of the nineteenth century. It was not hard to see or understand: you measure some basic facts, such as how much (literal) crap is being poured into the sea instead of being pumped back into the land, that told you how quickly you were depleting the soil, and that told you how long we could go on like this.In economic terms, the problem was that no strictly economic measure of well-being was going to capture society's ultimate sustainability if if did not measure the long-term, inter-generational impact of economic activity.

Basically, economic metrics look equally benignly on social 'bads' and goods, just so long as someone was paid to create them, and ignore both when no one is paid either to create them or clear them up. Nor do they generally take into account how we squander resources, not only using up what should be our children's heritage but even turning what one would have thought were inherently renewable resources such as fresh water and fertile soil and seed into non-renewable resources.

The reason we didn't pay attention to this kind of insight was simple but not obvious. Even while we were creating the science needed to understand just how unsustainable our economic system was, the economic system itself was throwing up both theoretical and practical barriers to understanding this fact. On the one hand, economic theory was claiming that a combination of market-driven efficiency and resource substitution meant that the economy would take care of all these problems automatically, so they did not need to be managed by anyone else, and society could blithely look the other way. On the other, by the time the size of this mistake was clear, we were too committed to an economy that was driven by constant growth to be able to see or admit that we were indeed in deep trouble.

So major studies of the (un)sustainability of the economy start to be published in the nineteen sixties and seventies - Only One Earth, The Limits to Growth, and so on - and here we are, four decades later, still unable to take them in. Rather, the dissonance between any realistic solution to the problems of environmental sustainability and capitalist economic viability have rendered the problem too complex, the forces aligned with the wrong answer too powerful and those charged with solving the problem have been rendered too scared, too confused and too weakly equipped to deal with it.

Economic myth no.1: Who are the wealth creators?

One of the necessary consequences of governments failing to measure up to the current economic crisis – and as yet there is no evidence whatsoever that they plan to do anything the change or manage the system that put us where we are today – is that the old self-congratulatory myths start to resurface. Perhaps the most important of these myths is the fantasy that it is bankers and investors who are the true wealth creators.

Why does this myth matter? Because it is this myth ensures that the rich are also the powerful, through their unchallenged control the commanding heights of the economy. Because it is the myth that they are doing something unique and almost magical that we must not importune them for taxes or justifications of their prestidigitations, lest these magicians, these golden geese, fly away, casting us into helpless penury. It is also this myth that allows them to escape the sort of scrutiny to which every other strategic area of society is rightly subject, such as the social services, manufacturing, the education and health systems, the military and so on. It is this myth that allowed them to reward themselves with a disproportionate share of society’s wealth. It is even more important than the myth of the market because, above all else, the myth of the wealth creators allows those it mythologises to disempower everyone else.

But in reality is quite preposterous to identify wealth creation with a single sector of society. It is a simple tautology that wealth is created every time anyone takes a resource and turns it into something it solves a human problem (from hunger to vanity), that makes the real world materially more efficient or effective, or otherwise makes the world a better place.

A small part of this wealth is economic. But even if one focuses exclusively on goods and services that can be bought and sold, even there it would be preposterous to claim that wealth is created at the top. Every bolt screwed onto a machine, every machine operated to make a useful product, every product used to perform a valuable service, every service performed – they all add value. Nor is simply a question of the direct production of wealth. Every manager with a discretionary budget has the opportunity to create more wealth or less, depending on how they chose to use it.

One feature of modern economies that especially militates against the idea that wealth is created at the top is the progressive professionalization of roles in the economy. An employee is someone you pay so that you can tell them what to do; but a professional is someone you pay so that they will tell you what to do. This is clear enough with doctors, lawyers and so on, but it is equally true of professional staff. And their role in the organisation is specifically to know how to create wealth in their area better than their superiors. So the more the modern economic organisation is staffed by professionals, the less claim those a the top have to be exclusively the wealth creators. On the contrary, they are increasingly only coordinators of those who create the wealth.

Hence the difficulty of maintaining a hierarchical structure in strongly professional organisations – because it is increasingly difficult to maintain the myth that those a the top know best. This leaves senior executives in the contradictory position of wielding the power to hire and fire, to invest and disinvest and generally control the organisation, yet lacking any realistic claim to unique insight, awareness or pre-eminent skill. Rather like the absolute monarchs who created to modern state in the seventeenth and eighteenth centuries, the business hierarchs of modern world have created a massively powerful system – the modern capitalist business – that has less and less time or place for those who were its progenitors.

