Stabilizing concentrations of greenhouse gasses (GHG) in the atmosphere, and adapting to the impact of climate change, have significant economic costs. Can these costs be met under the macroeconomic policy posture currently embraced by most countries? This is an important question given the massive scale of resources that are involved in a sustained time horizon.

In spite of the global economic and financial crisis, most advanced capitalist countries still adopt a view of macroeconomic polices dominated by the overarching objectives of price stability and fiscal discipline. In fact, this is what is guiding today the policy response to the crisis in Europe and the United States. In the developing world, the picture is a bit more complicated, but it is fair to say that most countries still define their macroeconomic priorities in terms that closely resemble the dogmas of neoliberalism.

Total costs of climate change are classified into three components: mitigation (reducing GHG emissions), adaptation (attenuating the damages caused by climate change) and residual costs. The last term comprises costs that are unavoidable, regardless of efforts in the previous two components of total cost.

How these costs are estimated is surrounded by great uncertainty. This is of course normal under the present circumstances. Any estimate will have to rely on scenarios concerning levels of the most important GHG in the atmosphere, the impact on mean global temperatures, rising sea levels, the desired trajectory for reducing emissions, and other important variables that make the exercise of producing estimates a daunting task.

Take the costs of adaptation in developing countries. Although most developing countries have not contributed significantly to the accumulation of GHG in the atmosphere, they will nevertheless have to incur  significant adaptation costs in order to take the edge off the impacts of climate change. The World Bank developed a methodology that first considers current investments in sensitive areas and then adds the cost of “climate proofing” them. This leads to underestimating the levels of investment that are required because the actual levels of investment in many “sensitive” areas (certainly in infrastructure) are already very low. The study commissioned by UNFCCC suffers from this same methodological bias and calculates total annual funding requirements by developing countries in 2030 in the range of $27–66 billion. After close examination, a team at the International Institute for Environment and Development (IIED) concluded these figures underestimated the investments needed to prevent catastrophic damage from climate change by a factor of between 2 and 3 for most of the sectors included in the UNFCCC study.

Returning to our initial question, is fiscal policy in developing countries ready to meet this challenge? It will be very difficult if the dogmas of fiscal discipline and the need to systematically generate a primary surplus are not abandoned. This creed has led to chronic underinvestment in areas that are intimately related to climate change vulnerability (health, housing, infrastructure). This has been the legacy of decades of fiscal discipline.

One way ahead is to increase fiscal revenues through progressive taxation schemes. (Because poverty is intimately related to vulnerability, regressive taxation needs to be avoided.) Of course, imposing higher taxes on high-income strata and duties on financial transactions are promising hunting grounds that need to be considered. This of course requires a fundamental change in the mindset in the ministries of finance of the developing world.

Mitigation involves economy-wide structural transformations that imply a shift away from big carbon footprints and greater reliance on renewable sources of energy. This is associated with significant changes in investment patterns as industry, transportation, construction, manufacturing and the energy sector transform their base of capital goods and equipment. The same UNFCCC study estimates that by 2030 developing countries will require $495 billion to address mitigation costs in key sectors (including energy, industry, transportation and construction).

In some of these sectors, public sector enterprises will have to play a critical role, and this also needs a change in fiscal policy priorities. In other cases, mitigation will call for large-scale private sector investments as technological trajectories change. The neoliberal macroeconomic policy package is ill prepared to meet the challenge of this structural transformation. In the past three decades, gross capital formation in developing countries has slowed down, in part due to the high cost of credit associated with restrictive monetary policies obsessed by price stability. In addition, investment patterns have been distorted due to attractive opportunities opened by speculation. Rethinking monetary and credit policies, as well as financial re-regulation are urgently needed to meet the challenges posed by mitigation objectives.

The magnitude of costs and the nature of the problem at hand clearly point towards the reconsideration of the neoliberal macroeconomic policy package.

When Arrow and Debreu published their famous proof of the existence of competitive equilibrium in 1954 their work was met with extraordinary praise. In fact, approbation was so intense that there was hardly any substantive criticism of the paper. Not a good omen. But then again, who needs to cast doubts when you want to have faith?

The existence question is not only a technical question (i.e., finding out if a system of equations has a solution). In the grand narrative of market theory, the issue of existence of equilibrium is relevant because it concerns the reference point towards which disequilibrium prices (and allocations) are supposed to converge. The idea of market forces leading an economy to a point of equilibrium would be meaningless without certitude about the existence of the promised land.[i] In macroeconomic theory, this is so important that in some extreme cases (i.e., dynamic general equilibrium models), it is assumed that the economy is always in an equilibrium position.[ii]

The existence of a general competitive equilibrium haunted neoclassical economics since Walras. He knew that equality in the number of equations and unknowns was not enough to guarantee the existence of a solution.[iii] The problem was assumed away and the question of existence remained without an adequate answer for decades. [iv]

The Arrow-Debreu model changed the name of the game. As Koopmans (1957) noted, “in this model the problem is no longer conceived as that of proving that a certain set of equations has a solution.” The idea was now to show there was a specific state of the economic system where at some prices of goods the manifold individual price-taking maximization behaviors are mutually consistent.

The Arrow-Debreu (A-D) model was acclaimed as the first rigorous solution to this problem.[v] The essential idea of A-D is to build a model of an economy and to utilize tools developed in game theory by Nash (1950). The center of attention here is a fixed-point theorem, considered today as the most important tool in mathematical economics (Geanakoplos 1989).

Arrow and Debreu’s intuition was that because every equilibrium is a rest point, the fixed-point theorem lent itself beautifully for the proof of existence. The trick was to be able to interpret the fixed point as an (general) economic equilibrium.

