Although policies based on mainstream neoclassical economics, famously enshrined in the Washington Consensus, have clearly failed, economic theory has remained in a state of paralyzed confusion. What has been missing is a full shift to modern modes of thought informed by contemporary science.
TOWNSHEND, VT – Economic theory exists to underpin and guide economic policy – and so it has done since the days of the mercantilists and the physiocrats, and from Adam Smith and David Ricardo to Karl Marx and John Maynard Keynes. While good theory helps us understand the world and make better policy choices, bad theory can lead to major policy failures.
Consider the dominant dogmas of today’s mainstream economics, which include perfect competition, constant returns, marginal productivity, money neutrality, rational expectations, the self-organizing potential of supposedly free markets, and general equilibrium. Translated into policy, these gave us the Washington Consensus, which calls for balanced budgets, tight money, privatization, deregulation, free trade, open capital markets, and so forth.
The policy failures of this bizarre confection are now obvious, but the even stranger underlying theory is little discussed today – and understandably so. Who wants to admit to having been in thrall to such peculiar notions, let alone to having devoted one’s career to them?
The mainstream doctrines failed because their proselytizers never emerged from eighteenth-century complacency – that is, from intelligent design, cosmic order, and classical mechanics – into the troubled dynamic vision of nineteenth- and twentieth-century science: evolution, relativity, and thermodynamics. They rebuffed or ignored the words of Marx and Thorstein Veblen, who invoked Darwin; of Keynes, who invoked Einstein; and of Nicolas Georgescu-Roegen, who invoked the law of entropy. Minor departures from the redoubt of general equilibrium – such as work on imperfect competition, asymmetric information, behavioral regularities, and chaos and complexity – are not enough to break ancient habits of comfortable thought.
In our forthcoming book, Entropy Economics: The Living Basis of Value and Production, my co-author Jing Chen and I show how to make the leap. The framework we propose offers three advantages (apart from being consistent with the real world). First, it integrates economics with biology, physics, anthropology, and other modern disciplines, including the information theory underpinning computer science. Second, it simplifies economic theory – both conceptually and mathematically – for the benefit of students, as well as businesses, households, and governments. Third, it can underpin policy in an intuitive and prospectively successful way.
The basics may be summarized in a handful of key propositions. First, like all life and all mechanical activity, economic activity taps into the entropy flow: it requires resources that must be extracted or harvested with an available surplus, called the energy return on investment.
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Second, all resource extraction requires prior fixed investment – be it a cell for photosynthesis, a machine to dig for coal or oil, a building for commercial or residential purposes, or an organization to manage technology.
Third, all organisms, machines, buildings, and organizations are built according to plans, which are encoded in genes, blueprints, habits, regulations, laws, and constitutions. Moreover, these plans evolve over time, which explains why organisms and societies differ, and why there is no single best economic policy for all circumstances. Bye-bye, Washington Consensus.
Fourth, all complex markets – in fact, all markets – exist thanks to effective regulation, just as all biological and mechanical processes must be regulated to keep the energy flow within the capacity of the system to handle it. Deregulation leads to decay or catastrophic failure.
Fifth, all cells, organisms, machines, firms, and societies have boundaries to maintain differentials and make useful work possible. Inequalities in this sense are necessary. However, at the social level, the regulation of inequality is a critical element of stability, as is the regulation of blood pressure in humans or of temperature and pressure in nuclear reactors. Inequalities become dangerous when they grow too large.
Finally, nothing is permanent. Empires and civilizations crumble, just as lives end and machines break down.
This framework is consistent with the way firms, households, and well-run countries behave. They make production and investment decisions under uncertainty, for a definite time, with an expectation of profit given the best available technology and the cost of resources. Things may or may not work out, but all economic actors strive to control as much of their environment, including resources and markets, as they can. Success is not about profit maximization, but about achieving a positive return for a sustained period.
This biophysical perspective on economic theory may be put to immediate practical use to clarify a wide range of policy questions. Consider inflation, sanctions, and human demography.