So what is it that distinguishes the bankers and the financial sector in general? In these terms, not very much. To the extent that they are merely managing budgets, nothing at all. The leverage and reach they exercise may seem vast, but to claim that this means that they create more wealth than others makes no more sense than saying that only the top person in a human pyramid gives it height. It’s rather like a previous era when it was salespeople who were idolised rather than the analysts, the superstar executives, the ‘quants’ and other financial monsters: they too were disproportionately rewarded for selling things other people actually made. Of course, an exceptional individual can make an exceptional difference, but that is true of wealth creation at every level. And it is not as though the evidence actually support the claim that bankers, let alone the financial sector as a whole, actually do create disproportionate wealth.

So what have they been doing for the last couple of decades that explains their fabulous rewards? Haven’t our economies grown exceptionally quickly? Isn’t that to the credit of the financial sector? In the illusory terms of global figures and monetary values, yes to both. But did anyone but themselves enjoy the wealth? No. When in 2008 the banks finally realised how unsure their financial footing was and started to pull the rug from under one another, it turned out that most of the monetary increase in wealth was an illusion. The bubbles had inflated the money but not increased the material wealth society enjoyed. In fact most people are no better off now than before the financial sector was let off the leash. The geese, it turned out, produced eggs of gilded lead, not true gold.

But even that is not the bottom of the barrel. Even if they had been creating exceptional wealth, those at the top of the tree are also the ones who decided on whose behalf wealth is created. This is not after all a completely neutral activity. You can decide how to divide up the surplus. The choice is quite simple: they can allocate the wealth to the shareholders, to the workers, to society (through taxation and true corporate social responsibility) – or to themselves. As ever, those at the top favoured their shareholders. But not as much, it turned out, as they favoured themselves. Despite the longer hours, the heightened insecurity and lower happiness, the average American is no better off than in the 1970s, and much the same is probably true in Britain too. There were no more goods and services, especially not for ordinary people – which is to say, for the vast majority of the real economic wealth creators. So even if they had created great wealth, don’t hold your breath waiting for your share. What you get is a insecurity and relentless pressure.

Finally, the bankers turned out to have produced something that is now busily reducing the total wealth in society. By dislocating the structure of ownership and credit in the economy as a whole, a great deal of its material wealth, its homes and security and comforts, has been debased from wealth to debt, as people of honest working people who thought they had the money to pay for it suddenly don’t. Through no fault of their own, millions are losing their livelihood. Among the very poorest in developing countries, tens of millions have been shoved into absolute poverty. Many will simply die.

But the mythology of wealth creation has already started to revive itself. And why not? For nothing has really changed, except that we now despise the bankers we once admired, and politicians (who have been offered a truly golden opportunity to become popular heroes without a hint of crass populism) are confirming the electorate’s worst suspicions about them.

Capitalist myth no.1: Who are the wealth creators?

One of the necessary consequences of governments failing to measure up to the current economic crisis – and as yet there is no evidence whatsoever that they plan to do anything the change or manage the system that put us where we are today – is that the old self-congratulatory myths start to resurface. Perhaps the most important of these myths is the fantasy that it is bankers and investors who are the true wealth creators.

Why does this myth matter? Because it is this myth ensures that the rich are also the powerful, through their unchallenged control the commanding heights of the economy. Because it is the myth that they are doing something unique and almost magical that we must not importune them for taxes or justifications of their prestidigitations, lest these magicians, these golden geese, fly away, casting us into helpless penury. It is also this myth that allows them to carry on without the sort of scrutiny to which every other strategic area of society, such as the social services, manufacturing, the education and health systems, the military and so on, is subject. It is this myth that allowed them to reward themselves with a disproportionate share of society’s wealth. It is even more important than the myth of the market because, above all else, the myth of the wealth creators allows those it mythologises to effectively disempower everyone else.

But in reality is quite preposterous to identify wealth creation with a single sector of society. It is a simple tautology that wealth is created every time anyone takes a resource and turns it into something it solves a human problem (from hunger to vanity), that makes the real world materially more efficient or effective, or otherwise makes the world a better place.