In its simplest version, the procedure using this tool can be schematized as follows.[vi] Imagine you have a set P of price vectors each with the property Σp_i = 1 (i.e., for each price vector in P the sum of its components is equal to 1). Now suppose you build a mapping f that transforms price vectors into new price vectors. This mapping transforms each price vector p in the set P to a point p’, that is, another price vector in P. The fixed point theorem tells us that under certain conditions, the mapping has a fixed point, i.e., there is a p* in P such that f(p*) = p*. The validity of the theorem depends on the properties of both the mapping and the set on which it is defined.[vii]

Suppose you build this mapping so that it represents the law of supply and demand, i.e., if demand is greater than supply, the mapping ensures that the price of that commodity increases. If it is less, the price will decrease. If the excess demand equals zero (i.e., supply equals demand) the price will remain unchanged. Now, under certain mathematical conditions, imagine you found that your mapping transformed one price vector into precisely the same vector. This is a fixed point at which the prices would remain unchanged. Suppose you also demonstrated that at this fixed point for every commodity with a strictly positive price, supply would be equal to demand and where a commodity’s price was zero the excess demand would be negative (i.e., positive excess supply). Your proof of existence would be complete.

But this is where one needs to look at the proof in more detail, especially at the structure of the mapping. In both Brouwer’s and Kakutani’s fixed point theorems, the mapping must be defined on a convex, compact set (i.e., a set that is closed and bounded). The unit price simplex P has this property. It is composed of all price vectors such that the addition of its components equals unity, Σp_i = 1. This is strictly a mathematical necessity in order to be able to use the fixed-point theorem.

There are various mappings (transformational rules) that change price vectors into new price vectors and represent the law of supply and demand.[i] But we need to guarantee that the new price vectors are elements of P, the simplex, for one simple reason: the fixed-point theorem requires that the mapping be defined on a compact set. Thus, the mapping must also involve a normalization procedure in order to ensure that all of the new price vectors belong to the price simplex (i.e., they must have the desired property: Σp_i = 1). And here is where things go awry: this normalization destroys the interpretation of the mapping as a representation of the law of supply and demand.

In our paper “The law of supply and demand in the proof of existence of general competitive equilibrium” (by Carlo Benetti, Alejandro Nadal and Carlos Salas) we demonstrate that none of the mappings used in the various proofs of existence of a general equilibrium involving a fixed point theorem is a good representation of the law of supply and demand.[ii] In some cases, commodities where demand is greater (less) than supply may have their price reduced (increased). The reason is straightforward: the normalization process needed to ensure that the new price vectors belong to the price simplex destroys the possibility of interpreting the mapping as consistent with the law of supply and demand. With the normalization procedure, price changes for one commodity not only depend on the sign of the excess demand of that specific commodity, but also on the sign of the excess demands of the other n – 1 commodities. This is not what the law of supply and demand indicates.[iii]

Our conclusion: the proof of existence of a general competitive equilibrium using a fixed-point theorem fails to possess an economic meaning.

In 1994 I had a brief meeting with professor Kenneth Arrow. I showed him the abstract of our paper. As he read it, he smiled and said “You and your colleagues are mistaken, you are confusing stability with existence and this is of course the source of your error”.

We had anticipated this type of reaction, so I replied: “No, we are clear on that. This has nothing to do with stability. We know the existence proof does not replicate a dynamic process. But you and professor Debreu claim that the mapping used in the proof of existence represents the law of supply and demand, and what we are saying is that the normalization procedure you have to use to ensure that the new price vector is in the unit simplex contradicts your claim”.

“Oh, it’s about the simplex”, exclaimed Professor Arrow, “Then you’re right”.

That simple comment confirmed our results: the mappings do not represent the law of supply and demand. As a consequence, the proof of existence of equilibrium using a fixed-point theorem is devoid of economic sense.[iv]

REFERENCES

Arrow, K. and F. Hahn (1971) General Competitive Analysis. San Francisco: Holden Day.

Geanakoplos, John (1989) “Arrow-Debreu Model of General Equilibrium”, General Equilibrium. The New Palgrave. (Eatwell,J., M. Milgate and P. Newman, eds.). New York: Norton.

Koopmans, T. (1957), Three Essays on the State of Economic Theory.

Nikaido, H. (1989) “Fixed-Point Theorems”, General Equilibrium. The New Palgrave. (Eatwell,J., M. Milgate and P. Newman, eds.). New York: Norton.

Smale, Steve (1982) “Global Analysis and Economics”, Handbook of Mathematical Economics, (Arrow, K. and M. Intrilligator, eds.). North-Holland.

Walras, L. (1952) Éléments d’Économie Politique Pure. Paris: Librairie Générale de Droit et de Jurisprudence.

Wickens, M. (2008) Macroeconomic Theory: A Dynamic General Equilibrium Approach. Princeton: Princeton University Press.

[ii] We analyzed four different mappings: Arrow-Debreu, Nikaido, Debreu, Arrow-Hahn. In Debreu’s version, commodities with a positive excess demand may see their price reduced to zero just because there are other commodities with greater positive excess demands!

[iii] In the mapping used by Debreu, the price of commodities with positive excess may be reduced all the way to zero just because there are other excess demands that are greater!

[iv] We leave out of this analysis the existence results of global analysis à la Smale (1982) because they rely on stronger assumptions. It is true that this line of analysis “is closer to the older traditions” as Smale claims but this is precisely what Arrow and Debreu wanted to leave behind by relying on a fixed point theorem.

[ii] See Wickens (2008).

