externalities

Doughnut Economics (5): Understand emergent behaviour. Oh, and what externalities are

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The fourth of Kate Raworth’s “Seven Ways to Think Like a 21st-Century Economist” is to replace the old, rather Newtonian model of economics by one that treats the economy as a complex adaptive system. There is a lot in this chapter I can agree with, but my enthusiasm is rather dampened by her embrace of the Suzuki Fallacy that in economics, “externality” means “irrelevant”.

Economists’ role model: nineteenth-century physics

In this chapter Raworth makes a rather convincing case that the efforts of nineteenth-century economists like Walras and Jevons to make economics the physics of the social sciences still linger in ways that are less than pretty. Before I read Doughnut Economics it had already struck me how articles in top economics journals seem to try to emulate theoretical physics with their complicated lemmas and formal proofs, and I often cite Jagdish Bhagwati’s joke that nice economists reincarnate as physicists whereas nasty economists reincarnate as sociologists. Rather ironically, Raworth cites Friedrich Hayek, the original neoliberal, as a prominent critic of the emulation of physics. Hayek features more than once in this chapter, and I can’t help wondering whether Raworth might have credited him more if only she had overcome her aversion to his neoliberal legacy to seriously consider his ideas. But I’m getting ahead of the story here.

In a sense, her criticism of this Newtonian economics falls in the same trap as the Newtonians themselves. General equilibrium is the wrong model, she says. Its assumptions are too stringent, too unrealistic, and in any case the Sonnenschein-Mantel-Debreu theorem has shown that in a system with multiple agents and multiple interdependent markets there is no such thing as a single equilibrium. I had to google for the theorem (hey, I never said I’m a expert) but I’m not so worried by it. Both the Newtonians and Raworth appear to be looking for the right model of an economy, like phycisists are still looking for the right model to explain such things as mass and gravity. But in economics, as in any science dealing with very complicated systems, all models are wrong, and so is the general equilibrium model. So “wrong or right?” is the wrong question.

Unlike physicists and, apparently, some economists, scientists in such fields as ecology, meteorology, and climate science aren’t bothered with finding the ‘right’ model: they know their models are gross simplifications of reality. Few ecologists would waste much time proving theorems of their models, or pretend that those models are accurate representations of reality. But like the computable general equilibrium models used by applied economists, their models help understand complex systems, and evaluate policy. As George Box said, all models are wrong but some are useful.

Externalities – oh puh-lease!

There it is, on page 143:

At the same time, drop the economist’s beloved notion of ‘externalities’, those incidental effects felt by people who were not involved in the transactions that produced them – like toxic effluent that affects communities living downstream of a river-polluting factory, or the exhaust fumes inhaled by cyclists biking through city traffic. Such negative externalities, remarks the ecological economist Herman Daly, are those things that ‘we classify as “external” costs for no better reason than because we have made no provision for them in our economic theories’. […] Far from remaining a peripheral concern ‘outside’ of economic activity, addressing these effects is of critical concern for creating an economy that enables us all to thrive.

Her characterisation of externalities as “effects felt by people who were not involved in the transactions that produced them” is fairly accurate, but the suggestion that economists ignore them because there is “no provision for them in our economic theories” or that “externality” means “not in the economy” is nonsense of a degree that makes one understand why so many economists dismiss the entire book. How can Raworth get this so spectacularly wrong?

And yes, I’m being defensive here. That is because my field, environmental economics, studies hardly anything else than externalities. Externalities are central to environmental economics, because they are market failures that can do a lot of real harm. There is a lot you can say about the behavioural model underlying the concept of market failure, including externalities. It treats people as incentive robots who cannot change their attitude and just blindly follow whatever impulses the market gives them. It has become a common excuse (among economics majors, especially) to act selfishly: sorry, you gave me the wrong incentives! But the idea that economists call environmental pollution an externality because they prefer to ignore it is the number one nonsensical canard popular among lazy thinkers who prefer to attack a caricature of economics rather than the actual thing. And it’s a shame she is perpetuating this myth, because it puts off a lot of people who otherwise may have learned about her more sensible ideas.

Complexity, emergence, and two liberal thinkers

In a sense, the chapter’s title (Get savvy with systems) is misleading: any economic model is a representation of a system. Raworth’s alternative is no different in this respect, and as I argue above, she falls into the same old trap of presenting her model as the final accurate representation of economic systems.

