(CE Vol. 37, No. 4-5)

Introduction: Faith and Economics
By Leslie H. Lowe
 

The residential mortgage debacle that began to unfold in 2007 triggered the financial crisis of 2008, which quickly turned into an economic crisis and a crisis of confidence in the intellectual architecture of neoclassical economics and its general equilibrium theory.  Like the Queen of England, many are pointedly asking the economics profession “Why didn’t you see this coming?”

There is no shortage of explanations for the professional myopia. In their answer to the Queen, several eminent practitioners of the dismal science acknowledged that, although some economists had foreseen the crisis, there “was principally a failure of the collective imagination […] to understand the risks to the system as a whole.” This, of course, begs the question “why didn’t most economists understand the systemic risks?”  Highly credentialed neoclassical economists, using sophisticated mathematical models (incorporating contemporary variants of game theory), had declared the collapse of financial markets on the scale we have just seen to be statistically impossible.  Given such abject error, rational actors must certainly question not only the usefulness of the economists’ models but also the validity of their theoretical premises and assumptions.

Neoclassical economics grew from 19th century efforts to ground the classical economic theories of Adam Smith, a moral philosopher, in Newtonian physics.  Variables in the equations of Newton’s mechanics were renamed and transmogrified.  Energy became “utility” and particles became atomized actors rationally pursuing material self-interest in this field of utility in which price and supply are the forces and spatial coordinates and natural laws, discoverable through mathematics, maintain the stability of the market in equilibrium.  That there was no empirical basis for these presumptions (given that utility, unlike energy, cannot be objectively measured as it exists only in the minds of the economic actors) did not deter William Stanley Jevons or Leon Walras, the early theoreticians who made this leap of faith into the new “science” of economics.  The irony that these two engineers had dressed metaphysics in mathematical garb and called it science seems to have been lost on their followers. 

Neoclassical economics in the 20th Century built upon the Walrasian construct but modern economists did not seek to re-evaluate its hypotheses in the new light of 20th Century physics. There were economists who saw the underlying problems with neoclassical theory and approached it with due skepticism.  John Maynard Keynes, whose heretical assertion that without government intervention the so-called natural laws of economics would lead not to prosperity but to economic collapse, called Walras’s theory “and all the others along these lines little better than nonsense.”  General equilibrium theory, nevertheless, preempted the field.  Its most ardent adherents, who espoused a brand of “free market fundamentalism,” occupied the mainstream of economic thought in the later decades of the 20th Century and brought “market-based” approaches into the realms of law, environmental policy and other disciplines.

Although neoclassical economists conceded that general equilibrium theory cannot be empirically tested, it was justified as a useful framework for describing empirical reality and predicting economic outcomes – that is, until a series of financial crises and the current Great Recession revealed that the dazzling mathematical raiment conceals threadbare myths.  Adherents offered a variety of fig leaves to cover the intellectual embarrassment of neoclassical economics, which still holds sway over business and public policy.  These include: over reliance on mathematical modeling; misuse of complex financial instruments; poor risk management within financial institutions; vested interests of academic and business economists; de-regulation and dereliction by the regulators.  Some economic thinkers, however, offer deeper critiques of neoclassical theory, citing: the recourse to arbitrary assumptions, particularly about human psychology and motivations; the illogical belief in the ability of prices to convey all relevant information; and the unwarranted faith in the efficiency of markets. However, until recently, their insights were largely ignored by business, policy makers and the committee that awards the Nobel Memorial Prize in Economic Science.

Mainstream economics has also refused to engage the even more telling indictment of the ecological and biophysical economists who point to the global environmental crises resulting from global economic activity as evidence not simply of market failure but of neoclassical theory’s incompatibility with the biophysical sciences.  Ecological economics is distinct from environmental economics.  The latter is associated with concepts of natural capital and efforts to price the ecosystem’s goods and services. Environmental economists attempt to “put a green thumb on the invisible hand” but they, nevertheless, accept fundamental premises of neoclassical economics: e.g., that the economy is a closed system separate from and outside of the Earth’s natural systems and that markets can appropriately value constituent parts of the environment.  Ecological economists and biophysical economists reject these ideas. 

The notion that the value of environmental goods and services can be determined by what today’s consumers (however ill-informed they may be about complex biophysical systems) are willing to pay for them is not only absurd but unethical, for it privileges the desires of the current generation over the needs of future generations.  When probed, mainstream economists rationalize this violation of intergenerational equity with claims that future generations will be “richer and smarter,” that technology will provide substitutes for scarce resources and solutions to the problems current technologies are creating.  But these assertions are articles of faith, not of fact.  History offers many examples when subsequent generations were, in fact, poorer and less advanced than their predecessors, as was the case in Europe for centuries following the fall of the Roman Empire.

More fundamentally, ecological and biophysical economists challenge the validity of the neoclassical construct and its pretensions to being scientific on the ground that general equilibrium theory cannot be squared with contemporary physics and biology.   The neoclassical belief that we can have a continually expanding economy is a fantasy.  Unlimited growth in a world of finite resources is impossible given the laws of physics, particularly, the First and Second Laws of Thermodynamics.  According to John Gowdy, President of the International Society of Ecological Economists who co-authored two of the papers in this issue, “ecological economics is the only approach treating the human economy both as a social system and as one imbedded in the biophysical universe.”

 
In this issue of The Corporate Examiner we offer the views of several leading thinkers in the field of ecological and biophysical economics.  The first article, “The End of Faith-Based Economics,” explores more fully the mythology underlying the Walrasian paradigm.  In the second article, “Energy and Water: The Real Blue Chips,” a biophysical framework of investment analysis is presented utilizing the concept of returns on the investment of increasingly limited energy and water resources.  The third article, “Energy Price Increases and the 2008 Financial Crash,” applies the biophysical framework to analyze the performance of the Dow Jones and the final article provides a real life cautionary tale about sustainability capital. 

In a world of finite resources and a growing human population projected to reach nine billion by the middle of this Century, it is obvious that there will be fewer resources per capita to satisfy human needs and wants.  If economics is truly to become a science that illuminates how human societies may achieve their ends using increasingly scarce means, then ecological economics provides the light by which we must be guided.

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