A small part of this wealth is economic. But even if one focuses exclusively on goods and services that can be bought and sold, even there it would be preposterous to claim that wealth is created at the top. Every bolt screwed onto a machine, every machine operated to make a useful product, every product used to perform a valuable service, every service performed – they all add value. Nor is simply a question of the direct production of wealth. Every manager with a discretionary budget has the opportunity to create more wealth or less, depending on how they chose to use it.

One feature of modern economies that especially militates against the idea that wealth is created at the top is the progressive professionalization of roles in the economy. An employee is someone you pay to do as you tell them; but a professional is someone you pay to tell you what to do. This is clear enough with doctors, lawyers and so on, but it is equally true of professional staff. And their role in the organisation is specifically to know how to create wealth in their area better than their superiors. So the more the modern economic organisation is staffed by professionals, the less claim those at the top have to be exclusively the wealth creators. On the contrary, they are increasingly only coordinators of the people who really create the wealth.

Hence the difficulty of maintaining a hierarchical structure in strongly professional organisations – because it is increasingly difficult to maintain the myth that those a the top know best. This leaves senior executives in the contradictory position of wielding the power to hire and fire, to invest and disinvest and generally control the organisation, yet lacking any realistic claim to unique insight, awareness or pre-eminent skill. Rather like the absolute monarchs who created to modern state in the seventeenth and eighteenth centuries, the business hierarchs of modern world have created a massively powerful system – the modern capitalist business – that has less and less time or place for those who were its progenitors.

So what is it that distinguishes the bankers and the financial sector in general? In these terms, not very much. To the extent that they are merely managing budgets, nothing at all. The leverage and reach they exercise may seem vast, but to claim that this means that they create more wealth than others makes no more sense than saying that only the top person in a human pyramid gives it height. It’s rather like a previous era when it was salespeople who were idolised rather than the analysts, the superstar executives, the ‘quants’ and other financial monsters: they too were disproportionately rewarded for selling things other people actually made. Of course, an exceptional individual can make an exceptional difference, but that is true of wealth creation at every level. And it is not as though the evidence actually support the claim that bankers, let alone the financial sector as a whole, actually do create disproportionate wealth.

So what have they been doing for the last couple of decades that explains their fabulous rewards? Haven’t our economies grown exceptionally quickly? Isn’t that to the credit of the financial sector? In the illusory terms of global figures and monetary values, yes to both. But did anyone but themselves enjoy the wealth? No. When in 2008 the banks finally realised how unsure their financial footing was and started to pull the rug from under one another, it turned out that most of the monetary increase in wealth was an illusion. The bubbles had inflated the money but not increased the material wealth society enjoyed. In fact most people are no better off now than before the financial sector was let off the leash. The geese, it turned out, produced eggs of gilded lead, not true gold.

But even that is not the bottom of the barrel. Even if they had been creating exceptional wealth, those at the top of the tree are also the ones who decided on whose behalf wealth is created. This is not after all a completely neutral activity. You can decide how to divide up the surplus. The choice is quite simple: they can allocate the wealth to the shareholders, to the workers, to society (through taxation and true corporate social responsibility) – or to themselves. As ever, those at the top favoured their shareholders. But not as much, it turned out, as they favoured themselves. Despite the longer hours, the heightened insecurity and lower happiness, the average American is no better off than in the 1970s, and much the same is probably true in Britain too. There were no more goods and services, especially not for ordinary people – which is to say, for the vast majority of the real economic wealth creators. So even if they had created great wealth, don’t hold your breath waiting for your share. What you get is a insecurity and relentless pressure.

Finally, the bankers turned out to have produced new, fully financialised layer to the economy that is now busily reducing the total wealth in society. By dislocating the structure of ownership and credit in the economy as a whole, a great deal of its material wealth, its homes and security and comforts, has been debased from wealth to debt, as people of honest working people who thought they had the money to pay for it suddenly don’t. Through no fault of their own, millions are losing their livelihood. Among the very poorest in developing countries, tens of millions have been shoved into absolute poverty. Many will simply die.

But the mythology of wealth creation has already started to revive itself. And why not? For nothing has really changed, except that we now despise the bankers we once admired, and politicians (who have been offered a truly golden opportunity to become popular heroes without a hint of crass populism) are confirming the electorate’s worst suspicions about them.