But there is an interesting difference between the two approaches. Mainstream economic models usually have only one equilibrium and one optimum (the two of which might not be the same – that is one way of understanding market failure). This property is based on how their costs and benefits depend on production levels. Marginal costs increase: in other words, the sacrifice needed to attain the next thing gets bigger with how many things we already have. Meanwhile, marginal benefits decrease: the more things we already have, the less we appreciate the next thing. Naturally, there comes a point where we have so many things that the costs of the next thing equal its benefits – voila, nous avons a market equilibrium.

Economists do acknowledge that things do not always work this way. Some technologies have network externalities: the more people are on Facebook, the more friends a new Facebook user can connect with through his newly opened account. This is probably one of the reasons why the Dutch company Hyves eventually stopped its network and switched to online games. Paul Krugman won his Nobel Memorial Prize for his contribution to a theory of international trade based largely on economies of scale: by specialising in a particular product, countries can make it at lower costs than would be possible if they had broadened their portfolio. Both network externalities and scale economies have the property that even if external conditions are the same, different starting conditions or even sheer coincidence can give very different outcomes (although I doubt Hyves would ever have beaten Facebook).

Ecologists have known for a long time that ecosystems can have such path-dependency. Ecosystems can also suddenly flip from one state to another. Shallow lakes, for example, usually have either clear water with much submerged vegetation and high densities of predatory species such as pike, or very turbid water with limited vegetation and a high density of bottom-feeding species such as bream. Like with scale economies, positive feedbacks drive this property: turbid water favours bream, which by its feeding behaviour maintains turbidity.

Ecologists have taken this idea much further, however. Rather than systems with a handful of equilibria, which can be described by a handful of equations, many ecosystems are best described as assemblages of a large number of individual agents, each with simple decision rules, but whose joint behaviour can produce highly complex outcomes. Such outcomes are difficult to predict from the properties of the individuals and emerge from the system when we just let it run its course.

The models that describe such complex adaptive systems, usually called agent-based or individual-based models, are not used as often in economics as in ecology. Ironically, to find emergent behaviour in economic thinking we need to look at two economic thinkers who have been most criticised by Kate Raworth and others. Adam Smith’s invisible hand was a metaphor to describe how a form of order emerges from a seemingly chaotic process. Friedrich Hayek described similar processes in his writings. Interestingly, however, I see few of these insights translated into quantitative models. Every now and again you come across agent-based models in the economics literature, but they are certainly no mainstream economic tools. I suspect the problem with such models is that it is difficult to distil generalisable insights from them, while that is precisely what most academic economists are looking for. And to understand why they do so we need to go back to economists’  tendency to take physics as a role model.

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Doughnut Economics (1)

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Kate Raworth’s book Doughnut Economics has caused a fair amount of controversy, not least among Dutch economists. This piece is a good illustration: Bas Jacobs (Erasmus University, Rotterdam) explicitly warns against reading it, accusing Raworth of attacking strawmen, while Ewald Engelen (University of Amsterdam) hails the book as “the book of 2017.” I find the sheer polarization and vitriol in such debates fascinating: what makes people disagree so fundamentally with each other on issues each finds self-evident?

And then fellow-tweeps Anthony Rogers and Ngaio Hotte suggested to read it as some sort of resource economics Twitter book club so I decided to buy it. I’ll write my impressions in a series of blog posts, but first I want to say a few things about where I come from, and with what state of mind I started reading the book. In the meantime this might already explain some of the extremely hostile responses by economists.

Where I come from

In an elevator I would introduce myself as a natural resource economist, but actually my academic background is a bit more complicated. At highschool I had only about two years of economics – I hated it and dropped it as soon as I could. After highschool I studied Environmental Studies at a Dutch polytechnic institute (Hogeschool in Dutch, comparable to the German Hochschule). Only somewhere in the fourth and last year of this education programme I developed an interest in the economics of the environment. Sure we want a clean environment, but how clean? When is it clean enough, and how much health care, wealth, and other goodies are we willing to forgo to reach that quality? I also felt my education so far had been inadequate: I knew a little of everything, but I was an expert in nothing.