The return of system-wide price increases in North America in 2021, after 40 years of stability, led mainstream economists to resurrect 1970s-era ideas about Phillips curves, fiscal deficits, and excess demand, while continuing to insist that central banks have sole responsibility for “fighting inflation.” Yet price increases peaked in mid-June 2022, long before higher interest rates could slow the economy. Even two years later, few if any of the predicted effects on growth and employment have materialized. The mainstream has been confounded, even though the situation is easily explained by the fact that energy-price increases and supply-chain disruptions drove prices up in the first place, triggering a wave of “catch-up” or “get-ahead” price hikes to preserve or increase profit margins.
With respect to sanctions, the measures adopted to cripple the Russian economy and war effort targeted the three neoclassical factors of production: capital, labor, and technology. Both Russian and Western sources agree that these were highly effective in throwing the Russian economy into crisis. Yet after a short period of successful crisis management, Russia embarked on a sustained recovery.
It was able to do so because a productive economy is not a bundle of neoclassical building blocks. The sanctions created large new profit-making opportunities for Russian businesses, by lowering the cost of resources inside Russia, removing incumbent Western competitors from Russian markets, transferring productive assets to Russian owners at low prices, and curtailing capital flight. Meanwhile, the sanctions had an inverse effect on Europe.
Finally, human demography is largely treated as a given in mainstream growth theory, even though the decision to have children is partly an economic one. Across wealthy countries, fertility rates have fallen far below replacement levels, and some populations have started to decline. Only in some of the world’s poorest societies does fertility remain far above the replacement level. To the extent that mainstream theory considers this issue, it is a paradox that children are scarce in the rich countries that can afford them.
The paradox is resolved by noting the conditions facing each household. In rich countries, children are a high fixed cost. They must be fed, clothed, educated, entertained, and tolerated for several decades with no economic return; and in many cases, they also deprive the household of a second income stream. As austerity policies, precarious work arrangements, rising resource costs, increased uncertainty, and higher interest rates squeeze the margin between fixed costs and income, having fewer or no children is the response imposed on many young households by the pressures of their budget.
Sad to say, the process is cumulative and self-reinforcing. For this reason, countries without immigration or strong pro-natalist policies are heading toward demographic collapse, which may ultimately prove to be the fate of the human species. Entropy, in economics as in biology and physics, is implacable.
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TOWNSHEND, VT – Economic theory exists to underpin and guide economic policy – and so it has done since the days of the mercantilists and the physiocrats, and from Adam Smith and David Ricardo to Karl Marx and John Maynard Keynes. While good theory helps us understand the world and make better policy choices, bad theory can lead to major policy failures.
Consider the dominant dogmas of today’s mainstream economics, which include perfect competition, constant returns, marginal productivity, money neutrality, rational expectations, the self-organizing potential of supposedly free markets, and general equilibrium. Translated into policy, these gave us the Washington Consensus, which calls for balanced budgets, tight money, privatization, deregulation, free trade, open capital markets, and so forth.
The policy failures of this bizarre confection are now obvious, but the even stranger underlying theory is little discussed today – and understandably so. Who wants to admit to having been in thrall to such peculiar notions, let alone to having devoted one’s career to them?
The mainstream doctrines failed because their proselytizers never emerged from eighteenth-century complacency – that is, from intelligent design, cosmic order, and classical mechanics – into the troubled dynamic vision of nineteenth- and twentieth-century science: evolution, relativity, and thermodynamics. They rebuffed or ignored the words of Marx and Thorstein Veblen, who invoked Darwin; of Keynes, who invoked Einstein; and of Nicolas Georgescu-Roegen, who invoked the law of entropy. Minor departures from the redoubt of general equilibrium – such as work on imperfect competition, asymmetric information, behavioral regularities, and chaos and complexity – are not enough to break ancient habits of comfortable thought.
In our forthcoming book, Entropy Economics: The Living Basis of Value and Production, my co-author Jing Chen and I show how to make the leap. The framework we propose offers three advantages (apart from being consistent with the real world). First, it integrates economics with biology, physics, anthropology, and other modern disciplines, including the information theory underpinning computer science. Second, it simplifies economic theory – both conceptually and mathematically – for the benefit of students, as well as businesses, households, and governments. Third, it can underpin policy in an intuitive and prospectively successful way.