Economic myth no.2: Trickle-down economics

One of the mainstays of market economics is the idea of trickle-down – that it does not matter that the rich corner the money, because eventually they will spend it only lesser mortals, who will then benefit from it.

This is not a very convincing idea, yet it stays on the lips of conservative politicians and economists everywhere. And it’s not true, of course – not even about the money, let alone the real economic consequences. Starting with the real economy, what happens when a rich person acquires money and spends it as a private individual? They spend it on, say, a house. Eventually everyone who works on the house is paid of course – hence the trickle-down. But what happens to the real human effort and the resources that go into that house? They are the real value in the economy, and what happens to them? They remain in the hands of the owner. They enter the economy through the paid work, but promptly leave society in the form of a private dwelling that absorbs a disproportionate amount of social activity and resources. That time, effort and resource can never be used by society again.

Contrast this to what would have happened if the same amount of money had been spent on, say, new classrooms and facilities for the local school. The same effort and resources would have been expended, but this time all those who built it would still benefit from the product of their work – the school itself. This remains in circulation in society, as it were, in complete contrast to the private home. So trickle-down economics is aptly named – only a trickle of the great flood of real social value benefits society as a whole, while much the greater part remains in the hands of the wealthy in the form of the real goods and services they enjoy.

What about the money, then? Surely that has to circulate? Some of it, such as the payment for work and materials, yes, but not all. A good deal will be set aside for investment. And what is investment for, if not to buy further property that both generates further income to be used for socially exploitative purposes and places more of the real economy into private hands? Of course, the money is eventually released, but only under conditions that not only repeat the same cycle but also reinforce the control of the propertied over the rest.

Quaking in their Gucci boots

... as George Monbiot described the bankers the other day[1], writing about the British government's utterly supine response to the banking crisis and those who caused it. Apparently Brown and Darling have declined to learn the lesson Nassim Nicholas Taleb suggested last April - that 'People who were driving a school bus blindfolded (and crashed it) should never be given a new bus'. In fact it's pretty hard to identify even one of Taleb's 'ten principles for a Black Swan-proof world' [2] that has found its way into public policy.

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail.
2. No socialisation of losses and privatisation of gains.
3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.
4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.
5. Counter-balance complexity with simplicity.
6. Do not give children sticks of dynamite, even if they come with a warning.
7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”.
8. Do not give an addict more drugs if he has withdrawal pains.
9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.
10. Make an omelette with the broken eggs.

No, as far as I can see it, not one of these lessons has been learned. Well done, chaps. Apparently, say Brown and Darling, it is 'impractical' to change the system so that we can exercise any control over it. Which can only mean that that system is out of control, but we are not worried enough about its unintended effects to do anything about it.

But is Taleb's own prescription enough?

Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

But even if we did all this (personally I love the one about abolishing the Nobel prize for economics), would Capitalism 2.0 really be the answer? We got into the present crisis by allowing capitalism's basic rules - the structures and interests that underpin all forms of capitalism, which Taleb and other critics from within show no inclination to criticise, even in the name of Capitalism 2.0 - to play themselves out with unprecedented freedom. This particular 'black swan' was no improbable mutant but the entirely predictable (and predicted on both right and left) effect of capitalsm's most basic causes, that was only inconceivable to those of the Thatcher/Reagan generation of politicians and the idealists of economic theory for whom, no matter what the question, unbridled capitalism was the right - no, the righteous - answer.

Meanwhile, George Monbiot's own diagnosis - that no one bears more responsibility for the current mess than Gordon Brown and Alan Greenspan - essentially that this was a crisis induced by political irresponsibility and weak regulation - has some merit, but by focusing on the individuals or even on rather secondary functions of the economy rather than the structure of the economy itself - distracts attention from the real problem. The crisis was not created by poor management of our economic system; no, it was created by the very nature of that system.

So what are we looking at here? Both capitalism's intellectual critics and its would-be political masters are unable to see what got us into this, or that there is no version of capitalism that will not, eventually, pull the same trick.

Not that capitalism is an unqualified disaster. Far from it - it is after all only through capitalism that the modern world, with all its fabulous wealth and freedom, took shape at all. But it must be understood that capitalism is rather like adolescence: a huge improvement on its predecessors, but not something to be hung on to for its own sake. There is life after the teens, and there is history after capitalism.

