Thursday, 12 April 2012

Economists need taught about physical constraints - but physicists need to learn about prices

Another excellent post from Tom Murphy entitled "Exponential Economist Meets Finite Physicist" is causing some interest. In the post the point is made that exponentially increasing use of energy is impossible, and that economic growth without energy use growth is difficult to imagine. These issues need to be more widely considered within economics, especially in these times of depressed output amid high energy prices. They are not simply for 400 years hence but are worth considering now - see relatively recent New Scientist article "How Clean is Green Energy?".

However certain points are made in the post that I don't think are justified and which are the sort of thing that is frequently stated without sufficient analysis at (informative and interesting) places like The Oil Drum and Our Finite World.

First of all, it is asserted that "If the flow of energy is fixed, but we posit continued economic growth, then GDP continues to grow while energy remains at a fixed scale. This means that energy—a physically-constrained resource, mind—must become arbitrarily cheap as GDP continues to grow and leave energy in the dust." This cannot be simply asserted - within most models it's simply not true, and the models in which it is true are the most unrealistic models (we would need elastic substitution of energy and other factor inputs but it appears that other factors can only substitute for energy on a very inelastic basis).

The baseline, first-order model of economic growth is the Ramsey model with Cobb-Douglas production and logarithmic utility (which the representative agent maximises in order to make consumption/investment decisions). If we suppose a constant returns to scale Cobb-Douglas production function with labour (fixed), energy (fixed) and capital (endogenous) subject to some exponentially growing productivity (*), then we derive a balanced growth path in which output, consumption and capital stock all grow at the rate of productivity growth (despite fixed labour and energy implying effective diminishing returns). The prices of the factors of production on the balanced growth path in this model are: constant for capital (i.e. interest rate is a positive constant); exponentially growing (at the rate of productivity growth) for energy and labour. This is because under Cobb-Douglas production, factors earn a constant share of output i.e. payments to energy are constant as a share of output, but the quantity of energy used is constant whilst output is exponentially growing: therefore energy's price must be exponentially growing.

So the first order model for describing economic growth predicts that if we had an economy with fixed energy inputs but positive economic growth, then energy prices would be growing, not falling. The post then relies on a floor for energy prices as it's mechanism in generating subsequent phenomena: but economic growth with constant energy input implies growing prices that do not run into this floor constraint, so the rest of the argument does not necessarily follow.

The post then also repeats various assertions that have been made for a steady state economy: "it’s not your father’s growth. It’s not ... , interest on bank accounts, loans, fractional reserve money, investment." I'm not sure where the idea comes from that a positive rate of interest on bank accounts relies on economic growth, but it's a meme that I've seen expressed before. It doesn't seem logical to me: a simple case is a model of generations in which the young work, consume and save (i.e. make loans) whilst the old consume out of their savings. These savings/loans are just pieces of paper so in reality the young work and their earnings provide the consumption goods for themselves and the older generation. The interest rate on the savings is just a price(**) that agents take when splitting their consumption from their own earnings into consumption whilst young and consumption whilst old - a high interest rate is perfectly compatible with a steady state economy if agents have a high rate of time preference. Fractional reserve banking likewise has nothing to do with economic growth. 

The post is fantastic at outlining an issue that economists have not grappled with, but in considering the economic impacts of the issue, the article makes clear a need for economists to provide some of the analysis!

(*) I'm not saying that this is a good model of long term growth, in particular I agree with this criticism of Noah Smith: "
Step 1: Take the parts of the economy you can't explain (i.e. the residuals) and label them either "culture" or "technology".
Step 2: Make ultra-confident pronouncements about the future behavior of culture and/or technology.
What I don't like, first of all, is that Step 2 just never makes any sense. The thing you are calling "culture" or "technology" is precisely the part that you couldn't explain with your models. Hence, it is the least likely thing for you to be able to predict going forward.
Admit it, economists: You don't know what is going to happen with technology. You don't know what is going to happen with culture. If you did, you would have included those things as endogenous variables in the model instead of simply labeling the residual."

(**) Though in steady state equilibrium it will be a positive function of both the growth rate and the rate of time preference.

Thursday, 5 April 2012

Complex Systems

I've just noticed that Prof Yaneer Bar-Yam of the New England Complex Systems Institute replied to my letter (full version here) on the New Scientist's Limits To Growth article. I'm quite chuffed about this - Prof Bar-Yam is a big guy in the world of applying complex systems theory to the social sciences: for example see his recent (joint) paper on social unrest and food prices, incorporating speculators and biofuel production, which makes a definite prediction that "Policy actions are needed to avoid a third speculative bubble that would cause prices to rise above recent peaks by the end of 2012."

Naively, and certainly before I started studying economics, I would have guessed that the above paper would have been classified as an economics paper. It's not though: complex systems is a separate discipline, and although of interest to many economists, it's a difficult topic for economists to get involved in. (On a seperate but potentially related topic, I recently came across this record of correspondence that Prof Ken Judd compiled on his difficulties in getting computational work published.)

The basic problem as I see it is that the economics profession has collectively made a methodological decision to study how decisions are 'optimally' made. This is a perfectly valid choice for microeconomics, and it does a good job of constraining and disciplining our models i.e. we cannot just assume any old behavioural rule or heuristic.

It is much more difficult to conclude that this choice is valid for macroeconomics (see recent debate on microfounded models in macro), partly because of aggregation issues, but also because this choice actively gets in the way of studying what many people would regard as economics: the allocation of scarce resources, regarding human society as part of an ecosystem that is subject to the same rules of thermodynamics as any other ecology. Has it really been demonstrated that the growth of human society within the fixed boundaries of the Earth is any more rational and forward looking than the growth of bacteria in a petri dish?