[iii] In his Éléments d’économie politique pure he showed that multiple equilibria were possible. He also considered the case where supply and demand curves lacked an intersection point. See Walras (1952: 66-68).

[iv] John von Neumann (1937) was the first to use a fixed point theorem in a proof of existence.

[v] Other authors presented similar proofs: McKenzie (1954), Gale (1955) and Nikaido (1956).

[vi] For a detailed description of the entire procedure, see chapter Nikaido (1968), Chapter 5.

[vii] Brouwer’s fixed point theorem for single valued functions requires that P be a non-empty, convex, closed and bounded set, and that f be continuous. Kakutani’s theorem requires that f be an upper-semicontinuous correspondence for which the image set f(p) is a non-empty, convex subset of P.

Once upon a time, stability of the general equilibrium was considered an important element in the education of students in economics. Today it seldom receives the attention it deserves and this is regrettable. Stability is one of the most important aspects of neoclassical theory because it addresses the question of just how the mechanism of free competition in the marketplace actually leads to the formation of equilibrium prices.

This crucial aspect of microeconomics is seldom covered adequately (if at all) in recent textbooks and university programs, whether at the undergraduate or post-graduate levels. Most students spend years learning how individual agents maximize, or exploring cases of oligopoly, or playing around with game theory, but when it comes to stability, their teachers skirt around the main issues.

As a result, a cloud of confusion persists. Students come to believe that somewhere in the sacred scriptures of the discipline there exists a theory that accurately reproduces just how the market forces of competition guide an economy through a price adjustment process that leads to the formation of equilibrium prices. In fact, if stability analysis received the attention it deserves, students would be able to see that it is the most important failure of general equilibrium theory.

Stability was typically introduced to students as a property of general equilibrium. The equilibrium was stable if the economic forces activated after it was disturbed returned the economy to the original (equilibrium) position. Local stability responded more to this definition, while global stability implied that the equilibrium position would be reached regardless of the starting point.

As Léon Walras (1969) explained (at the end of Lesson 11), demonstrating how the mechanism of free competition led to equilibrium prices was essential. But this was easier said than done. Hicks in the 1930s and Samuelson in 1948 were able to make some progress. But Hicks’ contribution in static stability was not associated with any adjustment process. Samuelson showed that stability analysis required an analysis of the evolution of excess demands over time and introduced the typical price adjustment equations used in modern formulations. However, he did not provide the conditions under which such a system of equations would converge to a general equilibrium.

In 1958-9 two papers, by Arrow and Hurwicz and Arrow, Block and Hurwicz, showed how under certain conditions an economy could converge to equilibrium. But these were extreme conditions: gross substitution (GS) for all goods or the validity of the weak axiom of revealed preferences (WARP) at the market level. In the key passage summarizing their results, Arrow and Hurwicz wrote: “none of the results so far obtained contradicts the proposition that under perfect competition, with the customary assumptions as to convexity, etc., the system is always stable”.

A year later, Scarf (1960) published his counterexample showing how unjustified this conjecture was. The extreme conditions of GS and WARP turned out to be indispensable, at least with the market processes described by Arrow and his colleagues. The ordinary structural conditions of the general equilibrium model were not enough to ensure convergence.

Other aspects of the model leave much to be desired. Perfect competition implies that no firm is able to modify prices, so in models in this tradition (called tâtonnement models) price adjustment is the responsibility of a fictitious character called the auctioneer, an agent that is incompatible with the notion of a private and decentralized economy. Tâtonnement models exclude transactions out of equilibrium, so that agents are stupid and believe prices announced by the auctioneer are equilibrium prices (also, initial allocations of individual agents remain unchanged until equilibrium is attained).

In the sixties a different tack was followed. Trading models were developed by Hahn and Negishi, Fisher (1983) and others in which agents were allowed to engage in transactions during the price formation process (i.e. out of equilibrium). The conditions for stability are less stringent (no GS, no WARP), but an “orderly market hypothesis” is introduced and the fictitious auctioneer is still required. Because the process changes initial holdings, the arrival point of equilibrium is path-dependent. More important, trading out of equilibrium requires the introduction of money, a serious problem in general equilibrium theory. Typically, when confronted with this revelation, students are perplexed: What? Money was always absent in my microeconomics courses?

The stability debate reached its climax with the papers published by Sonnenschein,  Mantel and Debreu in 1973-4. These results show that the usual assumptions of GET allow the dynamics of the classic tâtonnement process to be essentially arbitrary. To avoid this, additional restrictions must be imposed on excess demand functions.

The failure of stability theory is of relevance to macroeconomics. The notion that in the presence of rigidities markets fail to operate properly is the reciprocal of the belief that stability is a property of markets. The ‘rigidity’ view is pervasive in macroeconomics, from conventional Keynesianism to believers in the micro-foundations of macroeconomics and the new synthesis with its DSGE models (where transversality conditions impose stability).

This is what underlies Milton Friedman’s view that the natural rate of unemployment is “the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labor and commodity markets”. Maintaining ignorance about the limitations of stability theory comes in handy when perpetuating the mythology of market theory.

As Mundell once remarked, stability analysis is the most successful failure of general economic theory. It is also the best example of how an academic community pushes the most serious problems of mainstream theory under the rug and gets away with it. Students should learn to look under the rug. The ability to improve our understanding of economic processes depends on efforts to uncover the failures of mainstream theoretical constructs.

Alejandro Nadal’s recent book, Rethinking Macroeconomics for Sustainability, is available from Zed Books.

