Recently there have been a number of discussions concerning economic growth and global warming. Some have argued that the effort to prevent as much global warming as possible will incur unacceptable costs to the global economy in terms of growth. Others have argued that growth is causing global warming.
I want to argue that neoclassical economics is badly designed to help with this debate. The two main problems, in my opinion, are that economics does not see the economy as being composed of a set of nonsubstitutable “life support” functions, to use Joshua Farley‘s phrase; and the neoclassical theory of economic growth is inadequate (PDF) for understanding how global warming (and most everything else) will effect growth.
The problem of economic growth looms large in both the DICE model put forward by William Nordhaus, and the Stern Report, led Sir Nicholas Stern, because they both calculate the extent to which global warming and global warming mitigation will effect growth. In 1991, Stern opined that growth theory “has, however, been a popular topic for those involved in formal economic theory only for short periods, notably from the mid 1950s to the late 1960s.” There is a good reason for this: neoclassical growth theory doesn’t really explain economic growth.
Professor Robert Solow of MIT is credited with devising the basic theory of growth. In accepting his Nobel Prize in Economics in 1988 for his work, Solow stated that “The permanent rate of growth of output per unit of labor input … depends entirely on the rate of technological progress in the broadest sense.” But neoclassical economics cannot explain technological progress, neither in the broadest sense, nor in most other senses: the vast majority of economic models assume no technological change, because the models are based on short-term processes. No explanation for innovation, no explanation for economic growth.
Solow later tried to get out of this conundrum in 1994 when he alluded to “a criticism of the neoclassical model: it is a theory of growth that leaves the main factor in economic growth unexplained.” His solution: the work of Paul Romer, who devised a factor of production he calls “knowledge.” Without getting into any more details, Romer is trying — unsuccessfully in the view of many economists — to square a circle: to talk about positive feedback, or exponential growth, or, well, things just increasing faster and faster, even though neoclassical economics is incapable of incorporating these sorts of processes — the very processes that lead to economic growth.
Perhaps it is ironic that ecologists, who are acutely aware of the consequences of global warming, have been studying and writing about exponential growth since Darwin wrote On the Origin of Species. From a theoretical point of view, ecologists are in a better position to discuss economic growth than economists are. As I tried to show in a recent post, there are a set of kinds of machinery, which I called reproduction machinery, that are central to growth. For instance, a machine tool, a machine that make parts for other machines, can also make parts for more machine tools.
Capital, or more specifically the production machinery used to make goods and services, is at the center of growth of a modern industrial economy. The only social scientists who seem to have adequately developed this idea are the authors of The Limits to Growth, who use these processes to show that by the middle of the 21st century, our use of resources will peak and start to go down, with devastating results for the very global economy that economists are purporting to predict.
Now, if you look at the DICE model or Stern’s report, you will see the use of terms like “total factor productivity” or “technical progress,” which are given nice precise numbers. But that term is really nothing more than Solow’s “technical progress in the broadest sense”; that is, it has not been explained. And this is because the main equation used — called an aggregate production function — while ideologically convergent with neoclassical economics, doesn’t work in the real world.
In order to understand how this state of affairs came about, you have to know something of the intellectual history of the late 19th century. Economists were concerned that the theories of Karl Marx and other radicals were beginning to look very attractive. So John Bates Clark, one of the founders of neoclassical economics, countered with the concept of marginal productivity. While Marx was espousing the idea that each should give according to their abilities, and each should receive according to their needs, Clark wanted to show that this just state of affairs was already happening.
According to Clark’s theory of marginal productivity, everyone’s wages and salaries are the way they are because the natural operation of the free market insures that such will be the case. This is allegedly the consequence of the dimishing returns that every extra worker provides upon his employment; workers are hired until the next worker would yield not enough returns to justify his particular employment.
Both of these concepts, marginal productivity and dimishing returns, were used to construct an aggregate production function and a theory of growth. The world was divided into two “factors of production”: labor and capital. Labor gets about two thirds of the income of the U.S. economy; therefore, economists reason, labor must be responsible for two thirds of the wealth of the country. Capital, receiving one third of the national income, must be responsible for one third of the wealth. And if there is economic growth, then it must be because labor contributes two thirds of the growth, and capital must provide one third … except that they don’t. Labor, as measured by total hours worked, has been pretty stable over much of the last 50 years or so, but the economy has grown many times over. As it turns out, capital has increased by about the same rate as the economy. So it would seem that capital causes economic growth.
But that would contradict the theory of marginal productivity, and to a certain extent by implication, the importance of diminishing returns. In 1975, Paul Samuelson, then dean of American economists, and the predecessor and temporarily coauthor of the major introductory economics textbook with William Nordhaus, had this to say about this problem:
A steady profit rate [that is, share of capital in national income] and a steady capital-output ratio [that is, capital and the economy track each other] are incompatible with the more basic law of diminishing returns under deepening of capital. We are forced, therefore, to introduce technical innovations into our statical neoclassical analysis to explain these dynamic facts.
In other words, the facts have to be arranged for the convenience of the theory; we need to invent an X factor, some mysterious force that must be there because that way the main theory would make sense. So when you see an economic study that talks about technical progress or total factor productivity, remember that what is being measured is really, at best, what the economic historian Moses Abramovitz famously called “a measure of our ignorance” — and simply the random result of an inappropriate equation, at worst.
So what has all this got to do with global warming? First of all, the development of major technologies such as solar, wind, geothermal power, and trains are the development of the production machinery that I was referring to as the real source of economic growth. The same applies to technologies such as organic permaculture-type farming, or producing materials to retrofit buildings. So even if preventing as much global warming as possible led to a decline in certain activities such as the production of fossil fuels or bigger houses, it would build the foundation for larger economic growth — and sustainable, long-term economic growth, at that.
There is a further important lesson to be learned. I indicated at the beginning that economics does not recognize the importance of the functional necessity of various parts of the economy. While machinery is necessary for the raw growth of the economy, the health of each major sector of the economy is necessary for the health of the overall economy — the balance of nature turns into the balance of the economy.
What are these necessary sectors? Agriculture, for one, even though Robert Schelling, another economics Nobel laureate, recently stated that it didn’t matter if global agriculture is hurt by global warming because agriculture is only 3 percent of the global economy. This is the sort of statement that is made if you think that everything is substitutable. If you lose something, you can always substitute something else for it; in a similar vein, some argue that we can replace our declining manufacturing base with services (I argued against this idea recently).
But if we use an ecological point of view, we see that the idea that nothing-is-necessary is useless for understanding the way a complex system works. Trees cannot be substituted with deer, and deer cannot be substituted with wolves. All three are necessary in a thriving ecosystem, and agriculture, manufacturing, water, the climate, cities, and services are all necessary if we are to thrive. Now, global warming, if it becomes even moderately destructive, will effect many of these. So even if, in money terms, the damage is not so great, in functional terms, the damage might be monumental. Therefore, aggregate numbers of how much damage global warming will create is not particularly useful. We have to know what is affected, and where, and in relation to the other sectors, in order to know the effects of global warming.
Neoclassical economics works well within the specific domain that is the subject of economic models — a specific competitive industry, in the short-term, with little or no technological change. It is much less useful when needed to explain the economy as a whole system composed of many necessary functions, in the long-term, in the presence of continuous technological change. Before we decide that global warming won’t do much to the global economy, we should listen to what climate scientists, ecologists, civil engineers and businesses say particular effects of global warming will have on our complex and beautiful planet.