Getting the Story Right

Now that I have returned from my UK trip, where I had the opportunity to present the main story of the Crash Course at the Parliament, at the London School of Economics, and to councillors and members of the Scottish Parliament, I've come away with an even stronger sense of the true dimensions of our predicament and what must be done.

We desperately need to start telling ourselves a new story, one that at least fits the known data, and we need to be far more urgent in our preparations for a future that is now upon us. This is not a US or a UK story, but one that applies equally to us all, no matter where we live. It is a global story.

A Bedtime Story

New home sales fell apart in January, tanking to their lowest levels in nearly 50 years.  This is not surprising to me.  The economy is not doing okay, is not in recovery, and is sliding down a slope of excessive debt and decades of overindulgence and structural imbalances that will take quite some time to repair.  And that’s assuming there are no exogenous shocks from oil scarcity or other resource issues along the way.

Despite everything that has transpired to reveal the deep structural flaws in our economy and its main theories, few in the media and government seem to be able to grasp the concept that the story has changed and that all efforts to perpetuate ‘the story’ will only prolong the agony and make things worse.

Let’s examine the evidence:

Economists surprised as new-home sales fall to lowest level in nearly 50 years

Thursday, February 25, 2010

Sales of newly built homes unexpectedly plummeted in January to their lowest level in nearly five decades, providing more evidence of the housing market's fragility.

Purchases of new single-family homes dropped 11.2 percent in January from December to a seasonally adjusted annual rate of 309,000, the Commerce Department reported Wednesday. Sales fell in every region except the Midwest, and the raw number of new homes on the market rose for the first time in nearly three years.

"No sugarcoating these numbers," Mike Larson, an analyst at Weiss Research, wrote in a note to clients. "They stink."

The figures are the latest in a string of mixed indicators about the housing market's health and renew questions about whether the federal government should follow through on its plans to soon end initiatives aimed at stimulating sales. Those efforts include a Federal Reserve program that helped pull down interest rates and a tax credit for first-time buyers and others.

It’s that last paragraph that gets me.  The government has poured tens of billions of dollars into tax credits and loan modification programs in an attempt to coax more people to buy homes (or at least not vacate them), while the Federal Reserve has spent more than a trillion dollars buying up mortgages with the intent of driving down mortgage rates.

Of course, the lower the rate of interest, the more someone can afford to pay for a given house.  The rule of thumb is that for every 1% change in mortgage interest rates, a roughly 10% change in the affordability of a house is registered.  So the Fed mortgage buying program should really be named "the program to maintain house prices above what people can actually afford."

At this point, we might wonder if it is at all proper for the government/Fed to be responsible for controlling the housing market in this way.  I say it’s not.

Further bad news slipped out in the market for existing houses, further underscoring the extent to which the housing tax credit probably did little more than accelerate a few purchases.

Existing-home sales fall 7.2% to 7-month low

Sales plunge at record pace after first expiration of tax credit

WASHINGTON (MarketWatch) - Resales of U.S. homes and condos fell 7.2% in January to a seasonally adjusted annual rate of 5.05 million, the lowest in seven months, and raising concerns about the durability of the housing recovery, the National Association of Realtors reported Friday.

Sales of existing homes have fallen two consecutive months after rising steadily through the fall on the back of a federal subsidy for first-time home buyers. The 16.2% decline in December was the largest on record; January's decline is the second largest since 1999, when the NAR began tracking consolidated sales of single-family homes and condos.

Not only is it clear that housing is not out of the woods, but also that whatever recovery there was came about largely because of the tax credit.

To see the official story on display, all one has to do is read practically any article about banking.  In this one, where a sharp drop-off in bank lending is bemoaned, we see it on full display.

The decline in lending is a looming issue as the economy begins to recover. Companies start by returning to full capacity, filling open desks with new workers or running equipment more hours each day. But for the recovery to continue, for businesses to expand and employment to grow, lending must begin to expand, too.

Well, isn’t that just a fine systemic mess we’ve gotten ourselves into?  In order for our economy to basically function at all, lending “must begin to expand, too.”  We’ve bought into the collective story that money has to be loaned into existence, and the author of this piece is absolutely correct.  Lending does have to expand, but the idea that there are other economic models where that is not the case is left out of that assessment.

Wouldn’t it be far better to have an economic model that could operate well, independently of whether it was expanding or even contracting?

This all gets down to whether we are pursuing the right story.  I would guess that that one story line playing in the government/Fed goes like this:

“Housing is an important component of the economy that we’d like to see growing faster.  Therefore, anything we can do to try and rescue housing is a good thing.  If we fail to act, people will lose their homes, the economy will decline, and these things will be politically unpopular.  Without credit expansion, our economy can't function.  Even though low rates hurts savers and the prudent, it is more important that we artificially support credit expansion. Therefore our actions are warranted.”

I have some sympathy for this view and understand how it could ripple through the halls of power.  It’s compelling, and it gives both politicians and bureaucrats the ability to exercise enormous power while looking like they are doing something.

However, I have a different story line, and it goes like this:

“The extreme run-up in housing prices was just a symptom of the largest, most ill-advised credit bubble in history, the impacts of which extend across nearly all asset classes.  One effect of the credit bubble was that we lived well beyond our economic means for nearly two decades.  To try and sustain that unsustainable condition with further borrowing and money printing is not only probably impossible, but it risks the complete destruction of our money itself.  Worse, the larger story, that we are living well beyond the carrying capacity of the earth, is being utterly ignored.”

Those are very different stories.  Where the governments around the world are attempting to return us to economic growth as fast as possible – any type of growth, they don’t care – I would be seeking to direct our energies in a far more focused fashion.