LINKS AND REFERENCES

Arrow, K. and L. Hurwicz (1959)
http://www.jstor.org/pss/1907515

Arrow, K., H. D. Block and L. Hurwicz (1959)
http://www.jstor.org/pss/1907779

Debreu, G. (1974), “Excess demand functions”, Journal of Mathematical Economics. 1. (15-21) http://ideas.repec.org/a/eee/mateco/v1y1974i1p15-21.html

Fisher, F. (1983), Disequilibrium Foundations of Equilibrium Economics. Cambridge University Press.

Friedman, Milton (1968)
http://stevereads.com/papers_to_read/friedman_the_role_of_monetary_policy.pdf

Hahn and Negishi (1962)
http://www.jstor.org/pss/1909889

Hicks, John (1939), Value and Capital. Oxford: Clarendon Press.

Mantel, R. (1974), “On the characterization of aggregate excess demand,”  Journal of Economic Theory. 7. (348-353)http://econpapers.repec.org/article/eeejetheo/v_3a7_3ay_3a1974_3ai_3a3_3ap_3a348-353.htm

Samuelson, P. (1947), Foundations of Economic Analysis. Harvard University Press.

Scarf, H. (1960), “Some examples of global instability of competitive equilibria”. International Economic Review, 1 [157 – 172]

Sonnenschein, H. (1973), “Do Walras’ identity and continuity characterize the class of community excess demand functions?” Journal of Economic Theory. 6. (345-354), http://ideas.repec.org/a/eee/jetheo/v6y1973i4p345-354.html

Walras, León (1969), Elements of Pure Economics. New York: Augustus Kelley.

Suppose you had to deliver a complex message alerting future societies about a horrific manmade danger. Assume furthermore that you had to ensure your message would survive the ravages of time in order to deliver this warning to generations well into the future, say 10,000 years from today. How would you design a message for future societies that may not necessarily speak our language or share our cultural references?

Although this may sound like science fiction, finding an answer to this question was the task of a group of experts convened in 1993 by Sandia Laboratories of the US Department of Energy (DoE). Their mission was to design a marking system informing potential intruders from future societies about the dangers of radioactive material stored in the Waste Isolation Pilot Plant (WIPP) at Yucca Mountain, Nevada. The group was formed by archeologists, linguists, anthropologists and experts in materials sciences.

Yucca Mountain was supposed to be the long-term storage facility of spent nuclear fuel from commercial reactors and high-level radioactive waste coming from nuclear weapons programs. Spent nuclear fuel is no longer efficient in generating electricity because its fission process has slowed down. However, it remains highly radioactive and continues to generate significant amounts of heat. If the spent fuel rods are not cooled, their temperature may rise and their claddings may catch fire, releasing vast amounts of dangerous radioactive material into the atmosphere. This has been one of the problems in Fukushima in Japan.

The International Atomic Energy Agency (IAEA) estimates the global cumulative amount of spent fuel at 340,000 metric tons. By 2020 the total amount of spent fuel will be 445,000 tons. Today, most of the spent fuel is kept under water, but dry storage is also used (more than 12,000 tons are stored with this technology). In the United States, until a permanent disposal repository for spent nuclear fuel is built, licensees must safely store this fuel at their reactors. In Japan, half of the spent fuel discharged annually is kept in wet storage within the buildings housing the reactors (as in Fukushima) while the other half is sent to reprocessing units.

In 1982 the US Congress approved the National Waste Policy Act and made the Department of Energy responsible for finding a site for an underground disposal facility for nuclear waste. This would be the US strategy for long-term disposal of spent nuclear fuel. In 1987 it was decided the DOE would concentrate on Yucca Mountain, a promontory located in the Nevada desert and commence development of the project. The storage areas were to be located 700 meters underground. The site was chosen due to its relative geological stability and very small risk of water filtering into the storage facilities (official site performance assessments were hotly disputed by independent research).

The project came under fire from many quarters. In 2009 the Obama administration suspended financial resources for the WIPP and the US found itself without a long-term strategy for the storage of nuclear spent fuel (the Republican Party may very well resurrect the project).

The Fukushima disaster alerted the world about the dangers of spent nuclear fuel. The spent fuel pools in all of its reactors were a matter of serious concern, activating a powerful alarm bell: the accumulation of spent fuel from commercial nuclear reactors constitutes a clear and present danger. Reading the full report and the key recommendations of the expert panel convened by Sandia Laboratories is a forceful lesson about the magnitude of the dangers posed by the longevity of this threat.

The panel worked systematically and thoughtfully. It was concerned about the cultural context against which the architecture of the physical construction would be interpreted. Remember, the message had to warn potential intruders over a time span of at least 10,000 years! The waste isolation facility could be mistaken for a hallowed grave or an underground mausoleum. This is why the panel concluded the message had to convey, in addition to technical information about the radioactive danger, more fundamental concepts in a credible manner. The core recommendation of the panel was to install the following message at several strategic points of the WIPP.

“This place is a message. Pay attention to it. Sending this message was important to us. We considered ourselves to be a powerful culture. This place is not a place of honour. No highly esteemed deed is commemorated here. Nothing valued is here.

“What is here is dangerous and repulsive to us. This message is a warning about danger. The danger is still present, in your time, as it was in ours. The danger is to the body, and it can kill.”

The expert panel overlooked the most obvious fact: that this conclusion is a lesson for our own times! Did they do it on purpose? If we feel compelled to warn future societies about the dire consequences of playing with radioactive substances, obviously the technology associated with these materials is a clear and present threat to ourselves. So, why not alert today’s society? The short answer was provided by Carl Sagan in his letter declining to participate in the expert group: “I think the only reason for not using the skull and crossbones is that we believe the current political cost of speaking plainly about deadly radioactive waste is worth more than the well-being of future generations.”

