Source: LA Magazine

“Is she the chief economist, or who is she? I’m confused… After she goes and studies economics in college she can come back and explain it to us.”

Steven Mnuchin, US Treasury Secretary, about Greta Thunberg, January 2020, Davos.

Exactly a century after Arthur Pigou coined the term ‘externality’, the question our sustainability crisis poses is whether our economy is more market failure than market. What says economics, then…?

Of Greta and Steve

It was a quote tailor-made for Twitter – Mr Mnuchin suggested that Greta should get an economics degree before telling the grown-ups what to do…

Important issues of civility aside – he later claimed he had meant it as a joke – Mr Mnuchin expressed a common view that an economics degree might be more help than hindrance in comprehending the world.

Yet possibly what Greta has noticed is that many of society’s influential decision-makers are either formally trained or well-practiced in economic thinking and still struggling to find convincing remedies to our sustainability crisis. Perhaps the way we have been teaching economics is part of the problem…?

The key issue is not that economics is not a valuable body of knowledge – it clearly is – but rather that it has unwittingly propagated an exaggerated sense of its scope and lost sight of its boundaries. Ironically, it has achieved this by fatefully downplaying the significance of one of its own discoveries made exactly a century ago. Given the profound influence of economics within modern culture, this cannot be dismissed as mere academic lapse, but has potentially calamitous real-world consequences.   

Pigou’s inconvenient truth

In 1920, Arthur Pigou, a Cambridge economist, conceived the idea of externalities to describe how market transactions may create unintended harms or benefits for which no monetary compensation or reward occurs. Market exchanges effectively generate ripple effects for human value that go beyond what is captured by the originating transaction.

This was an inconvenient truth for economics. It suggested that there are real limits to what economics might say about matters of human value and, hence, to how far markets might serve human wellbeing.

Instead of confronting Pigou’s awkward proposition, mainstream economics headed in the exact opposite direction for most of the 20th Century, promoting the universal applicability of economic thought. A key milestone was the complete market theory of the 1950s which entirely denied the possibility of externalities. The market had all human preferences covered.

Of course, economists did not believe that real world markets were fully complete, but critically the discipline proceeded on the basis that markets were much more complete than not, shunting Pigou and his meddlesome externalities to the periphery. It made the equations and models much easier and permitted agreeable claims about the superiority of market outcomes for promoting human welfare. Where economics led, society duly followed.

The troubling question our sustainability crisis now poses is: what if our ‘economy’ is more market failure than market? What says economics, then?

For example, one study estimated the monetary value of the ‘services’ provided free by the Earth’s ecosystem at $125 trillion in 2011, nearly twice the value of global GDP (gross domestic product). That is just an estimate of certain ecological values ignored by the market. Important social values are missed as well. In the UK, unpaid housework in 2016 was estimated at about 65 percent of GDP – another huge block of nonmarket value. These two studies alone indicate that measured GDP captures about a third of some larger conception of value.  

Such estimates suggest that it is not that the market doesn’t capture all things of value, it doesn’t even capture most things of value. Far from externalities being peripheral, they may be the main event!

Our BESDA Economy

Businesspeople might grasp the point by reflecting on the similarities between GDP and the discredited metric of EBITDA (earnings before interest, taxes, depreciation and amortization). Though there are technical differences of construction, GDP and EBITDA both represent partial measures of ‘wealth creation’ disembedded from a fuller conception of value. With the ‘DA’, EBITDA conveys the profitability of a company as if it would never again have to spend a dollar on keeping its factories, equipment, property and software in good repair and up to date. In other words, EBITDA excludes the cost of maintaining the whole infrastructure upon which a company depends!

EBITDA persists because it masks the fact that a business may be overleveraged – that it may have borrowed against its future more than it can ever repay. As Warren Buffet has perceptively noted, it not only helps to deceive others but also to deny:  

“People who use EBITDA are either trying to con you or they’re conning themselves.”