[1] 'The Great Cop-Out,' Monbiot.com, 8 September 2009.
[2] 'Ten principles for a Black Swan-proof world', FT, April 7 2009.

Markets and the Return of the Economic Zombie!

As someone or other once said, generals always plan to fight the next war with the weapons of the last. Much the same seems to be true of economists. In the light (if that is the word) of the last year or two, the idea that market economics is still a contender for the basic model for the economy is quaint to say the least. Even if you take capitalism for granted (which, for the time being, I think we can), markets and market theory are hardly contenders for tools for managing it. The reason I say this is because a) markets don’t really exist, and b) even if they did, standard market theory is at best half-baked and at worst simply false.

Perhaps I should restate the claim that markets don't exist. Markets don't exist as market economists imagine them. The assumptions market economics is based simply do not apply to current economic conditions, and have not been relevant for at least half a century. Market theory has always assumed a number of things (the various perfections of 'perfect competition'), most of which only really exist in minimal, distorted and illusory forms.

For example, 'perfect information' was always nonsense and we have a whole raft of industries - marketing, advertising and lobbying - on hand to keep things that way. The recent history of financial engineering also demonstrates amply how easy it was for markets to be dominated by mechanism that many players plainly did not understand, so that they had little idea what they were doing from day to day. Even George Soros said he had kept clear of derivatives because he did not understand them. Recent developments such as ‘deep pools’ can only worsen this situation by deliberately concealing market information. There are some areas where markets are still quite real, but I doubt that plumbers and fish markets command much of anyone’s GNP.

As for another key condition for markets to be efficient, ease of entry, this ceased to make any sense when economies reached the scale where only major corporations and governments could summon up enough capital to enter any major industry. Conversely, ease of exit was rendered irrelevant with the arrival of large-scale fixed capital as the sine qua non of most industries. Fixed capital is notoriously difficult to dispose of at a decent price even when it is still usable, and if you are keen to exit a market it is probably because it is shrinking, so you won’t find anyone to buy it.

Likewise for all the other key assumptions of market economics. They make a neat, if narrow, theory, but none of them actually applies under modern economic conditions.

As for the idea that market theory is at best half-baked and at worst simply false, market economics claims that markets will always tend towards equilibrium. This is hardly what history would suggest, and it ignores at least two intrinsic features of market economies.

Firstly, the various kinds of market imperfection I have just mentioned all serve to push markets into disequilibrium, because they create special interests (often very widespread or of involving very large players) who are keen to seek, create and exploit disequilibrium.

Secondly, the real tendency of markets is not towards equilibrium but towards bubbles and monopoly. Bubbles arise when it is not the intrinsic value of goods and services that are being invested in but movements in the market itself (i.e., when, as Keynes put it, the speculative froth on the surface of the stream of solid investments is inverted into a maelstrom of speculation that drowns out real investment). This inversion became inevitable as soon markets become a forum for making money by speculation rather than for allocating scarce resources. When this orgy of money-making has reached the point where market players start to notice just how far this process has diverted the formal ownership of resources from any economically plausible use, collapse ensues as inevitably as the original bubble.

Given how market economists like to define the market as an efficient mechanism for distributing scarce resources, inveterate leftists like me find it grimly ironic to note that it capitalism itself, whose sole rationale is to make money, that ensures that markets lead inevitably to bubbles, the misallocation of resources and collapse.

As Oscar Wilde said, a cynic is a man who knows the price or everything and the value of nothing, so it’s nice to see that even in the impersonal world of the market, the inherent cynicism of market theory gets its comeuppance. Pity about the millions of ordinary people whose lives it destroys.

As for monopolies, as we all know, productivity is generally much improved by economies of scale. That in turn generally demands large-scale investment, typically in machinery and rationalisations that are closed to small players. But this reduces the number of businesses that can afford to operate in this market, or for which the size of the market leaves elbow room. And so the spiral starts and continues until only a handful of players is left. Not technically a monopoly, so there is still some limited competition, but even an oligopoly consists of a small number of players whose interests vis à vis their customer are identical – and identically predatory. And certainly any notion of a free market has long since disappeared.

Another nice irony of market capitalism then: as with bubbles, monopolies show how it is the very workings of historic markets that rendered modern market theory irrelevant. Not in this case because they create bubbles that destroy the value even as they generate lots of money, but because they create an economic universe in which, far from a large number of small players buying and selling, a small number of truly vast players distort the entire economy to suit themselves.