The crisis that erupted in 2007 has generated interest in re-thinking economics. As Mark Blyth noted earlier this week, one of the more visible efforts in this respect is the creation of the Institute for New Economic Thinking, INET, committed to promote “new thinking about how to reform our economic system and get economists to better serve our policy makers and our society”. That is certainly a good objective, but you still need to define several key words in that sentence, beginning with “economic system” and “policy makers”.

On the very positive side, INET’s executive director Rob Johnson says the Institute is still defining “on the fly what new economic thinking means”. This good news leaves the doors open for truly innovative thinking. On the other hand, several participants in the first INET conference in King’s College mention the magic words, “shifting paradigms”.

I hope INET offers the opportunity for something a bit more ambitious than just a shift in paradigm, especially if a narrow definition of “paradigm” is used. After all, when we change paradigms, we are still playing the same ball game. It is perhaps more appropriate to think of changing of ball park altogether. And if this is the task at hand, then we need to reconsider the basic building blocks of theory, as well as the nature of our discourse and the boundaries of our field. Let me give one example related to money and ethics.

It is no secret that economic theory has a problem with money, that “portentous issue” (Arrow and Hahn 1971:338). At the starting point of all price theory is the abstraction that puts money outside the field of analysis. This is accompanied by the postulate that commodities are physically determined. Then value theory restores the unit of measure that allows economic discourse to move on to price determination. This is true for classical political economy (and its contemporary Sraffian version). And it certainly is true for neoclassical general equilibrium theory (GET).

When linking monetary and value theory in GET, relative prices are determined first (in terms of physical rates of substitution) and, in a second stage, monetary prices are determined (say, with a version of the Cambridge money equation). Back in 1965 both Patinkin and Hahn showed this procedure was deeply flawed. Today general equilibrium theory remains essentially a theory of barter economics (or a theory where all exchanges are ruled out). At least Debreu (1959 Chapter 2, footnote 3) was frank about this. Can you imagine what people’s reactions would be if told that the most sophisticated model for market theory that economists can put on the table is limited to non-monetary economies?

Integrating monetary theory with value theory remains an esoteric field. Considerable time and effort has gone into solving this problem (for example, using overlapping generations models and search theory), but the results are still unsatisfactory.

It can be argued that macroeconomic theory takes a different starting point and does not examine the value of the common unit of account in terms of a value theory. Perhaps one exception is found in Keynes who thought it was natural “to enquire wherein the peculiarity of money lies as distinct from other assets” (GT, Chapter 17 on “The Essential Properties of Interest and Money”). As we know, this “mysterious chapter” (as Joan Robinson called it) generated more questions than answers.

In other terms, the concept of money remains fuzzy. Now, that’s something that most economists would hate to admit in public. So here’s an idea: new economic thinking cannot continue to abstract from money as a starting point. Money, it can be said, is arguably the most important “economic object” and thus it is truly amazing that economic theory could even think this abstraction is necessary. New economic thinking needs to start afresh in this problem area.

A way to approach this is to understand how prices and money were thought of before economics got in the way. In strong contrast with economic theory, we must stop thinking of money as a simple transactions technology. It is something much more complicated. This probably entails looking at money as a political and ethical object. This leads us into the critical issue of the relations between ethics and economics, a key component of new economic thinking. This is part of my research agenda and will be the theme of a later entry on this blog.

These are all relevant questions, for as Keynes warned one December night in 1935 “the difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds”.

References:
Arrow, K. and F. Hahn (1971)
General Competitive Analysis. San Francisco: Holden Day.

In 2006 Niall Ferguson and Moritz Schularick invented the term ‘Chimerica’ to illustrate the economic linkages that connected China and the United States. The new term summarized the fact that the world economic order was dominated by the combination of these two giants. Ferguson and Schularick also used the notion to explain the evolution of the asset price bubble in the US between 2002-2006. Their conclusion was that this new entity was an unsustainable chimera that should one day disappear. The time for this may be here.

In 1978 China started implementing the reforms that were to transform it into a market-based mixed economy. In the eighties, the leadership in Beijing decided that export led growth would be required to rapidly improve living standards of China’s population. Opening the economy to foreign direct investment became a priority. Rapid growth of the export platform since 1980 led to high current account surpluses. In order to avoid the appreciation of its currency, China bought US dollars and ended up building huge reserves in US dollar denominated assets (approximately half in US treasuries).

Of course, the other side of this coin shows China’s main trading partner carrying the burden of a chronic deficit in its trade balance. So when the present crisis exploded, it was no surprise that Chinese worries emerged about the health of the US dollar (and the value of Chinese reserves). After all, China has amassed reserves of more than 2.6 trillion USD.

As the crisis unfolded, protectionist pressures appeared. The debate has centered on the undervaluation of the renminbi as the key source of international competitiveness for China’s exports in the global marketplace. Evidence of this is abundant. It is widely believed that the renminbi is 30%-40% undervalued vis-à-vis the US dollar. An analysis comparing the renminbi against a basket of currencies arrived at a similar conclusion.

Not everyone agrees. The US-China Chamber of Commerce thinks an undervalued renminbi is not the source of the US trade deficit. It blames the dismal trade performance of the US on lack of exports from the high-tech sectors due to security concerns. The USCCC has been very vocal in fighting the surge of protectionist measures because many of its members are US firms that have transferred their activities to China. In fact, there has always been good evidence that US direct investment in China’s exporting industries is closely correlated with the American trade deficit. This explains why talk about applying tariff surcharges on Chinese exports is frequently met with skepticism.