So I came to Wageningen University to follow a study programme called, back then, Agricultural and Environmental Economics. I became fascinated with the combination of economics and ecology: I wrote a minor thesis on fisheries economics, and in my PhD thesis I combined metapopulation ecology with spatial-economic land use models. More recently I got bored with bioeconomic modelling so I am now exploring the boundaries between my field and other social sciences, such as psychology, sociology, and anthropology. Even though I first felt my environmental studies were too broad, I now think it enabled me to understand and communicate with other sciences – the horizontal bar in the T-shaped model that Wageningen University likes to champion. The vertical bar is my economics education.

So where am I now? I’m no Bas Jacobs, nor am I Ewald Engelen. If you want me to list my top five economics books of the year you’ll have to wait at least five years before I have read enough of them. (Note that this post appears more than a year after I started reading Doughnut Economics – so much to read, so little time.) I’m your average associate professor on the tenure track, struggling to find time to keep up with the literature between the teaching, supervising PhD candidates, writing proposals, and joining committee meetings. What I’m trying to say is: I cannot pretend to speak for the entire field of economics. The field is too broad for anyone to oversee anyway, so my perspective is only one of many possible perspectives and probably a very limited one at that. All I can and will do is draw from my own experiences in class, conference rooms, and coffee breaks with colleagues. I might avoid topics I know nothing of, and I’m sure I won’t be able to avoid saying a few silly things.

My mindset reading Doughnut Economics

I started reading the book with a fair dose of skepticism, and it is important to understand where that skepticism came from, not least because it may explain why economists’ responses have been so downright hostile. As a natural resource economist I work a lot with other disciplines, notably ecology, sociology, and environmental science. Here are just a few responses I usually get after telling people I’m an economist:

  • “You look more like a leftie to me!” (If only you knew.)
  • “What I think is really stupid of you economists is that you think the economy can keep growing forever…” (We don’t)
  • “You economists ignore the environment. You call it an externality, as if it does not matter!” (That’s not what an externality is)
  • “Economics is not really a science, is it? After all you did not see the crisis coming” (Neither can climate scientists predict specific hurricanes.)

I can relate to climate scientists who have to debunk the same old nonsense time and again (“You don’t take into account the sun’s influence!” “The climate has not warmed in 16 years!”). The difference is, unfortunately, that climate contrarians usually do not get the starry-eyed media attention that anti-economics writers tend to get.

Don’t get me wrong here – I think there is a lot in my field that can be improved and criticism is vital. The tragedy is that a lot of the criticism comes from people who don’t know what they are  talking about, who have their own dogmas, prejudices, and political bias, and, most tragically, whose prejudice and poor understanding of the field prevents them from seeing the problems that do deserve attention.

My experience with Economics of Good and Evil by Tomas Sedlacek is a good illustration of this. Sedlacek takes a very original approach to economics, drawing from philosophy and ancient mythology to reflect on how the field deals with moral questions. I gave up on the book when I read how Sedlacek interprets the concept of utility:

…it is clear that any sentence on the maximalization (sic) of such utility is naturally valid. We gain a tautology: Utility is gained by an individual through activities that increase utility. And because each person has utility from something else, we get: An individual does what he wants to. We can see that this sentence is vacuous – and for this reason it can be constantly “valid” because it says that A=A. […] If an individual maximizes utility, which everyone defines themselves, Popper would immediately ask: How would an individual have to act in order not to maximize their utility? In other words: Can one go in an opposite direction to their optimization function? If it is not possible to present a thinkable example, then the theory is not falsifiable and is de facto pointless. (Tomas Sedlacek, Economics of Good and Evil, Oxford University Press, 2011, pages 224-226)

Despite having been the Czech president’s economic advisor, Sedlacek does not seem to understand that utility functions were never meant to be a testable hypothesis any more than the Gordon-Schaefer growth function is supposed to hypothesize how populations grow. Both utility functions and biological growth functions are mere models, i.e. abstractions of much more complicated processes. In the case of utility functions this complicated process is how people decide what they want. Such a simplified model helps us understand the choices that people make and how their choices play out at an aggregate level in the overall economy. Utility functions are nothing but preference orderings: indeed, an individual does what he wants to do, but what he wants, how he acts upon what he wants, and how his choices interact with those of others, that is the object of investigation in economics.