Basically, Adam Smith’s enthusiasm for the market was based on an economy of small players with small, easily liquidated investments in a large market. A nice dream of a cosy middle class world. Market theory persists with this dream. But we don’t live there any more.

Overdosing on Dr Li’s Magic Formula

One persistent theme in my experience of business over the last quarter-century is how wrong-headed it is to rely on what suits business to determine the direction of the economy as a whole. A second is that intellectual narrow-mindedness can make otherwise apparently clever people do some very dumb things.

It is not that most business people aren’t clever or that they don’t understand economics; rather, it does not matter how clever they are or what they do or don’t understand, because once business is allowed its head, the natural tendency of markets toward monopoly, bubbles and assorted other economic irrationality and social disaster is inherent in business itself.

The basic principles of investment ensure that, even for a democratically minded investor, a financial return – a profit - must be extracted sooner or later, while the equally basic rules of risk management mean that the shorter the term over which that profit is made, the greater the chance of not losing it to serendipity, market vagaries or the other guy being smarter/meaner/luckier than you. Add to that the extent to which most companies – and certainly all economically significant ones – rely on investment and re-investment from bodies such as investment banks, pension funds and insurance companies, whose sole interest lies in maximising the returns on their investments, and no sooner do you leave business to its own devices than they all start rushing towards the cliff.

For allowing business to have its head is rather like shouting Fire! in a theatre: everyone rushes in the same direction, because that is where survival – which is to say, the profit - lies. And when people all start running in the same direction, two things happen. Firstly, things start to get distorted. And secondly, people start to notice that they can rely on people running that way, even though there is no obvious reason way they are. Hence bubbles: things start to rise, then people start to buy not because they can see intrinsic value in what they are buying but because they have confidence that other people will soon be willing to pay even more for what they have just bought, and they will make a tidy profit selling it to them.

Add to that the extent to which market economics became an all-conquering ideology from the 1980s onwards, and it soon became inconceivable that the interests of business and the plans of its leaders could be wrong for society as a whole. In reality, it turns out, they were completely opposed. Follies such as the Private Finance Initiative or rail privatisation should have been enough to convince any disinterested onlooker, but as far as deregulating markets was concerned, nothing was too much. So regulators had spent half a decade mouthing oxymorons such as ‘light-touch regulation’ and declining to be firm with whole industries because ‘business wouldn’t like it’.

This could only happen because the free market fantasy went right to the top. Thatcher, Reagan, Clinton, Blair, Bush and Brown all expressed a quasi-religious passion, and did not the upright Senator Phillip Gramm say, ‘Some people look at sub-prime lending and see evil. I look at sub-prime lending and I see the American Dream in action’. Indeed - where but in a dream could anyone couple human happiness with unbridled market capitalism with an untroubled mind? Or how about, ‘When I am on Wall St and I realise that that’s the very nerve centre of American capitalism and I realise what capitalism has done for the working people of American, to me that’s a holy place’. I trust someone has engraved such fine words on Senator Gramm’s retinas for future reference.

Where did all this lead to? Inevitably, right into the heart of (cliché alert!) the perfect market storm.

The absurdity of this situation is illustrated by the enthusiasm with which markets adopted David X. Li’s now-notorious equation for calculating just how risky buying and selling really were. This (somewhat medical-sounding) ‘Gaussian copula function’ in fact allowed them to work out the probability that a borrower would default on their payments. Once you have a simple answer to this question, it becomes much more profitable to lend to them (or at least, lend to a whole class of borrowers of the same kind), because you know exactly how much you can risk. You certainly don’t have to understand or pay regard to the underlying economic situation. With that, the market is reduced to a casino – from the individual punter’s point of view, most people lose their shirt, but from the house’s perspective, it’s almost impossible not to clean up.

Or at least so it seemed once Li had performed the seeming miracle of replacing all that intractably complex analysis of interacting variables and erratically fluctuating intangibles with a single neat number. This number was extremely easy to understand – a little too easy, it turned out – and allowed bankers and their minions to create a complete parallel universe populated with exotic beasts such as ‘collateralised debt obligations’ and ‘credit default swaps’. And rather like the real universe, it grew by a fantastic process of inflation that defied mere time and space, with the derivatives market quintupling in size from $100 trillion in 2002 to $500 trillion – that’s $500,000,000,000,000 - in 2007. George Soros might admit that he didn’t understand these fancy new kind of derivative and Warren Buffett might call them ‘financial weapons of mass destruction’, but the really smart guys weren’t fazed: what the hell – there was money – lots and lots of money – to be made.