One can venture the following hypothesis. During the seventies, the secular drop in the profit rate continued in the US economy. Corporations felt extra pressure to lower labor costs, so they looked at China’s immense labor force. They started to move operations to China in the late eighties, but this process intensified in the nineties. Interestingly, profit rates increased in the period 1983-2002. Exporting jobs to China may have been behind this evolution of the profit rate. If this is so, it means there are strong corporate interests in the survival of Chimerica. Research is of course needed to validate this point.

As Chimerica unravels China has three options. First, it can try to maintain the status quo. But this is going to be difficult. The US household sector has been hit and will not return any time soon to its previous role of consumer of last resort. This is not a viable option.

Second, it can engage in a process of meaningful revaluation of its currency, something Germany and Japan carried out with success. Beijing is concerned that a fall in exports might lead to slower growth, unemployment and even political instability. But this could be avoided with a different policy package, and China could stop unloading its unemployment problems on the rest of the world.

Third, China may try to diversify its assets. China knows the euro is far from being able to perform as a viable international currency. But it will probably continue developing alliances with emerging markets, negotiating swap agreements. In the meantime, it will intensify its purchases of large commodity producing assets such as oilfields and mines. But this doesn’t really address the undervaluation issue. What it really needs to do is to develop its domestic market and engage in meaningful reductions in inequality. The US needs to understand the time for a new international monetary order has arrived.

Lightning in the sky does not follow a straight line. The irregular patterns in a cauliflower or the capricious forms of a tree’s branch are a challenge to the clean geometric figures we learn in school. Neither the straight lines, nor the smooth curves of that geometry exist in nature. But after the wonderful work of Benoit Mandelbrot it is now possible to get closer to a theory of the manifold wrinkles and rough surfaces that are the stuff of our universe. And our economies.

Ten days ago this great mathematician, the creator of fractal geometry and other wonders closely related to chaos theory, passed away.

The word fractal, coined by Mandelbrot, denotes a logical semi-geometric figure that can be divided as many times as desired and every time you zoom in on these smaller fractions you end up looking at a replica of the original figure. The best example of this is the famous Koch snowflake, in which the wrinkles are intimately related to patterns of affinity between the parts and the whole. Another example is the cauliflower: no matter how many times one breaks it up, when the pieces are magnified, the same ruggedness and wrinkles of the whole reappear. The property of self-similarity emerges even in the tiniest crumbles.

In 1963 Mandelbrot analyzed the variations of cotton prices on a time series starting in 1900. There were two important findings. First, price movements had very little to do with a normal distribution in which the bulk of the observations lies close to the mean (68% of the data are within one standard deviation). Instead, the data showed a great frequency of extreme variations. Second, price variations followed patterns that were indifferent to scale: the curve described by price changes for a single day was similar to a month’s curve. Surprisingly, these patterns of self-similarity were present during the entire period 1900-1960, a violent epoch that had seen a Great Depression and two world wars.

Mandelbrot used his fractal theory to explain the presence of extreme events in Wall Street. In 2004 he published his book on the “misbehavior” of financial markets. The basic idea that relates fractals to financial markets is that the probability of experiencing extreme fluctuations (like the ones triggered by herd behavior) is greater than what conventional wisdom wants us to believe. This of course delivers a more accurate vision of risk in the world of finance.

The central objective in financial markets is to maximize income for a given level of risk. Standard models for this are based on the premise that the probability of extreme variations of asset prices is very low. These models rely on the assumption that asset price fluctuations are the result of a well-behaved random or stochastic process. This is why mainstream models (such as the infamous Black-Scholes model) use normal probabilistic distributions to describe price movements. For all practical purposes, extreme variations can be ignored.

Mandelbrot thought this was an awful way to look at financial markets. For him, the distribution of price movements is not normal and has the property of kurtosis, where fat tails abound. This is a more faithful representation of financial markets: the movements of the Dow index for the past hundred years reveals a troubling frequency of violent movements. Still, conventional models rule out these extreme variations and consider they can only happen every 10,000 years!

An obvious conclusion from Mandelbrot’s work is that greater regulation in financial markets is indispensable. Today, three years after the global crisis erupted, reforms for the financial system are clearly insufficient (whether in the guise of the Volcker rule or the Dodd-Frank act).

Mandelbrot confirmed what we know about the instability of markets, especially financial markets. But his analysis didn’t focus on the causes of this instability or the origins of financial crises. Many toy with the idea of applying Mandelbrot’s fractals to economic analysis. But for all those that look at fractals, chaos theory, complex and non-linear systems, it is perhaps useful to recall Koopmans’ admonition (Three Essays on the State of Economic Science): economists must forge the concepts of their discipline before going to look for new mathematical tools.

Mandelbrot was not an economist. Perhaps this explains why he tried to study how markets really work. This is better than the flawed 200-year-old research program of an economic theory obsessed with the aim of proving (fruitlessly) that markets are efficient. In the context of today’s crisis, Mandelbrot opened the window and let some fresh air in.

The beauty of fractal geometry knows no boundaries. Perhaps it was already inscribed in the first verses of Blake’s famous poem Auguries of Innocence:

To see the world in a grain of sand,
And a heaven in a wild flower;
Hold infinity in the palm of your hand,
And eternity in an hour.

The history of the United States is rather exceptional. This is the only country that has always lived under the aegis of capitalism. No slavery as the organizing principle, nor feudal lords in their castles. Just the anxious eye of capital. Maybe this is why, more than in other country, the most important source of political legitimacy resides in the ability of the power elite to maintain high living standards. And when the system that allows for this is in trouble, the power elite needs to renovate its source of political legitimacy.