GDP is a ‘wool-over-our-eyes’ metric for the same reason that it excludes the full cost of maintaining the social and ecological infrastructure upon which the whole economy depends. In steering society by GDP, we are effectively managing the planet on an EBITDA basis. GDP is not just a benignly incomplete measure of wealth, it is the tool with which we are hazardously conning ourselves.

Buffet’s partner, Charlie Munger, is characteristically more forthright:

‘I think that, every time you see the phrase “EBITDA earnings”, you should substitute the phrase “bullshit earnings”.’

By analogy, GDP is ‘bullshit wealth creation’. That we’ve been able to enjoy the comforts of its deception for so long is simply because it was introduced against higher levels of social and ecological infrastructure that we haven’t completely run down yet. The under-investment is only now becoming apparent.  

Long-term and ESG (environmental, social and governance) investors may protest that they understand all this but that their own investment process insulates them from such blinkered thinking. (‘We don’t use EBITDA’). Yet the point is that the whole financial system is operating on a ‘before ecological and social depreciation and amortization’ basis – call it BESDA, perhaps.

…the whole financial system is operating on a ‘before ecological and social depreciation and amortization’ basis – call it BESDA, perhaps.

So, every single financial metric on the Bloomberg screen is a BESDA metric – profits-BESDA, earnings per share-BESDA, return on capital-BESDA, return on equity-BESDA, etc. The millions of financial numbers processed daily by our increasingly automated markets – which, in turn, steer our economy and drag our culture along behind, ripping up nature in its wake – are all BESDA numbers.  It might not only be EBITDA with which we’re conning ourselves, but every financial number in the book. They all represent different degrees of disembedded value, some of which we have unmasked, some of which we have not.  

We have a sustainability challenge because the entire financial system repeats the problem of the discredited EBITDA metric at the level of the whole economy. This is the invisible conceptual cage we have wrapped around our decision-making and from within which the ESG movement is frantically trying to make a difference. Alas, given the incompleteness of our markets, the ESG movement increasingly resembles a hopeful grafting of good intentions onto an unchallenged accounting reality that remains the largely intact source of our problems.

We have a sustainability challenge because the entire financial system repeats the problem of the discredited EBITDA metric at the level of the whole economy.

More prices, please

Thanks to Pigou, economics has long held the answer to this predicament – in short, price externalities – but has not sufficiently prioritized the idea as one of the subject’s most important findings.

It is absurd that in the face of an unprecedented species-level challenge, we are underutilizing the most powerful tool we know of to influence individual behaviour at mass scale – namely, price signals. Just to take greenhouse gas emissions: according to the World Bank, only 1 percent of total global emissions are currently priced at a level consistent with achieving the temperature goals of the Paris Agreement.

Bluntly, we need a lot more prices than ‘free markets’ seem able to generate of their own accord. This speaks to the issue of who has the power in modern society to make new prices. Consider, for example, that over the last decade my Google search for ‘carbon emissions’ has been commodified and now commands a price – not to me, but to advertisers bidding for my attention – while my actual carbon emissions remain unpriced despite economists making a serious case for such pricing for nearly half a century, now. Hmmm.

So, economics has answers but has been too content to focus on markets rather than the larger market failures that surround them. If Greta chooses to study economics at college, she might ask her professors to teach the course ‘inside out’ – from market failures in rather than from markets out. She might ask not how does the Invisible Hand work, but where did it come from? And how does it extend?

In the meantime, Treasury Secretaries – and legislators and CEOs and investment managers and many other types of grownup – know more than enough to demand prices where we need prices to address the critical point Greta is voicing. Or, we can keep conning ourselves that our current economic system is not simply one great elaborate means by which we overleverage the Earth.

Duncan Austin, February 2020  

This article was published by Preventable Surprises in February 2020 and is a summary of a longer essay, “Pigou and the Dropped Stitch of Economics”.

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