The basics may be summarized in a handful of key propositions. First, like all life and all mechanical activity, economic activity taps into the entropy flow: it requires resources that must be extracted or harvested with an available surplus, called the energy return on investment.
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Second, all resource extraction requires prior fixed investment – be it a cell for photosynthesis, a machine to dig for coal or oil, a building for commercial or residential purposes, or an organization to manage technology.
Third, all organisms, machines, buildings, and organizations are built according to plans, which are encoded in genes, blueprints, habits, regulations, laws, and constitutions. Moreover, these plans evolve over time, which explains why organisms and societies differ, and why there is no single best economic policy for all circumstances. Bye-bye, Washington Consensus.
Fourth, all complex markets – in fact, all markets – exist thanks to effective regulation, just as all biological and mechanical processes must be regulated to keep the energy flow within the capacity of the system to handle it. Deregulation leads to decay or catastrophic failure.
Fifth, all cells, organisms, machines, firms, and societies have boundaries to maintain differentials and make useful work possible. Inequalities in this sense are necessary. However, at the social level, the regulation of inequality is a critical element of stability, as is the regulation of blood pressure in humans or of temperature and pressure in nuclear reactors. Inequalities become dangerous when they grow too large.
Finally, nothing is permanent. Empires and civilizations crumble, just as lives end and machines break down.
This framework is consistent with the way firms, households, and well-run countries behave. They make production and investment decisions under uncertainty, for a definite time, with an expectation of profit given the best available technology and the cost of resources. Things may or may not work out, but all economic actors strive to control as much of their environment, including resources and markets, as they can. Success is not about profit maximization, but about achieving a positive return for a sustained period.
This biophysical perspective on economic theory may be put to immediate practical use to clarify a wide range of policy questions. Consider inflation, sanctions, and human demography.
The return of system-wide price increases in North America in 2021, after 40 years of stability, led mainstream economists to resurrect 1970s-era ideas about Phillips curves, fiscal deficits, and excess demand, while continuing to insist that central banks have sole responsibility for “fighting inflation.” Yet price increases peaked in mid-June 2022, long before higher interest rates could slow the economy. Even two years later, few if any of the predicted effects on growth and employment have materialized. The mainstream has been confounded, even though the situation is easily explained by the fact that energy-price increases and supply-chain disruptions drove prices up in the first place, triggering a wave of “catch-up” or “get-ahead” price hikes to preserve or increase profit margins.
With respect to sanctions, the measures adopted to cripple the Russian economy and war effort targeted the three neoclassical factors of production: capital, labor, and technology. Both Russian and Western sources agree that these were highly effective in throwing the Russian economy into crisis. Yet after a short period of successful crisis management, Russia embarked on a sustained recovery.
It was able to do so because a productive economy is not a bundle of neoclassical building blocks. The sanctions created large new profit-making opportunities for Russian businesses, by lowering the cost of resources inside Russia, removing incumbent Western competitors from Russian markets, transferring productive assets to Russian owners at low prices, and curtailing capital flight. Meanwhile, the sanctions had an inverse effect on Europe.
Finally, human demography is largely treated as a given in mainstream growth theory, even though the decision to have children is partly an economic one. Across wealthy countries, fertility rates have fallen far below replacement levels, and some populations have started to decline. Only in some of the world’s poorest societies does fertility remain far above the replacement level. To the extent that mainstream theory considers this issue, it is a paradox that children are scarce in the rich countries that can afford them.
The paradox is resolved by noting the conditions facing each household. In rich countries, children are a high fixed cost. They must be fed, clothed, educated, entertained, and tolerated for several decades with no economic return; and in many cases, they also deprive the household of a second income stream. As austerity policies, precarious work arrangements, rising resource costs, increased uncertainty, and higher interest rates squeeze the margin between fixed costs and income, having fewer or no children is the response imposed on many young households by the pressures of their budget.
Sad to say, the process is cumulative and self-reinforcing. For this reason, countries without immigration or strong pro-natalist policies are heading toward demographic collapse, which may ultimately prove to be the fate of the human species. Entropy, in economics as in biology and physics, is implacable.