The Wealth of Nature. John Michael Greer
some favored class of assets out of its normal relationship with the rest of the economy, and it ends in the economic sphere with the smoking crater left by the assets in question as their price plunges roughly as far below the mean as it rose above it, dragging the rest of the economy with it. It’s the middle of the trajectory that passes through the particular form of crowd psychology that drives speculative bubbles, and since this is outside the economic sphere, neoclassical economics fails to deal with it.
This would be no problem if neoclassical economists by and large recognized these limitations. A great many of them do not, and the result is the type of intellectual myopia in which theory trumps reality. Since neoclassical theory claims that economic decisions are made by individuals acting freely and rationally to maximize the benefits accruing to them, many economists seem to have convinced themselves that any economic decision, no matter how harshly constrained by political power or wildly distorted by the mob psychology of a speculative bubble in full roar, must be a free and rational decision that will allow individuals to maximize their own benefits, and will thus benefit society as a whole.
As mentioned earlier, those who practice this sort of purblind thinking often find it very lucrative to do so. Economists who urged more free trade on the Third World at a time when “free trade” distorted by inequalities of power between nations was beggaring the Third World, like economists who urged people to buy houses at a time when houses were preposterously overpriced and facing an imminent price collapse, commonly prospered by giving such appallingly bad advice. Still, it seems unreasonable to claim that all economists are motivated by greed, when the potent force of a habit of thinking that fails to deal with the economic impact of non-economic forces also pushes them in the same direction.
That same pressure, with the same financial incentives to back it up, also drives the equally bad advice so many neoclassical economists are offering governments and businesses about the future of fossil fuels. The geological and thermodynamic limits to energy growth, like political power and the mob psychology of bubbles, lie outside the economic sphere. The interaction of economic processes with energy resources creates another end run: extraction of fossil fuels to run the world’s economies, an economic process, drives the depletion of oil and other fossil fuel reserves, a non-economic process, and this has already proven its power to flow back into the economic sphere in the form of disastrous economic troubles. Once again, the inability to make sense of the interactions between economic activity and the rest of the world consistently blindsides contemporary economic thought.
Harnessing Hippogriffs
This same blindness to non-economic factors also affects another of the fundamental assumptions of modern economics, the law of supply and demand. According to this law, the supply of any commodity available in a free market is controlled by the demand for that commodity.
The law is supposed to work like this: When consumers want more of a commodity than is available on the market, and are willing to pay more for it, the price of the commodity goes up; this provides an economic incentive for producers to produce more of the commodity, and so the amount of the commodity on the market goes up. Increased production sets an upper limit on price increases, since producers competing against one another will cut prices to gain market share, and the willingness of consumers to pay rising prices is also limited. Thus, in theory, the production and price of a commodity are entirely determined by the balance between the desire of consumers to buy it and the desire of producers to make a profit from producing it.
This process is the “invisible hand” of Adam Smith’s economic theory, the summing up of individual economic decisions to guide the market as a whole. Within certain limits, and in certain circumstances, the law of supply and demand works tolerably well. The problem creeps in when economists lose track of the existence of those limits and circumstances, and this, to a remarkable degree, is exactly what most contemporary economists have done.
As a result, even those branches of economic thinking that ought to take physical limits into account have come to treat money as a supernatural force that can conjure resources out of thin air. The most important example just now, as already suggested, is the way conventional economics treats energy. It’s an article of faith among the great majority of today’s economists that the supply of energy in the industrial world is purely a function of the law of supply and demand. This article of faith has remained fixed in place even as world energy supplies have plateaued in recent years, and the most crucial of all energy supplies — the supply of petroleum, which provides some 40 percent of the world’s energy and effectively all its transportation fuel — peaked in 2005 and has been slowly declining ever since.7
The resulting mismatch between theory and practice can approach the surreal. Consider the estimates of future petroleum production circulated by the Energy Information Administration (EIA), a branch of the US government. Those estimates have consistently predicted that petroleum production would go up indefinitely. The logic behind these predictions, stated in so many words in EIA publications, is the assumption that as demand for petroleum goes up, supply will automatically keep pace with it. The most recent estimates have kept the supply of petroleum in step with rising demand, despite the decline in known sources, by inserting a category labeled “unidentified projects” — predicting by 2030 no less than 43 million barrels a day of “unidentified projects,” comprising around a half of total world production by that date.8 These “unidentified projects” are nowhere to be seen in the real world; their sole purpose is to make reality fit the requirements of economic theory, at least on paper. Energy blogger Kurt Cobb has aptly labeled this sort of thinking “faith-based economics.”9
The faith in question remains cemented in place across most of contemporary economic thought. Whenever an economist enters the debate about the future of world energy supplies, it’s a safe bet that he or she will claim that geological limits to the world’s petroleum supply don’t matter, because the invisible hand of the market will inevitably solve any shortfall that happens to emerge. There’s a rich irony here, for shortfalls began to emerge promptly after the world passed its peak of conventional petroleum production in 2005; economists responded to those shortfalls by insisting that declining production is simply a sign that the demand for fossil fuel energy has decreased. No doubt when people are starving in the streets, we will hear claims that this is simply a reflection of the fact that the demand for food has dropped.
It may be worth exploring an extreme counterexample in order to clarify the limits to the law of supply and demand. Imagine that a plane full of economists makes a forced landing in the Pacific close to a desert island. The island has no food, no water and no shelter; it’s just a bare lump of rock and sand with a few salt-tolerant–grasses on it. As the economists struggle ashore from the sinking plane, the demand for food, water, and shelter on that island is going to be considerable, but even if each of the economists has a million dollars in his or her briefcase, that demand is going to go unfilled, until and unless a ship arrives with supplies from somewhere else. The lesson here is simple: economics does not trump physical reality.
More generally, the theoretical relationship between supply and demand functions only when supply is not constrained by factors outside the economic sphere. The constraints in question can be physical: no matter how much money you’re willing to pay for a perpetual motion machine, for instance, you can’t have one, because the laws of thermodynamics don’t take bribes. They may be political: Nazi Germany had a large demand for oil from 1943 to 1945, for example, and the Allies had plenty of oil to sell, but anyone who assumed on that basis that a deal would be cut was in for a big disappointment. They may be technical: no matter how much you spend on providing health care for an individual, for instance, sooner or later it will be of no use, because nobody’s yet been able to develop an effective cure for death.
Economists have come up with various workarounds to deal with external factors of this sort, some more convincing than others, but an inability to see economics as a subset of a much larger world governed by non-economic forces remains endemic to the discipline, and has caused some of its more spectacular failures. That inability undermines the theory of free markets governed by supply and demand: however pleasant free markets look on paper, they do not exist. Strictly speaking, they are as mythical as hippogriffs.
It occurs to me that some of my readers