James K. Galbraith: The Implications of Rising Resource Costs for Economic Systems
Posted below, with kind permission of the author, is the transcript (see note below) of James K. Galbraith’s talk to the Association for Evolutionary Economics (AFEE) session of the Allied Social Sciences Association (ASSA) meeting on January 9, 2011. Please see the source link at UTIP for the audio, which I highly recommend. — selise
This is joint work with Jing Chen and it’s work in progress addressed to a question that we believe has not be adequately dealt with, in fact barely dealt with at all, in any major tradition — neither in the mainstream nor in the Keynesian or progressive responses to the crisis so far.
The question that we are addressing, that we would like to address, is to the implications of rising resource costs for economic systems in general and for the structure of economic society.
Our approach is to treat the economy as having the same form as a biophysical system — something that it obviously does — insofar as economic life is part of human life and involves interaction between organized society and the natural world.
The meaning of this idea, in essence, is that you have to be able to get more value out of your environment than it costs to extract it. Otherwise, you cannot live.
That is true for any form of living organism and it ought to be true, certainly is true, for society as a whole.
The key to extracting resources in an efficient way is to make an investment, that is to say, to build up that part of the economic system which works on the basis of essentially fixed physical resource costs.
And the appropriate analytical framework for thinking about this issue is therefore very much akin to the Marshallian theory of the firm and its treatment of diminishing and increasing returns — topics which seem to have dropped out of economic thinking in modern times but which were, of course, very much alive in the early days of the Keynesian revolution with Allyn Young and Nicholas Kaldor talking about, in particular, the importance of increasing returns.
A system which operates with a high level of fixed costs, that is to say, with a substantial prior investment can achieve a high level of efficiency at a high rate of utilization. To get there you have to have a perspective that involves thinking ahead for a long duration, that is to say, making plans and investments in systems that are expected to last a long time. And for that you have to have a reasonably low uncertainty about the implications of making those investment decisions.
These systems reach their maximum profitability when resource costs are relatively low and thus we think it is not accidental that the Keynesian era debuted in the 1930’s and was able to be pursued for 30 or 40 years without significant interruption because this period occurred in the moment in world economic history when the cost of resources fell by an unprecedented extent. That is to say, we had massive discoveries of cheap energy, of oil and other resources as well as the addition of other ways of extracting energy from the environment, provided you made sufficiently high front end investments.
On the other hand, systems of this kind are quite fragile and vulnerable to rising resource costs. Why? Because physically they require the same level of resources and therefore the cost of operating them rises proportionately to the cost of extracting the energy, the underlying resources, in real terms.
Systems which operate with very low fixed costs and a much higher proportion of variable costs are, on the other hand, more flexible, they’re more resilient. They can contract and expand with the changes in the cost of resources. And therefore they are more likely to survive in a form that is recognizably similar to what they are presently in the face of rising resource costs.
But, they are much less efficient and they operate at a much lower standard level of living.
It is not a smooth transition to move from a system that is built up on the basis of high fixed cost to one which does not have those high fixed costs. It is, on the contrary, abrupt, brutal, and may well involve the disappearance necessarily of a large part of the population supported by the system.
You can think about this in practically any context that you can imagine, and Jing Chen is very ingenious in coming up with examples so I will not tread on that territory by giving too many of them.
But, just as a very simple and intuitive matter, think about transportation systems. You have a network of trains or a network of aircraft that require certain functions to be performed on a continuous basis in order for the system to operate. Such a system will be vulnerable to disruption in the face of relatively small increases in the cost of resources, or for that matter, diminution in the expenses necessary to keep the system going, such as de-icers in airports, for example, in the face of a storm, something which I think everybody with recent experience in Europe probably has some acute and unpleasant memories of in the not very distance past.
On the other hand, if the transport system is built on low fixed cost, say based on animal transport, something you can still observe on the island of Cuba incidentally, you will find that it is not that vulnerable to disruption. On the other hand, it does not provide you with anything like the extent of the services that you can extract from one which has been built up on a heavy investment.
To take an example from an almost seemingly entirely different sphere, consider the dynamics of human reproduction. We have made it very expensive to raise children. The investment required to bring them up to a functioning standard in our society is very, very high. It involves a massive education, massive adaptation to the various systems that we have created, in order to function at a high level in that society. For many people, it is not worth it.
Is it therefore a surprise that many people choose to have fewer and fewer children, or none at all? You can have a much higher living standard if you are not raising a kid — still higher if you are not raising four kids, as some of us are.
On the other hand, in low fixed cost societies, the economics are entirely different and we argue that is a reasonable first approximation explanation for the demographic dynamics in which richer societies have much lower reproduction rates than poorer ones.
Think about the problem of system collapse. It becomes possible within this framework to conceptualize what has happened, and what is happening on an ongoing basis, in the last 30 years in a single unified way. The first major full scale system collapse of the modern era was the USSR in 1991.
