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…’
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?
Click on the title of this post for some interesting observations on cap and trade. It can't work unless we force the price of carbon so high that it is uneconomic to burn fossil fuels, and that will never be allowed to happen so long as everyone thinks a) economic benefit can be created while disregarding the environmental consequences, and b) this is a zero sum game in which we have to make someone else pay.
There are in fact at least five ways in which the rationality of markets can be challenged, and all of them have implications – not all negative - for the environment.
Firstly, sometimes people just aren’t rational by any standard. However, this is not all innocent folly or individual caprice. Not only are individuals open to irrational behaviour on their own account, but they can often be manipulated, stampeded and panicked into actions that are, from their own point of view, profoundly irrational, but that are very much in the economic interests of others.
This possibility is routinely exploited through (and often by) the mass media, of course. In the absence of a systemic account of the ways in which individuals in the economy are behaving irrationally, it is hard to say just what that means, or what it does to conventional economic theory apart from render it more or less fuzzy. But whatever the answer is, it is unlikely to figure in conventional economic theory, as it my suggest that the power to exploit and control is fundamental to our economic system, yet decidedly not the benign (or at least neutral) thing markets are supposed to be.
Secondly, if by ‘rational’ we mean, ‘pursuing economic self-interest’, it is obvious that a great deal of human behaviour can’t be forced into this particular (indeed, peculiar) mould. That does not mean that we are irrational – only that the rationality according to which we operate is not narrowly economic. I doubt that a committed church-goer tithes a significant fraction of their income out of reasons of economic self-interest, and the idea that people contribute to charities out of a very indirect calculation that they may need that charity’s services one day is surreal, to say the least. It would be doubtful to propose that a person on the streets of Manchester or San Francisco contributes to Oxfam because they expect to need Oxfam’s support any time soon. People have values, goals, interests, relationships, and any number of other motives that affect their behaviour, all of which can be pursued rationality without ever reflecting economic rationality.
This can be extremely fortunate for the environment, because it means that people are willing to pay for environmental management even when it ‘harms’ their economic self-interest. Unfortunately there are quite a few ways in which the same ability to rise above economic self-interest is likely to harm the environment – as when a certain kind of fundamentalist is persuaded that environmental problems are signs of Last Days, or that any kind of collective action is ‘communism’.
Thirdly, when we hand over the direct management of our economic interests to others (typically investment professionals, the senior management of the firms by which we are employed, our government’s treasury department, and quite a few others), this creates a dilemma for the theory of economic rationality. Either they pursue our interests on our behalf, and not their own, in which case they are not being rational from their own perspective, or they do the reverse – in which case they aren’t being rational from our perspective.
This is the problem of ‘agency’, as economists like to call it, and it had a major impact on creating the recent global economic crisis. Investment banks hotly pursuing their own interests netted themselves billions in fees for investment advice and dubious sales, not to mention outright fraud, but added little value as far as the rest of us – including their immediate customers – were concerned.
From an environmental point of view this could prove to be a serious issue, as it is crucial that environmental problems are seen as affecting all of us equally, and, conversely, that one group cannot evade the consequences by exploiting another. Unfortunately, although this may be true in the long run, especially if the problems turn out to be still more severe than most people expect, it is unlikely that such a long-term perspective will be the rule. Indeed, we can certainly expect some groups – from privileged individuals up to corporations and national governments – to do their utmost to exploit the weaknesses of others.
Fourthly, there is the more profound kind of irrationality that follows from the fact that what is rational for an individual can be counterproductive, or even outright destructive, when replicated all across a market.
From an environmental perspective this is all too common, as can be seen from the ratchet effect of many investments. To take a very parochial example, right now the London underground train system (the Tube) is being blighted with hundreds of screens that show dynamic advertisements in place of the old posters. This raises the impact of these advertisements, but they probably also represent only the thin end of the wedge, and we can certainly expect these deeply annoying devices to become the norm. But with that, all advertisements will be restored to an equal footing, so no advantage will be gained by using electronic screens. But no one will be able to go backwards either, to old fashioned paper posters. From an environmental point of view, these necessarily lead to more material resources – electronics, energy, and so on - being invested to achieve absolutely no net material benefit (as opposed to monetary) value.
Finally, there are situations – some extremely widespread – in which the economically ‘rational’ option simply isn’t available. In any market that is dominated by large-scale capital (which is to say, any area of heavy industry, any long-term commitment, and so on), rapid movements to reflect a sudden change of circumstance are simply not options.
For example, if a lower-cost operator suddenly enters the market – as often as not taking advantage of the most recent methods, processes, technologies, etc. – they can price their goods and services below more established operators, who are still committed to the old approach. The latter may have the option of moving to a lower-cost operation too – but the long-term nature of many financial commitments may mean that the old investments still have to be paid off, and the arrival of a radically new operating model may mean that the systems and resources by which they currently operate simply cannot be sold off, because no one want them.
From an environmental perspective, this is almost invariably disastrous, as it obliges the owners of that capital to carry on using it, regardless of the environmental consequences. A power station or car plant built today must be operated for decades to come if it is to be paid for, and its proprietors will lobby for the continuation of dirty energy and transport for the same period.
And all that is leaving aside the conscious exploitation of other complexities such as 'informational asymmetry' (i.e., they're lyng to you). All in all, the case for the ‘rationality’ of markets, or for the so-called ‘efficient markets hypothesis’, is not strong. As far as the environment is concerned, it is pretty disastrously flawed.
Currently reading Nicholas Stern’s Blueprint for a Safer Planet, and I find – as I usually do when reading authors for whom the market is some kind of shibboleth – that he really doesn’t understand how secondary the market is to strictly political decisions – or the absence of decisions – about how we want our economy to work.
Markets are rather like games: how well they work and what their consequences are depend very much on how you set up the rules and referee individual games. Without that there is no game, so to appeal to ‘the game’ as a solution to problems with the game itself makes very little sense. In the case of markets, to imagine that ‘the market’ can solve social, environmental or even economic problems on its own is irrational, to say the least.
In the present context, we know that markets will not, in their current incarnations, solve environmental problems of the size and kind we now face. Stern himself lists a very large number of market failures and rightly insists that markets need to be regulated in very deliberate ways if they are to contribute to environmental solutions. But what he does not seem to recognise three fundamental problems with the entire model.
In summary, ‘market failure’ is actively created by markets, is deliberately perpetuated by participants in that market, and is in fact an inescapable fact until markets can no longer operate solely in terms of prices – which is an unlikely state of affairs without very substantial political intervention.
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