But, like unicorns, CDO’s and CDS’s – not to mention still more mysterious animals of the genus ‘CDO-squared’ - turned out to be beautiful, magical and mostly fictional. There was something there, but once the lights came up, they turned out to be little more than dead donkeys. What is more, the vast sums these true believers made were conjured up not, as it seemed both to City and Wall Street financiers and to their political accomplices, by the magic of the market, but by those very same bankers allowing a combination of ignorance and greed to create a market treadmill it was all but impossible to get off. With that, they broke all connection between business and the economy, to the point where the two became fundamentally opposed.

Hence both the illusory nature and the market triumph of David Li’s formula and the hypnotically simple ‘correlation’ it generated. For this clever tool offered to replace with a single, precise, eminently intelligible number any kind of analysis of the connection between a product’s price and the complex and imprecise underlying economic realities that gave it material value. The mere fact that the result was simply a single number should have started the alarm bells ringing – it is completely unbelievable that anything of economic significance could be meaningfully defined in such simple terms. But then the markets aren’t trying to manage the economy - they are looking for safe, swift and above all spectacular profits.

Which is what they got, for a while at least. But what was David Li’s magic number really based on? Two things: short-term thinking and the market feeding on itself. Not that David Li's model was unusual in that respect. The Bank of England director for financial stability, Andrew Haldane, has commented that 'With hindsight, the stress-tests required by the authorities over the past few years were too heavily influenced by behaviour during the golden decade' (i.e., 1998-2007). Not very smart, given how exceptional everyone knew this period really was.

Yet Li's model took this process to its extreme, by taking into account only right now.Underlying Li’s equation is the assumption that, far from trying to understand the value of an investment – which is to say, its true economic value – it is only necessary to know how much the market is currently pricing it at. Once you know that, you can estimate the risk you are taking when you buy or sell it. But such an approach can only work while the market is buying or selling in unison and is either completely static or continuously changing in the same direction. The former is almost unheard of in recent decades, while the latter can only endure while the market is in bubble-mode, and people are buying and selling at silly prices primarily because other people can be relied on to sell and buy at sillier prices still.

Eventually, however, the strains this creates are too much even for these florid times. Eventually, investors start to realise that a) they no longer have any idea what anything is really worth, b) whatever it is, it is a lot less than what the market is saying right now, so c) the prices of their assets makes no sense at all. With that, Li’s reassuringly singular equation starts point firmly downwards, and everyone starts shouting Fire! And heads for the exits. The market burns down with most people still inside, and the central mechanism for manage truly huge swathes of the entire global economy goes up in smoke.

This is yet another instance of the notorious ‘mark to market’ strategy, of course – of valuing something solely by current price rather than taking into account any notion of material (social, economic, etc.) value that might sustain its price. As the current crisis has amply demonstrated, this has the disastrous effect of exaggerating a company’s value enormously when a bull market is in progress and asset prices are all going up. This in turn allows that company to borrow far more than they would have been allowed in less bullish conditions, even though the economic value of the company has not changed. Conversely, as soon as the market turns, the company’s assets are worth less and less, its credit collapses and all those loans are called in. What has changed in the economy? Nothing. What has changed in the market? Everything. So what then happens to the economy, at whose heart these unfettered markets sit? Disaster.

And all this is epitomised in Li’s formula. It’s timescale is not so much short-term as instantaneous, so any rapid market shift can bring on a catastrophe. By reducing everything to a single index it demonstrates that its sole purpose is to price risk and feed short-term speculation, rather than calculate realistically complex economic values, and so support true investment. Its simplicity concealed far more than it revealed, to the point where 30% of the US mortgage market could be made up of sub-prime mortgages and no one noticed. By being nice and simple, it seduced mathematically illiterate managers into believing they could do magic. Which, like the sorcerer’s apprentice, they could – they sprinkled Dr Li’s fairy dust over the financial sector, and it disappeared. Finally, it values risk based solely on what the market says it is worth, which (like all speculation) is both economically trivial and completely circular. So as soon as it starts to be widely used it is almost designed to generate a bubble, and the very nature of bubbles is that they take make everyone believe that they can defy economic gravity – just like they could with the dot.com boom, the supposedly ever-expanding ‘knowledge economy’ and a host of other booms and busts. The fate of bubbles was Economics 101 then and it is Economics 101 now.

