Jeremy Grantham has long advocated that economic growth is inexorably constrained by physical resources, especially oil and other fossil fuels. Thus, in GMO’s Third Quarter 2014 Quarterly Letter, he writes, “I think that the old growth rates in productivity will not come back, at least until we have had a transition away from fossil fuels.” But Grantham also announces that, having regularly insulted economists “for their lack of interest in resource limitations,” he gratefully notes that “a new book appears that amazes me by doing the opposite, and by an increasingly well-known economist no less … It is entirely sensible from start to finish … I agree with almost everything he writes.”
The End of Normal
In his new book, The End of Normal: The Great Crisis and the Future of Growth, James K. Galbraith actually does much more than display interest in resource limits. His argument is developed in more depth than Grantham’s – at times too much depth to fully take in – but their end results are very close.
If Galbraith is “an increasingly well-known economist,” he has had a hard row to hoe along the way. His entire position and world view fly in the face of everything that economics has become in the last 30 to 40 years. This makes him a little difficult to understand in places. He doesn’t speak the usual economics-speak. He doesn’t accept as a given most of the casual verities that the vast majority of economists accept, almost unconsciously, as their starting point.
The main thing he doesn’t accept is that if the economy is in a slump, it will recover. This puts him at odds with both Keynesians, who think it will recover relatively quickly and painlessly if the government applies stimuli, and economists of the Austrian school, who think that if the government does nothing the economy will recover after some – probably necessary – pain.
Galbraith thinks the whole idea that the economy will recover – that is, that it will recover to rejoin its former growth trajectory – was deeply embedded in economic thought by Nobel laureate Robert Solow’s growth model. One senses that it is this model, among others, Galbraith has in mind when he rightly observes, “No one with a sense of aesthetics would take the clumsy algebra of a typical professional economics article as a work of beauty.”
Solow’s model depicted economic growth as a smoothly accelerating exponential function, dependent on only two inputs, or “factors of production”: capital and labor. Solow recognized that this doesn’t come close to explaining economic growth; so even if you assume it is smoothly increasing along an exponential curve, there has to be an additional unexplained factor, which is called “technology.”
Galbraith’s biggest problem with this formularized economic growth theory is the implicit assumption of an underlying growth function with an underlying growth rate. That means that although movements in actual GDP may follow a fluctuating graph, we are prone to assume a shadowy exponential curve underlying it, showing the “real,” or “smoothed,” or “potential” values – to which we assume it will return. (The same might be said of a graph of the S&P 500 and “reversion to the mean.”)
Another problem Galbraith has with the theory is that the growth rate became unhinged from both resource abundance and resource constraints – factors you would expect to be crucial for growth. Instead, Galbraith says, “It became a psychological subject, dematerialized. The parameters of prime interest to economists would henceforth be matters such as ‘credibility,’ ‘confidence,’ ‘expectations,’ and ‘incentives.’ ”
In other words, economists began to assume that economic growth could take place without natural resources or with natural resource supplies taken for granted, and moreover, that it would.
The assumption of a natural return to growth
So if an interruption in growth – a recession – occurs, then the economy must be performing below its full capacity, or its “potential rate of total output.” What is this full capacity? It’s that shadowy exponential curve. Galbraith illustrates that the “potential rate of total output” has been blithely assumed to be wherever the exponential growth trajectory that fit the data before the recession would have ended up after it.
There’s no real theory behind this, it’s just an assumption, and an unstated one at that. But it grips economic consciousness firmly.
Galbraith believes that because policymakers make the assumption of strongly continued growth, they must adopt policies to make good on it. This leads to bubbles driven by fraud, facilitated by policies that wink at fraud. (Galbraith notes that “in the fall of 2001, the Bush Department of Justice reassigned five hundred FBI agents from financial fraud to counterterrorism – an understandable move. What was less understandable, however, is that they were never replaced. In 2003 Mr. James T. Gilleran, the head of the Office of Thrift Supervision, held a famous press conference at which he took a chain saw to a stack of federal underwriting standards – an unmistakable signal to even the most slow-witted lender.”)
Galbraith also devotes a chapter to showing that although war, especially World War II, propelled U.S. economic growth in the 20th century modern wars no longer promote economic growth and can no longer be expected to.
Rising, jerky energy prices
Furthermore, the curve of economic growth will not be smooth in an age of high energy prices if policies are constantly adopted to pump up growth. He describes what happens when there is a net scarcity of a critical resource such as oil, using the image of the “choke-chain effect.” By this he means the choke chain on a dog’s neck. I did have a dog that I led by a choke chain when I was a teenager. Due to the choke chain, a dog will alternate between straining mightily forward and giving up breathlessly.
What Galbraith refers to as the choke-chain effect can be observed in a recent article in the Financial Times by the publication’s chief economics commentator, Martin Wolf, entitled “Two cheers for the sharp falls in oil prices.”1 Wolf says that prices are low because Saudi Arabia refused to cut output in the face of increased unconventional oil production in North America, recovery of production in Libya and economic weakness in the Eurozone, Japan and China.