This sometimes has implied the redefinition of the social compact, as in the Thirties, when Roosevelt’s New Deal established a new foundation for income distribution and for labor relations. The American right never forgave that affront and was always ready to revert that social pact. The favorable conjuncture presented itself in the Seventies and Eighties.

Paul Volcker decided to get rid of inflation once and for all, increasing interest rates spectacularly and bringing about a recession and a global debt crisis. Reagan continued with his offensive against labor unions (beginning with his firing of the Air Controllers Union), marking the beginning of the dismantlement of the labor unions in the US. The interesting point here, of course, is that the growth of real wages started to stagnate in those years.

How was aggregate demand sustained after those years? The answer is easy credit. Pretty soon abundant credit was available for mortgages, automobiles, electrical appliances, college education, travel and everyday consumption. Credit cards became the equivalent of a national identity document.  As the share of wages in the national product started to contract, household indebtedness expanded in order to compensate for stagnating incomes.

This kept the economy going, although it also led to a series of bubbles, from the high tech asset bubble of the late Nineties, to the current crisis. As Brenner points out, those crises were the dress rehearsal of the current debacle. The detonator of today’s crisis is of course this dangerous idea that houses could provide equity and thus serve as a booster to households in their quest for the “American dream”.

So, although uncontrolled speculation (with all its innovations in the financial markets) and deregulation appear to be the source of the current crisis, they are the last link of a long chain of transmission that starts with stagnant wages.

In turn, the beginning of this period is marked by the contraction in profit rates and a steady decline in the vitality of the advanced capitalist economies. Brenner provides a good in-depth analysis of this, as well as the paper on “The Crisis of Neoliberalism and U.S. Hegemony” by Dumenil and Levy. These analyses point out in one direction: firms have been able to avoid an even deeper decline in profitability only by resorting to a generalized contraction in wages. This means that the economy of the most advanced capitalist country in the world has had to reduce the purchasing power of the working class in order to sustain profitability. And living standards have been maintained through greater indebtedness in a process that has proven to be unsustainable.

The thirty-year long process was also accompanied by the gradual dismantlement of the manufacturing sector in the US. Today, the US economy is failing to generate enough jobs and one of the possible causes for this is that the manufacturing sector accounts for no more than 10% of total employment. The important point here is that manufacturing has a higher employment multiplier than other sectors but this advantage is now rather weak in the US economy.

As the signs of “recovery” fade away, the debate over austerity versus fiscal stimulus rages. But that debate is over the wrong issue. Yes, it is true that resorting to fiscal austerity in the middle of a crisis is dangerous. But this should not obscure the fact that the “normality” to which many believe the US should return is a failed model. There are monumental forces inherent to the regime of capital accumulation in the US in need for change. Nobody in the ruling elite appears to be concerned about this, the real issue.

The forecast is not encouraging. The US economy may lapse into a long period of stagnation. So we return to the initial question.  If political legitimacy has been attained through ever-increasing mass consumption, what happens if this is not possible? What will happen when the American people discover that the US is just a country like any other? Will the ruling elite start looking for scapegoats?

A serious campaign in favor of “de-growth” has been going on for some time and has made important contributions. This movement has opened new avenues for debate and analysis on technology, credit, education and other important areas. It’s an effort that needs support and attention, and we must applaud their initiators and promoters for their boldness and dedication.

De-growth is defined as “a reduction of production and consumption in physical terms through down-scaling and not only through efficiency improvements”. Kallis-Schneider-Martínez Alier explain that de-growth is a smooth, voluntary and equitable downscaling of production and consumption that insures human wellbeing and ecological sustainability locally as well as globally on the short and long term. Thus, de-growth is not limited to a technological dimension.

A conference in Barcelona presented several policy measures aimed at bringing de-growth to fruition. Some of these are related to macroeconomic policies but their effectiveness remains unclear. For example, monetary reform with the elimination of fiat money may or may not lead to de-growth or stable steady state economies.

But there is a fundamental problem with de-growth (or zero growth) theories: they perceive growth as stemming from manias, fetishism, cultural or psychological roots. The best example of this worldview can be found in Serge Latouche.

The problem with this perspective is that the cause of growth becomes psychological, a question of mentalities and even fashion. The idea that growth could originate from endogenous forces in capitalist economies is ignored.

Growth is not only a cultural phenomenon or a feature of a maniac mentality. It is the direct consequence of how capitalist economies operate. This is true of capitalism as it operated in Genoa in the sixteenth century, and it is true today with the mega-corporations that rule global markets. The purpose of capital is to produce profits without end, that’s the meaning of its particular form of circulation. Its purpose is not to produce useful things or useless stuff, its object is to produce profits without end and produce more capital. This is the engine of accumulation and it is fuelled by inter-capitalist competition.

In the words of Marx’s Grundrisse, “Conceptually, competition is nothing other than the inner nature of capital, its essential character, appearing in and realized as the reciprocal interaction of many capitals with one another, the inner tendency [presents itself] as external necessity. Capital exists and can only exist as many capitals, and its self-determination therefore appears as their reciprocal interaction with one another.” By the forces of competition, “capital is continuously harassed: March! March!” Thus, Marx’s analysis shows convincingly that capital can only exist as private centres of accumulation that are driven by (inter-capitalist) competition. This is why, in its quest to expand and survive (as an independent centre of accumulation) capital is continuously opening new spaces for profitability: new products, new markets. The corollary of this is that the only way in which we can get rid of “growth mania” is by getting rid of capitalism. It is not possible to have capitalism without growth.