Why did it happen? We have become accustomed to not thinking about it, to conceptualizing it, if we think about it at all, as an ideological matter.
But, we would argue, it makes much more sense to consider that the USSR was a single integrated high fixed cost industrial system which operated with very little flexibility in the face of rising resource costs. And given the inefficiency with which resources were extracted and the cost of doing so, it is not surprising that it was very, very fragile.
The question of the Japanese lost decade or two has been extensively explored, but not from this point of view. It was always an article of faith of my generation that Japan was the example of the society — of the proof — that you didn’t need to have access to resources in order to be a prosperous society.
But that was true in a period when resources, the real cost of extracting them, was much lower than it is now. And Japan, not having its own control of resources, has to pay the market price. And one plausible argument is that in a society which is built up and very advanced, the rising cost of resources put such pressure on profitability that even though living standards didn’t collapse in Japan, profitability did. And you get the indicators of a long term and uncorrectable, effectively, economic environment.
What are we going through in Europe and in the United States as we speak?
Is it possible that we are facing, to some degree, a very similar environment in which the conflicts associated with higher real costs of resources are beginning to be played out in the political system? Is there any evidence for this? Well, one of things to remember is that just in advance of the financial crisis, there was a period for a number of months when the oil price went up to $140 a barrel and that had to do with the fact that the swing producers were in a position to control the price, essentially in conjunction with speculative traders in the financial markets.
And so they were able to bring what appeared to be a resource that was running into its physical limits to a point where the price was essentially out of relationship to the current cost of production.
And at the time, in the spring and summer of 2008, those of us who were fully aware that there was an impending financial crisis, for reasons related largely to the fraudulent character of American housing finance markets, were also practically equally concerned about the economic consequences of the run up in oil prices. That tended to have gotten lost in the subsequent history because the oil price came back down again. But there it is.
What are the policy choices when you think about the problem in these terms?
Well, it seems to me basically there are three broad ways of approaching it and then I will stop and let Jing Chen give you a little more depth of the argument we have been trying to make.
The first way to approach it is to break the system, to try to move from a high to a low fixed cost environment. The way you do that, of course, is by destroying the institutions that support the system: government, the social welfare system, the infrastructure. The way you do that is by cutting its budget.
It seems to us that it is obvious that there is a very powerful movement, perhaps of overwhelming power going on right now, to do precisely that in every advanced country that you can think of, in the UK, in the United States, in Europe.
Is it going to be our argument that this is entirely based upon an ideological predilection or stupidity? It seems to me, that is not necessarily adequate. One has to understand, perhaps, that this is one approach which would preserve, at least, the predatory profitability of certain parts of the private system. Although the cost is forcing everybody to live at a much lower standard and the system effectively being able to support far fewer people.
The second way to approach it, which we might call the Chinese model, is to run the system at a loss. The Chinese industrial system largely runs at a loss. Vast numbers of enterprises continue to operate although they have never made a profit, that wouldn’t know how to make a profit, and their losses are absorbed by the banking system which is supported by the state.
The difficulty of that system, something the Chinese authorities understand very well, is that it gives you no control over the rents that are earned by the people who control the scarce resource, namely energy.
What is the approach of China in the face of that? It is to put as much energy as possible under long term contract. Something which they are doing as systematically as is possible in order to make the system continue for as long as it can.
And the third, which might be called the Nick Stern approach, or the approach of progressive, environmentally conscious economists, is to try to rebuild and reconfigure the system to make the long term investments that would be required to keep the rising costs of resources under control by moving from higher cost resources to lower cost resources and by conserving the resources you have available to the maximum extent possible and dealing, not incidentally along the way, with the deferred cost of resources associated with climate change.
That is a hugely demanding agenda. It is being presented to us by our friends at the Union of Concerned Scientists. I heard Nick Stern talking about this two nights ago — to an audience of economists. It is very clearly what they have in mind. But, you have to ask what institutional and policy frameworks can conceivably get us from here to there.
It is not something which can, in the ordinary course of events, yield high private profits unless institutions are created which make it profitable for private actors to do so. And it is not something which can easily be done in the face of private control over large parts of the energy supply sector because, once again, pressure on that sector generates rents which cannot, under those conditions, be turned to the problem of investing. It’s not something that’s going to happen in an environment of uncertainty and doubt about the potential effectiveness of the scheme.
If there is a fourth option, I’d be happy to hear it.
Chen, Jing and Galbraith, James K., Institutional Structures and Policies in an Environment of Increasingly Scarce and Expensive Resources: A Fixed Cost Perspective, (2011), forthcoming in Journal of Economic Issues.
Chen, Jing and Galbraith, James K., A Biophysical Approach to Production Theory, Working paper, (2009).
NOTE: Remarks above were transcribed from the audio file at UTIP. All errors are mine. — selise
x-posted from my blog — selise