Tuesday, 7 October 2008

The Zeroth Way

Social democrat parties have in recent years (going back to Bill Clinton and Tony Blair, more recently joined by Australian Labor leader and prime minister Kevin Rudd) been espousing the Third Way – supposedly a middle ground between capitalism and socialism. Socialism was widely believed to have failed with the collapse of the Soviet Union and the ascendency of tendencies like Thatcherism and Reaganomics, collectively amounting to a “greed is good” mindset. While supporters of this latter tendency called themselves free market capitalists, in reality, they were happy to support market distortions that supported particular interests. Thatcher herself denied that she was a strictly “laissez faire” capitalist.

Going back to the Third Way, rather than a reformation of social democracy to something less socialist with elements of fiscal responsibility, it was essentially a capitulation, an acceptance that the “greed is good” mindset had won.

With the 2008 Wall Street meltdown and the increasingly obvious problems purely market-based mechanisms are having in dealing with a transition from carbon-based fuels, it becomes useful to rethink the whole economic paradigm again.

With the failure of the Third Way, I advocate going back to basics: considering what humanity is actually collectively striving to achieve. Naturally in the process of doing so, we should not discard lessons of the past: the utility of the market mechanism when it works, the values of social goods such as a healthy society that are hard to quantify in a market and the limits of these mechanisms.

But since I want to go back to basics, I would like to call my approach the Zeroth Way.

What has proved to be a limiting factor on previous economic thought?

The inability to grasp the necessity of handling limits to trends has caused many of the problems we face today. Long-term growth in fossil fuels has led to the peak oil problem. Whether we have reached that point or not is something that will only be clear in hindsight but there is growing evidence that it will soon be impossible for oil supply to continue to meet growth in demand without big price increases, once sources of oil that are cheap to extract deplete. Another difficulty is a lack of understanding that risk in home loans depends on expectations of growth in house prices. While prices are increasing, the risk is low, as in the event of anyone defaulting on their loan, most if not all of the money can be recovered in a forced sale. When prices drop, any doubtful loans turn into liabilities not only for the home owner but for the lender. That same principle applies across many financial instruments: as long as the trend is up, the risk is lower, because failures can be covered by other successes.

The combination of a number of these effects has resulted in a major economic crisis, the like of which has not been seen since 1929.

What is the alternative, the Zeroth Way?

The alternative is to adopt a principle of sustainable economics. “Sustainable” in general terms as a description of a practice simply means that that practice can be continued without any reasonably foreseeable limit. This definition is very general, and can apply to an activity that is constant in time, one that is growing or even one that is shrinking. To give some examples, using solar energy is sustainable in the sense that the sun will continue to be available for as long as a human requirement for energy is likely to be an issue. Growth in demand can be handled up to a very high limit compared with demand today, though ultimately there is a cap. By contrast, fossil fuel use is clearly not sustainable, as we are already running out of some resources, and we are using fossil fuels up at about a million times the rate they were created.

Sustainability in energy terms is a well-known concept, but how does it adapt to economics?

The same definition applies, except the measure we are using becomes an economic measure. For example, returning to mortgages, lending money at a level that requires house prices to rise before the loan becomes secure (in the sense that the loan could be recovered by selling the propery) is not sustainable. Lending at a level that requires prices to be static could even be argued not to be sustainable. The lowest-risk strategy would be to limit a loan to the level that a valuation is likely to hold in any economic scenario short of a total collapse. In practice, this may mean limiting loans to something like 80% of the valuation in normal times, and less when the market was rising rapidly. Naturally banks do not like this sort of restriction, as a rapidly rising market is exactly the scenario where borrowers battle to find a higher fraction of the price as a down payment. However, a sustainability requirement such as this on mortgages would slow down rapid price spikes, and smooth out fluctuations in the market by reducing trends for price spikes to overshoot a reasonable level, and correct downwards. Why not just leave it to the market? Because the market results in the opposite effect to sustainability: practices that only work in a growing market tend to be amplified as growth increases, inevitably leading to a bigger than necessary collapse at the peak of the economic cycle.

There are two important things we have learnt from market capitalism and socialism:
  • The market is not good at ensuring sustainability, and
  • over-complex regulation has a tendency to become an end in itself, failing to deliver the intended benefits.

The example of mortgages illustrates a general principle. The notion of discouraging or preventing unsustainable practices could apply more broadly to the economy. The key trick to making the Zeroth Way work is to find simple mechanisms to enforce sustainability. Sometimes very simple measures can have profound effects. For example (I don't claim this example is one of sustainability, but of how simplicity can be effective), the German Reinheitsgebot (beer purity law) was a simple measure that prevented adulteration of beer by specifying the exact allowed list of ingredients. The economic effect was to prevent large-scale monopolistic breweries from forming. Such relatively simple measures have the advantage of simple implementation and enforcement, and avoid the downside of socialism, bureaucratic entanglement.

Why would we want to make this change? A simple answer is that the existing approaches have all failed. A more complex answer is that understanding sustainability in economics terms helps us to avoid considerable human misery. Think of thousands of people losing their homes and jobs in an economic collapse. Think of the hardships of the poor as energy gets expensive. Think of the impossibility of poorer countries ever having the advantages of an energy-intensive economy if the wealthy burn up all the cheap energy.

Another answer is that the market is designed to price short-term fluctuations accurately, and performs poorly when the requirement is to reconfigure the basic settings of the system. For example, agriculture could be severely impacted by rising energy costs (whether from peak oil or from carbon taxes). A solution is to include energy production as an income stream in agriculture. Options include biofuels and placing wind turbines on farms. Biofuels have started to get a bad name because of unsustainable practices, like using food crops as feedstock, and clear-cutting old growth forests to grow fuel crops. Both of these approaches can be avoided; there are options like using agricultural waste, and growing crops on land that is not suited to food crops. Sustainability in this instance is not only in ensuring the continued economic viability of farming by including farmers in energy production, but in ensuring sustainable practices for producing biofuels. Absent interventions like subsidies on research to jump-start new approaches to energy, however, these things will not happen on their own. Left to the market, farmers will simply go broke as costs get too high, as we reach the point where food prices are too high for poorer people, and consumption drops.

All of this is purely a question of sustainable economics. Add in the environment, and there is another important consideration that is often overlooked. Yes, environmentalists can and should worry about our furry and feathered friends in the wild, the great trees in our old growth forests, and the mysterious creatures of the air, the dark forest and deep sea. But we are also a species, and, like any other species, we have a habitat. Destroy that habitat and we destroy ourselves.

The challenge therefore I would like to throw out is to think through other areas of economics where the sustainability principle could apply, and how to enforce that principle with least effort.

Further Reading

There's like thinking in other parts of the world. For example, the Green New Deal idea from the UK is worthy of further study.


Sam Clifford said...

Philip, I've reposted this on my blog with attribution to you. Here.

Philip Machanick said...

Great, thanks. If anyone else would like to do this with any content on this site, feel free: do as Sam did and post a link to your copy in a comment here as well a a link back to the original on your site.