PU Peak Oil Conference, Washington, DC DA May 9, 2006 HD The Steady-State Economy and Peak Oil AU By Herman E. Daly* *School of Public Policy University of Maryland In classical economics (Smith, Malthus, Ricardo, Mill) the steady- state, or as they called it the "stationary state" economy was a real condition toward which the economy was tending as increasing population, diminishing returns, and increasing land rents squeezed profits to zero. Population would be held constant by subsistence wages and a high death rate. Capital stock would be held constant by a lack of inducement to invest resulting from zero profits thanks to rent absorbing the entire surplus which was itself limited by diminishing returns. Not a happy future -- something to be postponed for as long as possible in the opinion of most classical economists. Mill, however, saw it differently. Population must indeed stabilize, but that could be attained by Malthus' preventive checks (lowering the birth rate) rather than the positive checks (high death rate). A constant capital stock is not static, but continuously renewed by depreciation and replacement, opening the way for continual technical and qualitative improvement in the physically non growing capital stock. By limiting the birth rate, and by technical improvement in the constant capital stock, a surplus above subsistence could be maintained and equitably distributed. The stationary state economy would not have to continually expand into the biosphere and therefore could leave most of the world in its natural state. The stationary state is both necessary and desirable, but neither static nor eternal -- it is a system in dynamic equilibrium with its containing, sustaining, and entropic biosphere. The path of progress would shift from bigger and more, towards better and longer-lived. In the late 1800's classical economics was replaced by neoclassical economics, and although the term "stationary or steady-state economy" was retained, its meaning was radically changed. It no longer referred to constant population and stock of capital, but to a situation of constant tastes and technology. In Mill's conception physical magnitudes (population and capital) were constant, and culture (tastes and technology) adapted. In the new version culture (tastes and technology) are constant and the physical magnitudes (population and capital stock) adapt. Given that our cultural tastes were assumed to reflect infinite wants, and that technical progress was considered unlimited, the way to adapt was by growth, so-called "steady-state growth" which means proportional growth of population and capital stock. The absolute magnitudes continue to grow while the ratio between them is supposed to remain constant. Furthermore the concept of a steady-state is no longer thought of as a real state of the world, whether desirable or undesirable, but as an analytical fiction, like an ideal gas or frictionless machine. It is a useful reference point for analyzing growth, and has neither normative nor ontological significance, whereas for Mill it had both. Mill's steady state was both necessary in the long run and desirable much sooner. It is not too much of an oversimplification to say that in a sense the classical economists were concerned with adapting the economy to the dictates of physical reality, while the neoclassicals want to adapt physical reality to the dictates of the economy. In an empty world the dictates of physical reality are not immediately binding on growth; in a full world they are. Consequently, and paradoxically, it is the older classical view of the steady-state, Mill's version, that is more relevant today, even though the neoclassical view dominates the thinking of empty-world economists. Another basis for the stationary state comes from the demographers' model of a stationary population, one in which birth rates and death rates are equal and both the total population size and its age structure are constant. This model is both an analytical fiction and also for some a normative goal. Indeed, a constant population is part of the classical view of the stationary state. A constant population requires only that the birth rate equals the death rate, and that could be the case at either high or low levels. Most of us prefer lower levels, within limits, because we value longevity. Likewise, the constancy of the capital stock requires production rates equal to depreciation rates. Basically the preference here is also for equality at low rather than high levels. Greater life expectancy of capital (the total stock of durable goods) requires less depletion and pollution (lower rates of throughput). In this view new production is a maintenance cost of a capital stock that unfortunately depreciates as it is used to serve our needs. Like other costs it should be minimized, even though the idea of minimizing the flow of new production is strange to most economists. Something similar to the classical stationary state was revived by Keynes in his concept of the "quasi stationary community". This was also a real state of the world rather than an analytical fiction, and was considered desirable by Keynes. It assumed population stability, no wars, and a couple of generations of full employment and capital accumulation. Keynes believed that in the resulting world of abundant capital the "marginal efficiency of capital" would fall to zero, leading to a situation in which new investment would merely replace capital depreciation and the capital stock would cease growing. Capital would in effect no longer be scarce leading to a near zero interest rate and the happy consequence that it would no longer be possible to live off of accumulated wealth -- the "euthanasia of the rentier." As Keynes put it, "The owner of capital can obtain an interest rate because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital" (General Theory..., p. 376, 1936). That Keynes' vision did not come true is due to many things, including destruction of capital by wars, dilution of capital by population growth, and an enormous increase in consumption in wealthy countries such as the US, fed by novel products, advertising, and financed not only by reduced savings and investment, but also by capital decumulation. In the US this