How Can We Achieve a Sustainable Economy? – Background Note

28th November 2017

“Anyone who believes that exponential growth can go on forever in a finite world is either a madman or an economist” – Kenneth Boulding

Economic policy is aimed at sustainable growth. Yet science and politics suggest our economy has physical and social limits. Our biosphere, atmosphere and energy supplies are almost certain constraints on future output. How can we include limits on physical resources into macroeconomics so as to create a more nuanced understanding of sustainability? Measures of well-being are diverging from economic growth, including rising health concerns and disengagement from economic activity. How can we create new measures of the standard of life?

Economic growth has generated unprecedented increases in human wealth and prosperity during the 19th and 20th centuries, largely via technological and social innovations, human capital accumulation and the conversion of resources and natural capital into more valuable forms of produced capital. Yet we know that it is possible to boost GDP – aggregate, market-based output – via activities that cause suffering (e.g. fatigue or even war) or by running down wealth, for instance exhausting renewable resources such as fish stocks.

Running through this research theme, therefore, is the much-discussed issue of what do we mean by prosperity beyond narrow, current income-based measures? When we talk about sustainable prosperity, what, precisely, is to be sustained?

How central is the role of energy in economic growth?

Views vary on the outlook for energy availability. But if we do enter a world of energy scarcity, as many predict, how would this affect well-being and GDP? The mainstream view in economics is that we would see a spike in energy prices, accompanied by demand destruction in the near term. The substitution elasticity of energy is assumed to be low in the near term. Further out, though, it is assumed to be much higher as high prices stimulate substitution. But is that right? One alternative view is that you would see low elasticity in the short run and even lower elasticity in the long run because low quantities of energy eventually make further substitution impossible.

One argument for this is based on a reappraisal of the role of energy in the production function. According to the mainstream view, the output contribution of energy is equal to the cost share, which is pretty low: around 5% – 10%. This suggests there is not too much to worry about from energy scarcity. The typical production function, if it features energy at all, implies labour and capital can function without energy: very high energy prices make you use capital instead. But might this reasoning be misplaced? It perhaps serves as the production function of the shopkeeper, but does it work as the production function of the engineer or the physicist?

What might we learn from other approaches? Studies from “biophysical economics”, for instance, find a far higher output contribution of energy, as high as 50%. Another perspective considers the link between energy and technology. These are typically taken to be separate. But one can argue that energy is a critical enabler of key technologies: that technology is only possible because of energy. In that case, clearly, the economic importance of energy extend well beyond the cost shares. If we are entering a world of energy scarcity and security, does this become a pressing issue to consider?

Does macroeconomics need to take biological boundaries more seriously?

There is evidence emerging that the mainstream “growth” model may be environmentally unsustainable as we approach biological boundaries that scientists warn us from crossing. Environmental economists argue that the conversion of natural capital needs to slow down rapidly and then be reversed.

Climate change is one such boundary. The Paris Agreement to reduce emissions to 2 degrees above pre-industrial levels stems directly from a recognition of this. Air and water pollutants are another example: the human extraction of nitrogen from the atmosphere, largely for agricultural use, is now over three times the “safe” level, polluting waterways and coastlines. A third example is biodiversity loss. Rates of extinction are estimated to be 100 to 1000 times higher than pre-industrial times, likely as a result of human activity. This matters economically: if bees were to be wiped out, for instance, enormous sums of money would need to be spent on manual pollination within agriculture for our food systems to continue to function.

What can we learn from these planetary boundaries? Are they factored in (sufficiently) to macroeconomic models and methodologies? To what extent do economic models – with or without explicit roles for environmental factors – need to take account of feedback loops, thresholds/tipping points, fat-tailed distributions and non-equilibrium system dynamics? How might different modelling approaches fare, for instance, DSGE models versus agent-based approaches? And do we think it will be these planetary boundaries, rather than material or energy constraints, that will limit economic growth? How quickly and effectively do we think we might transform current consumption and production trends, substitute for natural resource use and protect ecosystem functions? Ultimately, will we need to stop growing altogether, or is “green growth” possible in the long run? What would this mean for our macroeconomy?

What insights can we bring to the economic treatment of ‘desires’ and ‘individuals’ in the context of sustainability issues?
Economics is sometimes defined as the study of how people use scarce resources to satisfy their desires. “Success” is defined in terms of how well we satisfy our desires – which are assumed to be unlimited and outside of our control. This success is measurable in terms of the market value of the goods and services we consume. In short, we are locked into a particular definition of prosperity and a particular metric for measuring it. Yet we know from behavioural economics, just how far human behaviour departs from the textbook model. What can we learn from psychological and neuroscientific knowledge about human motivation, emotion and social cognition? How might insights from these fields inform models of economic decision-making relevant to the task of achieving a sustainable economy?

Insights from psychology and neuroscience, however, indicate that this notion of exogenously given and unlimited desires is both misguided and harmful. And some of the evidence gathered over the past few decades in the happiness literature suggests that when you assess prosperity in terms of how happy people say they are, material prosperity has a diminishing payoff. Although people with relatively high incomes in a particular county at a particular time report relatively high happiness, for the population as a whole, rising income through time is associated with less and less reported happiness (the Easterlin Paradox).

Why might a population-wide rise in income have diminishing returns on reported happiness? Perhaps people quickly become accustomed to their more affluent lifestyles – the notion of the so-called “hedonic treadmill”. Research also suggests that we persist in the pursuit of material wealth out of habit and because everyone around us is doing so. We also systematically overestimate the pleasure we will gain from material wealth. Indeed, one finding that goes to the heart of the homo economicus assumptions is work showing that people with materialistic mindsets – those orientated towards extrinsic goals like money and status – report lower subjective well-being.

Where should we take this body of findings from a macroeconomic standpoint? How might we better (further) integrate economics – and the underlying assumption s and objectives of economic models – with findings from psychology? What could studies on the plasticity of the motivational system – hence the formation of our desires and preferences – mean for the possibilities for changing preferences through mental training? This is important because different motivations are associated with different desires. Studies from other human sciences suggest that we have (far) more choice over our desires than economics as a discipline would lead us to believe.

Another angle to explore is the strict methodological individualism underpinning mainstream economic analysis. Some argue that this has blinded us to important channels of well-being tied to human cooperation, thereby limiting the prosperity that we are able to achieve. Should prosperity be assessed not only individually but also socially? Does the traditional conception of homo economicus need to be replaced by a new conception of homo relationis, namely, individuals who are linked to one another through personal relationships and their capacity for empathy and compassion?

Such a new conception could suggest that people are capable of intrinsically prosocial behaviours, enabling them to cooperate in ways that standard economic theories ignore. One angle looks at the potential for so-called “caring economics ” – in which cooperative, pro-social and sustainable economic behaviours take centre stage. On this account, as long as we choose to conduct our activities in a social setting that is individualistic, grasping, materialistic, competitive, and selfish, we should expect to stimulate our appetitive and competitive motivations. If instead, we choose to make our decisions in a more cooperative, supportive, kind and compassionate setting, would we perhaps then stimulate our more caring motivations?