The biggest tragedy, however, is that Sedlacek apparently has not read enough economics books to pinpoint the restrictive properties underlying utility functions. Utility functions need to have particular properties in order to be rational, i.e. consistent, so that they can be used in the kind of formal analyses that economists like to do. These properties can be tested, they have been tested, and some have been shown to be false in at least some situations and individuals. For example, utility functions (to be more precise, preference orderings) have to be transitive in order to be rational. This means that if you prefer A over B, and B over C, you must prefer A over C. This property can be tested in a simple laboratory setting, so many psychologists and behavioural economists have done so. Rather unsurprisingly, they found it is often violated.

Perhaps I should have checked who Tomas Sedlacek is before I read the book, because a search on Scopus yields two publications in Czech-language journals and one interview, where in the latter he repeats the tired old slur that “economics is a religion”. With all due respect to the Czech, publishing only in your local language is not exactly convincing of your awareness of the state of the art in your field. Nobody should take my opinion on economics seriously if my publication list featured nothing more than two publications in Economische en Statistische Berichten.

You might respond that in a field so fundamentally stuck in its own dogmas it takes an outsider to shake it up. But then I have to refer to climate science again. Suppose somebody who has never published in climate science, or only in a handful rather obscure journals, writes a book that purports to revolutionize climate science. Would you read it? Now add another feature: suppose that a casual browsing through the book reveals that it regurgitates all the nonsense that climate scientists have been debunking for years: that the so-called climate pause invalidates all of climate science, that climate scientists ignore the sun’s influence, that climate variation on geological scales suggests that current changes are nothing to worry about, and so on. Would you take it seriously – at all?

I hate to say this, but in that light I had every reason to be skeptical of Doughnut Economics. In Scopus I can find a whopping three peer-reviewed publications by Kate Raworth – none in economics journals. What’s more, see what Ewald Engelen wrote in his review of Doughnut Economics:

Take “externalities” – as if environmental pollution, depletion of resources, immeasurable animal suffering, declining species richness, carbon dioxide emissions are ‘external’ to our economic production, and not an intrinsic part of it.

I don’t know what I would find more shocking: that a best-selling book by somebody hailed as the new Keynes (granted, coming from George Monbiot you might not take this as a compliment) perpetuates the Suzuki Fallacy, or that somebody considered a celebrity economist in The Netherlands repeats this faux pas in his review.

So no, I did not expect much when I started reading Doughnut Economics.

Is it any good?

So now that I’ve read it, what do I think of the book? It’s certainly not as bad as Sedlacek’s – but that’s quite a low bar. Raworth makes an honest effort to construct an economics that is fit for the problems of the twenty-first century (global environmental change and dwindling resources combined with grinding poverty and repulsive inequality), where she believes that the economic approach has so far been inadequate. Not all is new, indeed, and while some economists accuse her of attacking strawmen, she actually cites a fair number of big names in economics who look beyond the standard neoclassical model, such as Elinor Ostrom, Richard Thaler, and Daniel Kahneman. She makes a number of very good observations, but also some statements that range from problematic to simply untrue – yes, she repeats the Suzuki Fallacy. My note book has a couple of “Spot on!!” notes as well as some “Nonsense!!” ones. Her recommendations are a mix of classical environmental-economic solutions, radical but interesting ideas, and poorly thought-through, hopelessly naive pies-in-the-sky.

So would I recommend it to my students? The short answer is: perhaps my MSc students, but definitely not my BSc students. For them there is simply too much in there that is simply not true (I want them to get the definition of externalities right, for example). The long answer is in the following blog posts.

Coming up next:

Why (not) price nature?

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A few remarks on today’s debate on economic valuation of ecosystem services, here in Wageningen:

  • Having two non-economists as the only speakers in a debate on economic valuation of ecosystem services led to the usual misconceptions of economics, some if which I will explain below.
  • I have written most of what I can say about the issue in this post.
  • In my three-species typology in that post, Dolf de Groot is a typical pragmatic ecologist: he literally called valuation “a necessary evil.”
  • The same typology might label Bram Büscher (a sociologist) a hardcore ecologist, but actually his arguments were more of a Marxist critique of economics and capitalism than of a moral nature (intrinsic value ‘n all). In short his argument is that ecosystem degradation is caused by the logic of capitalism; pricing nature perpetuates that logic rather than abolishing it.
  • De Groot claimed that “conventional economists ignore most externalities, like ecosystem degradation.” As a conventional environmental economist, who has been working on nothing else for the past ten years than externalities and other market failures, and who meets hundreds of similar economists every year at the meetings of EAERE, AERE, IIFET, BIOECON, and so on, I found this very strange to hear, to put it mildly.
  • Another statement by De Groot was that unlike pricing, valuing “is not about substitution.” Economic valuation is ALWAYS about substitution. If you don’t like the idea that people can be compensated for ecological degradation, don’t do valuation. De Groot wants to have his cake and eat it too.
  • It is a more general problem I have with the so-called ‘ecological economists’: a lot of their valuation work is poorly thought through, poorly executed, and done from a political agenda rather than out of scientific curiosity.
  • Common mistakes by ecological economists are (1) not properly defining what they measure (like doing a stated preference survey among tourists to measure indirect use values); (2) aggregating values to such a scale that prices are bound to change (the most fundamental critique of Costanza et al.’s 1997 paper); (3) treating economic values like they would treat biophysical variables such as temperature or density (which are not context-dependent while economic value depends on what question you are asking).
  • Büscher repeated the Suzuki fallacy that “externality” means “not part of the economic system”
  • Büscher “did not have time” to propose an alternative to the capitalist system. Perhaps he should have a look at the historical alternatives to capitalism and their wonderful impact on the environment.
  • Büscher quoted a Chinese philosopher (probably Sun Tzu) that “if you can get your enemy to speak your language you have won the battle” or something in that spirit. I don’t agree. Economists study the rules of market allocation (property rights, taxation, and so on) to understand where such rules work and where they don’t. This would suggest that our advice would always favour big business. But being market-friendly is not the same as being business-friendly.
  • I’m in favour of pricing ecosystem services, but only in the context of concrete policy decisions, in a proper cost-benefit analysis that is part of a wider policy-making process that also takes into account other considerations besides economic value (such as intrinsic value, distribution of effects, and so on). Don’t try to estimate the total value of the planet, as Costanza did.

Why economists argue with ecologists (5): The Suzuki fallacy

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I quit smoking when I was about 30 years old. It is an unhealthy habit, of course, but I also disliked the idea of being dependent on my stock of tobacco. One of the few things I miss about smoking, however, is the excuse to go outside during a break and have a fag and a chat with a few likeminded nicotinists. So occasionally I go outside with the addicts and have the chat without the fag.

I did this a while ago with an ecologist who started a long complaint about economists’ ignorance of the limits of our planet. Economists, he claimed, refer to environmental problems as ‘externalities’: they think the environment is external, i.e. irrelevant, to the economy. I tried to convince him how he misunderstood what externalities are, pointing to his sigarette. It may be his own choice to light a cigarette, or something between him and his dealer to buy a pack of cigarettes, but I also had to inhale his smoke. The damage that he thus inflicted on me was a negative externality: a cost that did not show up on his mental ‘balance sheet’. Perhaps, if he had to pay a tax for each of my lost lung cells he would have made a different choice. (You know what they say: nobody is purer than an ex-prostitute.)

I doubt whether I convinced him, but in any case his comment had me thinking. Where did he get this ludricous idea that the economic term ‘externality’ means ‘irrelevant’? After all, every introductory microeconomics book has a chapter on how externalities are a form of market failure. Then I saw this clip.

My toes still cringe when I watch this – it’s just too embarrassing. When he talks about ecosystem services:

All of the things that nature does for us, for nothing. Pollination, for example, or a forest that takes carbon dioxide out of the air and puts oxygen back in, or that holds the soil and prevent erosion.

That’s the point where I would have expected an explanation that these services are unpriced, and that we should make those services visible in the market place. For instance, by putting a price on them in public decisions, or by levying environmental taxes, or through paying the owners of the ecosystems for the services they provide. But somehow he got it into his head that

All those services that nature performs, economists call them “externalities”. And what that means is: “they got nothing to do with the economy. We don’t put a price on them, they are irrelevant.”

The speaker, David Suzuki, is a famous environmentalist. He should know his stuff, but he is making these statements without a single speck of irony, and apparently he has been doing this for years. Of course there is lots of nonsense spouted on the internet and you don’t have to react to everything, but people like my smoking ecologist listen to David Suzuki. I don’t mind criticism of economic theory, in fact I think a lot can be improved. The nice thing about interdisciplinary work is that you learn not just about the contents of other disciplines, but also their way of doing science. And this reflects back on your own discipline. But such cooperation is not helped if people start spreading this kind of prejudice and misunderstanding about one of the fields involved.