decumulation takes the form of enormous consumer debt as well as huge continuing deficits in both the domestic budget and the foreign balance of trade. In addition, regardless of the marginal efficiency of capital, the interest rate has been kept up by the Fed in order to attract foreign investment from our surplus trading partners, and to avoid inflation -- as well as by the Fed's feelings for the rentier class that are more tender than were Keynes'. Nevertheless Keynes, like Mill, saw a real possibility that was simply rejected by the growth mentality, to which of course conventional "Keynesian economics" has itself contributed to substantially. The classical view of the steady-state economy was replaced by the neoclassical view for two historical reasons. First, the neoclassical subjective utility theory of value replaced the classical real cost theory of value that emphasized labor and land. There are no obvious limits to growth in utility (a psychic magnitude), as there are to growth in labor and in the physical product that labor extracts from nature. Second, with the advent of the industrial revolution there came the enormous subsidy of fossil fuels. The annual flow of solar energy captured by land and harvested by labor was now supplemented by the concentrated sunlight of millions of Paleolithic summers accumulated underground. Growth now seemed limitless, and neoclassical economists attributed this bonanza not to nature's nonrenewable subsidy, first of coal then of petroleum, but to human technological invention that was taken to be renewable and not limited to the particular resources being exploited. Indeed, a general presupposition of neoclassical economics is that nature does not create value. Peak oil signals the end of the bonanza with no alternative subsidy in sight, either from nature or human invention. And even before the source limit of global peak oil hits, we have begun to experience the sink limit of greenhouse-induced climate change. Not only are the sources emptying, but the sinks are filling up as well. A modernized classical view of the steady-state economy as a subsystem of a finite, non growing, and entropic biosphere, as foreseen by Mill, must now replace the misnamed, misconceived, oxymoronic, and temporary "steady- state growth" still celebrated by the neoclassical economists, even as the oil bonanza is burning out. Many will say that I am selling technology short, and that it will find a substitute for cheap oil. Even assuming this were true, should we not limit our depletion of petroleum now to drive up prices and provide an incentive for developing these new hoped for technologies as soon as possible? Should not the technological optimists have the courage of their convictions and provide the incentives to develop the very technologies of which they are so confident? A policy of frugality first will induce efficiency as a secondary response: our currently favored policy of efficiency first does not induce frugality second, and in fact makes it less necessary, as often documented in the so-called "rebound " or "Jevons effect." The most obvious policy response to peak oil, and to furthering the classical steady-state economy is to shift the tax burden from "value added" (income produced by labor and capital) and on to "that to which value is added", namely the resource throughput, especially fossil fuels. We need to raise public revenue somehow, so why not tax what is truly most scarce, and is not the product of anyone's labor, rather than tax labor and entrepreneurship? Why not tax resource rents, "unearned income" as the tax accountants so honestly call it, instead of earned income or value added in the form of wages and profits? This is not only fairer but also more efficient because it raises the relative price of the truly scarce and long run limiting factor, the throughput of low-entropy matter-energy, natural resources. In addition to being the long run limiting factor the resource throughput, principally fossil energy, is also the factor most responsible for external environmental costs -- another reason to raise its price by taxation. The tax shift could be revenue neutral, taking the same amount from the public but in a different way. It would offer an opportunity to get rid of some of our worst taxes (e.g. the payroll tax) at the same time we add taxes with better incentives. To the extent that a throughput tax reduces its base, that is all to the good since throughput is depletion and pollution, both costs. However, such reduction is likely to be limited because resources are absolutely necessary for production and both demand and supply for them are inelastic. But taxing a factor with inelastic demand and supply is minimally distortionary, whereas the supply of labor and enterprise is more elastic, and taxing them is likely to reduce the incentive to add value. It is true that a resource tax, like any consumption tax, is regressive compared to an income tax. However, even the Mafia, drug dealers, crooked politicians, illegal aliens, and Enron executives would have to pay taxes on their condos, Mercedes, and yachts, whereas they currently manage to escape income taxes by off-shoring, trusts, special lobbied tax exemptions, or submersion in the cash economy. In any case, as even neoclassical economists have long correctly argued it is better to help the poor by direct income supplements than by indirectly lowering prices through tax subsidies. A subsidized price gives the most money to the biggest consumer, who is usually not poor. Why is such a simple and obvious policy not advocated by neoclassical economists? Because for them natural resources are unimportant and ultimately non scarce. If this sounds extreme remember that the usual neoclassical production function in micro economics omits resources altogether -- production is seen as a function of labor and capital only. And if sometimes neoclassicals do include R into the equation it makes little difference because the multiplicative form of the usual production functions implies that manmade capital is a good substitute for resources -- you can bake a ten-pound cake with only five pounds of flour, eggs, and sugar, if only you use a big enough oven and stir vigorously! And, with admirable