Profitable unconventional oil production requires that high oil prices persist. Says Wolf, “The case that the decline [in oil price] will prove temporary is that Saudi Arabia’s desire to cripple production of unconventional oil, which demands a high level of capital expenditure, will swiftly succeed… Having made their point2, the Saudis might yet cut production.”
So like a dog alternately straining forward and relaxing backward under the control of a choke chain, oil prices are more likely to take wide swings and be unpredictable in the short- to medium-term, than to be maintained at a dependable level. This outlook of unpredictable and widely fluctuating prices is not wholly favorable for unconventional and alternative-energy investments.
As Galbraith admits, “The history of natural resources was littered with predictions of depletion that, for some reason, had never quite come true.” But, he adds, “The economists argued that therefore they never would.” The boom in unconventional oil and gas is the latest salvation to arise. Galbraith points out, however, that “the outlook for sustained shale gas production over a long time horizon remains uncertain, for a simple reason: the wells have not existed long enough for us to know with confidence how long they will last.”
New sources of fossil fuels have been tapped not so much because they were discovered, but because fossil fuel prices rose high enough to make more expensive recovery economical. Even if this pattern could continue forever, it would mean endlessly rising fossil fuel prices in the long term, increased price uncertainty and increased price fluctuation. Alternatives like renewables and nuclear may become fully competitive eventually, but only because the price of energy has risen so much. This means that the cost of an economy’s most basic requirement – energy – will become an ever-larger and more uncertain share of the budget.
The slow-growth economy
Under these circumstances Galbraith believes – as does Grantham – that the high economic growth rates of the past cannot continue. It bears frequent repetition that economic growth rates appreciably above zero are a quite recent phenomenon in human history, having occurred only since about 1850, and they coincided with the discovery of large deposits and widespread utilization of fossil fuels – first coal and then oil and natural gas. For most of their history, these fuels have been very inexpensive. But since the middle of the 2000s, the real price of oil has averaged four and a half times what it was in 2000, and it has been highly volatile.
Furthermore, the “shadow price” of fossil fuels, or the price including externalized social and environmental costs, is estimated to be much more than its current market price. The cost of coal would increase by about 50%, for example, if commonly-estimated CO2 emissions costs of about $20-$30/ton were added.
All of this means that the almost-free resources that powered high rates of growth in the developed world for 150 years are becoming much more costly, and their costs are becoming more unpredictable. The “dematerialization” of economics has resulted in insouciance about these facts; it assumes that economic growth is driven by human ingenuity and not the access to physical resources that allow humanity to leverage that ingenuity. If humans never could have accessed iron and fire, would ingenuity have been enough? Will it be enough when we can no longer access them?
Galbraith’s answer is simple: the future must be one of learning to live with and manage slow growth. This is not necessarily a bad thing. It would have many advantages. It would, for example, resolve French economist Thomas Piketty’s problem – that increasing wealth inequality is foreseeable forever, with unpleasant consequences, because the return to capital will exceed the return to labor.
In a slow-growth world the return to capital will be low, so there will be less investment of capital. According to Galbraith, “A slow-growth model should … foster a qualitatively different form of capitalism: based on more decentralized economic units with relatively low fixed costs, relatively high use of labor compared with machinery and resources, relatively low expected rates of return, but mutually supported by a framework of labor standards and social protections. Much of what a high-income, prosperous society values – education, health care, elder care, art, and sport – meet these criteria.”
Another view
This is of course not the only possibility. I have taken a position on this3 – though in large part to point out that “growth” as we define it rests on an accounting and statistical fiction, GDP. Just as the conversion of monetarily-uncompensated housewives to wage earners increased GDP, an endless procession of dematerialized commercial activities, which could be easily monetized thanks to vanishingly small transaction costs (such as people giving each other massages and being paid for it), might increase it ever further.
But it is also possible that what may prove to have been a 200-year window of opportunity, given to us by the existence and discovery of fossil fuels, will ultimately prove to have jump-started a new era of development and growth based on clean renewable and nuclear energy. And if we can solve the energy problem, we may be able to use that energy to deal with humanity’s second-biggest resource challenge; water. A wealth and diversity of natural resources (both virgin and, increasingly, recycled resources) is of course necessary, if only to offer adequate opportunities for substitution of one resource for another when one becomes too scarce. Economics really should not ignore natural resources as it does – but the dematerialized economics that it has fostered is not wholly irrelevant.
Nevertheless Galbraith’s – and Grantham’s – views must be seriously considered.
In fact, I give Galbraith’s and Grantham’s long-term slow-growth scenario about a 50% chance. The other 50% chance I give to the more “optimistic” scenario that I just painted and that most economists believe in without much examination.
Is it really, though, more optimistic? What exactly would be so wrong with slow growth?
Michael Edesess, a mathematician and economist, is a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, a principal and chief strategist of Compendium Finance and a research associate at EDHEC-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, has just been published by Berrett-Koehler.
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