But it would be quite wrong to blame David Li and his equation. Many experts warned against taking it seriously. So did David Li - though that didn’t stop him making his fortune out of it. In fact it makes more sense to ask not how the Li formula destroyed the financial markets, but how the financial markets, with their superficiality, their collective egoism, their indifference to long-term consequences and their power to strong-arm anyone caught up in them to play economically and socially insane games, created an audience for Li’s formula.

But what about all those clever business people who declined to heed the many warnings? The regulators who endorsed its use, even though one Standard + Poor analyst remarked ‘Let’s hope we are all wealthy and retired by the time this house of cards falters’? The politicians who gave business the ‘light-touch regulation’ it wanted? All those clever free-market acolytes from the Wall St Journal, the FT and the Economist? Yes, I think we can blame them. Not that I blame them for being wrong; but I do blame them for being so utterly uncritical, so deaf and blind, so patronising to those who questioned their shallow fantasies and so cowardly when the end was in sight. Unlike explorers searching for Eldorado, they had every reason to know exactly where we were heading.

They just preferred not to notice until it was too late – for all of us.

Mood of sobriety and self-recrimination at Davos

Well, that’s how the Financial Times describes the scene as bereft millionaires and billionaires, down to their last few helicopters, swan into Davos to keep the world on the straight and narrow. Along with Angela Merkel, Vladimir Putin, Gordon Brown and the prime minister of China, Wen Jiabao, and 2500 other VIPs. Not too many from Lehman Bros, but you can’t have everything. Plainly the right people for the job, considering the spiffing job they've done to date.

Don’t they have any sense of responsibility for the disaster they have visited upon the world? It’s not as though the mistakes they have made were hard to spot - basically it was just Financial Management 101. But perhaps they could not see beyond the vast and constantly growing piles of money that were blocking their view, and so stopped them being able to detect the misery this would cause to absolutely everybody else. That’s what happens if you give the making of traffic laws over to the drivers with fastest cars – everyone else ends up run over.

So what are they talking about in Davos? It’s still the economy, stupid. Some, it seems, are likely to be a bit less bullish about globalisation, free-market economics and insane levels of risk. A little ‘sobriety and self-recrimination’ will become them. Yet it turns out that not all are contrite. Apparently Duncan Niederauer has pronounced that “We’ve had a globalised economy and markets over the past few years and that’s been brought into question given the financial crisis. But there is no turning back”.

I’m sure Mr Niederauer’s perspective is not clouded by the fact that he is the CEO of NYSE Euronext, which owns two of the world’s biggest stock exchanges and is liable to serious damage if the world starts to think that endless speculation (which until recently made up about 95% of all trades, with only 5% going into real investments) is a pretty poor way to run the economy.

But of course it’s a completely spurious argument anyway. No one is asking them to ‘go back’. This isn’t a choice between trading and not trading. It’s not very likely that anyone in Davos is thinking that even globalisation is under threat. The question is, if we trade, to what purpose do we do it, and so by what rules should it be done. As things currently stand, we trade so that big companies can profit, as though that is the necessary and sufficient premise for global well-being. That is why we have the WTO – to implement a very abstract and theoretical model of economics.

But the way WTO rules actually work favours governments and businesses that are already rich and powerful and all but encourages corporations to despoil cheap resources and then move on. So is this what we want to perpetuate? I doubt it, because we have just seen what deregulating businesses does to the world, and everything we know about the environment screams out what will happen if we continue to globalise manufacturing, transport, energy generation, public services and a host of other pillars of the world economy in accordance with what can only be called the standard Davos model. The impact on climate change, ecosystems damage and resource depletion (starring Peak Oil) will be vast, unmanageable and catastrophic. Certainly there won’t be any more snow in Davos.

So what should they be doing? Hard to say. It’s not that it’s hard to invent plausible recommendations for moving the world economy to a safer path. It’s just that these are just about the last people on Earth I would ask for advice from. How about, walk home, train more rational successors, and resign en masse?