consistency, macroeconomists calculate our national income without attributing value to resources in situ. Resources are valued according to their labor and capital costs of extraction (value added), and any royalty paid for resources in situ is simply a premium paid for access to a mine or well whose extraction costs are lower than the margin that it is currently profitable to exploit. All resources are free gifts of nature, but some gifts are easier to unwrap than others and therefore trade at a premium. Paralleling the shift from a real cost (labor and capital) to a subjective (utility) theory of value was a shift from classical commodity money (gold) to fiat money (paper). Just as value measured by subjective utility loses its connection to the objective factors of labor and land, so value symbolized by fiat money loses its connection to the real costs of mining gold, especially when amplified by fractional reserve banking. Both utility and fiat money are unconstrained by the biophysical world of finitude and entropy that characterize resources, land, labor, and physical wealth. The token or counter of wealth, money, is now governed by laws different from those that govern real wealth. Fiat money can be created and destroyed; physical wealth cannot. Money does not spoil or entropically disintegrate over time; real wealth does. Money does not take up space when accumulated; real wealth does. Money spontaneously grows at compound interest in a bank account; manmade capital does not -- its spontaneous default tendency is to diminish. The world of money, debt, and finance becomes increasingly disjoined from the world of real wealth and physical resources. The financial world is built around debt and expectations of future growth in wealth to redeem the debt pyramid built by expansion of fiat money. Peak oil will disrupt those growth expectations and lead to a financial crash resulting in levels of real production that are even below physical possibility, as happened in the Great Depression. The steady-state economy needs a money more congruent with real wealth. Hubbert in his early writings suggested an energy-based currency. The history I have sketched may suggest a return to gold or some other commodity money. I would favor a continuation of fiat money, but subject to the discipline of one hundred percent reserve requirements, as suggested by Frederick Soddy, Irving Fischer, and Frank Knight -- but that is another story. There is a bright side to peak oil if we can adapt to it. Obviously lower inputs of petroleum will, other things equal, reduce outputs of CO2 and greenhouse effects, albeit with a lag. Also, higher prices for petroleum will act not only as an incentive to more efficient technology, but also as a tariff on all international and long- distance trade providing protection to national and local producers, thereby increasing local self-sufficiency and slowing down the lemming rush to globalization. Without the subsidy of cheap oil the rates of exploitation and takeover of the natural world by mining, drilling, cutting, draining, filling in, digging, blasting, paving, dredging, leaching, overharvesting, monoculturing, etc., will all be slowed. The big obstacle to the steady state economy is our religious commitment to growth as the central organizing principle of society. Even as growth becomes uneconomic we think we must continue with it because it is the central myth, the social glue that holds our society together. Consider the Washington Post's recent editorial, "The Case for Economic Growth" (4/2/06). They admit that the case for growth has been greatly weakened in the US by the fact that most of the growth for over a decade has gone to the rich and little if any to the poor. Also, even that growth to the rich has produced little welfare in view of studies by psychologists and economists showing that beyond a $10,000 per capita GNP threshold self-evaluated happiness ceases to rise with rising income. Despite these two blows, however, the Washington Post believes the case for growth remains strong, for two additional reasons. First, as Americans become richer they become more optimistic and tolerant, and therefore act more generously toward racial minorities, immigrants, and the poor. Second, only a richer America can continue making the world safe for free trade and democracy. If the mouthpiece of official Washington can't make a stronger case than that, then I think the growth ideology may finally be in trouble. But notice that even to make that weak case they had to assume that growth in GNP is in fact making us richer, when that is the very point most at issue in the growth debate! The evidence is that at the current margin growth increases environmental and social costs faster than it increases production benefits, making us poorer, not richer. Furthermore, by their own admission nearly all GNP growth has all gone to the rich. It has not, therefore, led us to act more generously to the poor. Is that because GNP growth has in fact not made us richer, or perhaps because generosity has little to do with wealth in the first place? Nevertheless, this is the level of reasoning that passes for serious economic discourse in Washington DC. Does it reflect honest confusion, or cynical pandering to the ruling class ideology? In either case it falls far short of John Stuart Mill's 150 year-old analysis. In the absence of a good substitute for petroleum, something currently not identifiable on the required scale, peak oil will signal an era of rising prices and dwindling supplies of the major energy source of the industrial economy, requiring a thorough adaptation of the economy to more severe geological and biological constraints. The classical steady-state economy is a way of thinking accustomed to adapting the economy to reality. The idea of a steady-state economy predates and is independent of peak oil -- this is true even for M. King Hubbert who wrote about the steady state long before his famous prediction of US peak oil. But the growing evidence that we are close to peak oil for the world should dramatically increase interest in the classical steady-state economy as a better fit for the real world than the current neoclassical perpetual growth machine. Does someone have a better idea?