Is there a technological fix out of this? In other words, can we have such an efficient technological infrastructure (in buildings, energy and transport systems, manufacturing, etc.) that even with growth the ecological footprint could be reduced? This remains to be seen, but one phenomenon seems to conspire against this: the rebound effect. As technologies become more efficient and unit costs become smaller, consumption increases. Either existing consumers deepen their consumption, or more people have access to the objects or services being put on the marketplace. The end result is that the positive effects of greater efficiency are cancelled by deepening consumption rates. And let’s not forget what happens when consumption stops or slows down: those centres of accumulation cannot sell their commodities, inventories grow, unemployment soars and we have recessions, depressions and crises.

From the side of production, for those individual centres of accumulation every gadget, every nook and cranny in the world, or any vast expanse of geographical space is a space waiting to be occupied for profits. From pep pills to tranquilizers, food and water, health and even genetic resources or nano-materials, to the anxious eyes of capital all of these dimensions are but spaces for profitability. Talk about investing in “natural capital” as a way out to the dilemma is devoid of any sense. It could very well be that, in the words of Richard Smith we either save capitalism or save ourselves, we cannot do both.

The Deepwater Horizon disaster has the familiar ingredients of deregulation, deception, and destruction that characterize the relations between governments and multinational corporations. It was a man-made disaster, like Chernobyl. And like the global financial crisis, it all started with the explosion of a bubble, this time of methane gas.

The Wages of Deregulation

In 2008 the Bush-Cheney duo lifted the executive order banning offshore drilling, and the House of Representatives agreed to let a 26-year-old moratorium on offshore drilling expire. Deregulation was moving full speed ahead.

Monitoring agencies were unable to keep pace with British Petroleum’s (BP) operations. Marine biologist Rick Steiner, an expert on oil spills from the University of Alaska, has documented how BP cut corners in its hurry to disconnect and prepare for a production rig. In addition Steiner reveals the blowout preventer (BOP) was not built as designed, included some demonstration parts, and had a failed battery.

Offshore drilling operations in Norway and Brazil use acoustic triggers and remote control cut-off devices to enhance the capacity of BOPs to work adequately. But a report commissioned by the Minerals Management Service (MMS) stated “acoustic systems are not recommended because they tend to be very costly.” Was former vice president and oil man Dick Cheney behind the Department of Interior’s decision not to mandate the valve for off-shore oil rigs? Nor did the U.S. government mandate the simultaneous drilling of relief wells, as required in Canada’s Arctic. Only now, with the failure of the “top kill” technique, is BP drilling these wells, and they won’t be functional before August.

The MMS also routinely overruled its staff of biologists and engineers, who had raised concerns about the safety and environmental impact of certain drilling proposals in the Gulf and in Alaska. The U.S. government permitted BP and other oil companies to drill with cutting-edge technologies without the usual permits.

Were the government regulators doing their job of regulating, or were they in bed with the industry?

Parallels to Financial Crisis

British Petroleum bragged about being at the frontier of technology. Goldman Sachs and the other behemoths of the financial world also claimed to be at the cutting edge of financial innovation. They all lied, hid information, and speculated behind a facade of corporate professionalism built through their advertising campaigns.

Just like the derivatives that took junk assets into every balance sheet of financial institutions, the Deepwater Horizon disaster has no frontiers. The gushing oil will eventually threaten not only Cuba and Mexico, but it will end up reaching the Gulf Stream. It might even make it to England and several world financial centers.

Many are the scams concocted in the financial world, from structured investment vehicles carrying subprime mortgages to credit default swaps and short-selling. They call it business on Wall Street, but it’s really weapons of mass financial destruction. British Petroleum also has a long list of accidents and incidents, all leading to the loss of life and oil spills (including the explosion in its refinery in Texas City in 2005 that cost 15 lives). There will probably be no bailout for BP, but there already exists a liability cap of $75 million.

That cap is invalid in cases where criminal negligence exists. The U.S. Attorney General has already launched a criminal investigation. Already there is circumstantial evidence that BP’s technicians altered the sequence of events and ordered the removal of drilling mud before the cement cap was put in place in order to gain time. This was done in spite of the fact that BP was already working with a damaged blow-out preventer. If this is confirmed, BP will have a hard time convincing authorities that this was just an accident.

Who’s in Charge?

BP has used more than 800,000 gallons of oil dispersant Corexit on the surface and underwater. Corexit is manufactured by Nalco, whose board includes at least one BP executive. Because Corexit is less efficient and more toxic than other dispersants, the Environmental Protection Agency requested that BP use another dispersant. BP quickly overruled this request, showing who’s in charge.

As he came into the White House, Obama became a hostage of the financial system and essentially gave Wall Street a free hand in solving “its” problems. For weeks after the rig exploded, BP appeared to be the main entity in charge of the response to the oil spill.

Obama’s lack of firm leadership has prompted comparisons with Katrina. But in fact, the similarities with Chernobyl are stronger. Katrina was a natural disaster, while the Deepwater Horizon is a man-made catastrophe related to greed and cost minimization.

Just as the global financial and economic crisis is entering its most dangerous phase, the oil spill is now developing into a catastrophe that will affect ecosystems and livelihoods for decades. It is more like Chernobyl than anything else.

When Unit 4 in Chernobyl exploded on April 26, 1986, it not only caused the worst disaster in the history of nuclear technology. It also shattered the technological prestige of the Soviet Union, boosted concerns about the nuclear safety of the remaining plants and forced Soviet authorities to be less cryptic. Ultimately, Chernobyl ushered in the demise of the Soviet Union. Perhaps the destruction of the Deepwater Horizon will open the way for a new era of accountability and the end of corporate capitalism in the United States.

This commentary was also published by Foreign Policy in Focus.