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Two schools and the path to the steady state

All of economics is divided into two schools: steady state theory and infinite planet theory. They can’t both be right. You’d think the choice between them would be obvious, but infinite planet theory still holds sway in classrooms and in the halls of power where policy is made. Last month, though, brought a significant development: the manager of a major hedge fund registered a carefully reasoned dissent from infinite planet theory. And in doing so, Jeremy Grantham offered a glimpse of how and why steady state economic theory will ultimately come to prevail.

Grantham is the head of GMO LLC, a hedge fund with $100 billion under management. His latest letter to his investors was headlined “Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever”—a title that calls to mind the urgent warnings raised by steady-staters as far back as the 1970s. Those warnings were dismissed by most economists as Chicken-Little fears that could safely be ignored—and the western industrial world proceeded to do just that. Infinite planet theorists pointed to the work of Julian Simon, who argued that human ingenuity is The Ultimate Resource (as he put it in the title of a book). Since technology, a human invention, is a factor of production, and since human capacity for invention is infinite, there can be no resource limits to economic growth. Infinity times anything is infinity, right?

You can get to that conclusion only if you ignore the laws of thermodynamics. However inventive humans have been or may yet prove to be, they’ll never invent a way around the first and second law. You can’t make something from nothing and you can’t make nothing from something (the first law). You can’t push a car backwards and fill the gas tank (the second). Together these laws rule out perpetual motion, schemes in which energy is created out of nothing or recycled and used again.

In steady state theory, the economy is seen as a thermodynamic machine, drawing in matter and energy, processing them with more energy, and excreting a high entropy wake. The economy thus has two ecological footprints: one on the uptake and one on the discharge side. Since both footprints land outside the abstract world of theory and in the physical reality of a finite planet, neither can increase forever.

Economists might have put these truths into practice decades ago. Had they done so, they would have been in good company. Physics had its thermodynamic revolution in the person of Albert Einstein, whose path from Newton to relativity began with thermodynamics, as he played out the un-mechanical implications of the second law. (Mechanical motion is reversible; energy use is not.) Biology was transformed in the 1920s and 1930s, as biologists saw that evolution is driven by competition for energy, which structures and maintains ecosystems—food webs—in which sunlight becomes green plant then herbivore, carnivore, detritivore.

Why, then, has the thermodynamic revolution in economics been postponed? The question will intrigue historians of the future, who will wonder at the profligacy of our culture and our cavalier disregard for ecological limit.

Part of the answer is the bet that Julian Simon made in 1980 with population activist Paul Ehrlich. Simon maneuvered Ehrlich into wagering on the future price of any group of resources that Ehrlich cared to pick: if Simon’s theory was right, he claimed, the prices would be lower within ten years. Simon won.

His victory was widely taken as proof of his infinite planet theory, despite the obvious flaw in it. The market price of any commodity is a human construct, the result of market supply and demand, not an indicator of scarcity in any absolute sense. From a limited stock of a finite resource—oil, say—we can choose to extract the resource at a greater or lesser rate. If the rate at which we pump oil out of the ground exceeds the rate at which demand for oil increases, the market price will fall. This doesn’t prove that oil is plentiful, let alone infinite. It doesn’t prove that we’ve invented our way around the laws of thermodynamics. It merely proves that we’ve extracted oil fast enough to keep its market price from rising.

Grantham goes head-to-head with Simonism not on these theoretical grounds but with solid empirical evidence: commodity prices are rising and aren’t likely ever to come down again. Volatility in prices can be assessed by looking at change in terms of standard deviations from the mean: how big, exactly, are the swings, as measured against average variability over time? Sharp increases in the prices of significant commodities since 2002 fall well outside the standard deviation; for iron ore, the rise has been 4.9 times the standard deviation, a result that (Grantham tells us) has a one in 2.2 million chance of being “normal” variation. More likely, it signals a new and different reality. For coal, copper, corn, silver, sorghum, palladium, rubber, etc., the odds aren’t as long, but still pretty sizable: one to 48,000, one to 17,000, one to fourteen- and nine- and four thousand. This basic, deep-seated trend lies beneath the statistical noise—price spikes and troughs, including those created by speculation and subsequent “market corrections.”

Based on this analysis, and on a review of energy use that reaches back to when wood was our primary fuel, Grantham concludes that we have entered a new era: we are on the cusp of what he calls The Great Paradigm Shift, “one of the giant inflection points in economic history”—the moment, he warns, that lies at “the beginning of the end for the heroic growth spurt in population and wealth caused by…the Hydrocarbon Revolution.”

You don’t find too many economists, let alone market analysts, reaching back to look at energy use before the era of coal. In the infinite planet neoclassical model, anything before James Watt is quaint and distant, and everything before Adam Smith is simply darkness. It’s true enough that steam-driven factories, embodying the division of labor that Smith celebrated, were game changers, leading to phenomenal economic growth; but you can’t see the scope of the game, or even begin to see that it has an end, unless you put those inventions into an historical and geophysical perspective that reaches back before Watt and Smith.

That’s why the Industrial Revolution is more properly called the Hydrocarbon Revolution. In focusing on the machinery, “Industrial Revolution” leads us to think that the engine of economic growth was human invention—and thus leads to the mistaken idea that more and better invention will let us increase productivity forever. “Hydrocarbon Revolution” makes clear that the modern economic miracle has thermodynamic roots. Economic history changed when we began systematically to exploit a new stock of energy, the stored fossil sunlight of coal and oil, with its historically unprecedented rate of energy return on energy invested (EROI)—as high as 100:1 for oil in the early part of the twentieth century. “Hydrocarbon Revolution” reflects the reality that the enormous productivity gains of the machine age are rooted in that very favorable EROI. It also implicitly includes the warning that the modern economic miracle must end when this stock of thermodynamically cheap energy is used up.

The essence of steady-state thinking is that we have to shape our economy to operate on a finite planet, within a stable, sustainable budget of matter-and-energy throughput. That throughput has to be sized so that the economy’s two footprints fit into the available ecological shoes. Grantham has noticed that one of the shoes is pinching, and he’s begun to articulate the reasons why, to an audience highly motivated to listen. If they heed his warning— “From now on, price pressure and shortages of resources will be a permanent feature of our lives”—the considerable engine of self-interest will be hitched to the adoption of steady state economic theory.

If practitioners adopt steady-state principles, the economists who theorize about them can’t remain far behind.

Upton Sinclair once observed, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” In the past that logic has worked against the spread of steady-state thinking. Now the logic has turned: if you want to make money, you’d better acknowledge reality, including the reality that on a finite planet there are limits to growth. To those of us concerned about the fate of a civilization that’s outgrown its ecological niche, this is a welcome development.

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