The most profound questions of all time are now, right at the surface, and we are wasting an opportunity to explore them.  Questions such as, “How much is enough?” and, “What’s the role of the human on the planet as one of many organisms living within a complex environment?” are critical and demand significant attention.

Where Traditional Economists Have it Dead Wrong

What the Crash Course offers is a framework for understanding the larger world.  You can drape past occurrences upon it, fit new happenings into it, and use it to make predictions about the future.  So far, I think it offers both better explanatory and better predictive power than traditional economics, which means it is more useful to me.

I am now reading a fantastic book that has brought the reasons for that into even sharper focus.  I am deeply impressed with both the author's mastery of the topic and his lucid writing style.  It’s called The Origin of Wealth and is by Eric D. Beinhocker.

The essential case made in the first part of the book is that classical economics built itself around a mathematical approach that fundamentally mischaracterized the most basic nature of an economic system, then used the wrong sorts of math, and rested all of this upon deeply, provably, and obviously flawed assumptions about human behavior.

The most important insight is that traditional economics presumed and modeled the economy as a closed system. Here’s how Eric put it:

A closed system is any defined set of space, matter, energy or information that we care to draw a box around and study. The universe itself is a system, and within that largest of all systems, one can define any numbers of smaller systems, For example our planet is a system, as is your body, your house or a bathtub full of water. A closed system is a system having no interaction or communication with any other system – no energy, matter, or information flowing into or out of it. The universe itself us a closed system, There is no “outside” the universe, no other system beyond its boundaries that it can interact with.

The problem, of course, is that the economy is very much not a closed system. Without energy, all the money, desire, and human ingenuity in the world won’t make the slightest bit of difference.  The economy is quite obviously an open system.  Again, here’s Eric:

The second type of system is an open system, with energy and matter flowing into and out of it. Such a system can use the energy and matter flowing through it to temporarily fight entropy and create order, structure, and patterns for a time. Our planet, for example, is an open system; it sits in the middle of a river of energy streaming out from the sun. This flow of energy enables the creation of large, complex molecules which in turn have enabled life, thus creating a biosphere that is teaming with order and complexity.

The importance of this model cannot be overstated.  By making the assumption that an economy is a closed system, economists were freed from having to ever account for resource limits – the other two Es.  This represents a colossal failure, and much will have to be refashioned in the field of economics for it to be useful in a resource-constrained future.  One more quote:

Closed systems always have a predictable end state. Although they might do unpredictable things along the way, they always, eventually, head toward maximum entropy equilibrium. Open systems are much more complicated. Sometimes they can be in a stable, equilibrium-like state, or they can exhibit very complex and unpredictable behavior patterns that are far from equilibrium – patterns such as exponential growth, radical collapse, or oscillations. As long as an open system has free energy, it may be impossible to predict its ultimate end state or whether it will ever reach an end state.

So let's not think of our economy as a collection of numbers and complicated financial products and confusing statistics.  Instead, let's think of it as a system that owes its complexity and organization to the constant input of high-quality, useful energy and other resources.  If we take away that energy or those resources, we can readily predict that some of the complexity and organization will be lost.  Exactly how and where is more difficult to predict, but the general trend of the process towards a loss of complexity is pretty easy to predict.

And here’s the crux of the issue:  By ignoring the importance of energy in maintaining the complexity structure of our open-system economy, economists have done far more harm than good.  The risk we face, the one that has attracted so many people to the ideas in the Crash Course, is very simply a large and possibly sudden loss of complexity - when, not if, the vast energy subsidy of the past 150 years begins to be withdrawn.

Because our economy is a complex (and not a linear) system, it is virtually impossible to predict how things will unfold in their precise details, but we can describe the basic process.  Think of a wave crashing on the beach - we cannot predict every turbulent eddy or tossed bit of foam, but the fact that it will rise, crest, crash, and then retreat is known.  Similarly, our economy is propped up by an exponentially increasing flow of energy and resources, like a beautiful and rising wave, and we can readily predict that it will pass a point of maximum height and structure and then devolve chaotically into a much lower and less organized state, unless more and more energy is pumped into it.

Hopefully, we can all appreciate that this is a most (if not the most) crucial turning point in history.  We are about to run a very large experiment, where we take the largest and most complex economic system ever devised and starve it of the exponentially increasing flow of energy upon which it was entirely fashioned.

It’s very hard to overstate the significance of this.  It will literally touch everything we do.

This is why there’s no “solution” out there.  And it the reason why I am continually vexed by the recurring question, “What should we do?” because often it is posed in a way that implies a different question is being asked:  "What can we do to maintain everything we currently see around us?”  Unless a massive new source of high-quality energy is found, there is almost no chance of maintaining our economy in its present form.

And this is why I claim that the next twenty years will be completely unlike the last twenty years.  They don't necessarily have to be terrible, but they certainly won't follow a similar trajectory.

It is critical that we understand that we are not facing a problem, but a predicament.  Problems have solutions, while predicaments only have outcomes.  You can solve the former but only manage the latter.

Since we have a gigantic predicament on our hands, and we cannot predict how things will evolve or devolve when our economic model is starved for energy, the only rational response is to try to build resilience into our most basic and critical operating systems.

At this point, I simply don’t think there is time to develop new, large understandings and hope they’ll penetrate our major institutions quickly enough.  I think triage is called for, and, lacking better information, I would propose that we’d do best by concentrating our efforts on our most basic life support systems, with food, water, sanitation, and energy on the bottom of the ladder, and health care, education, and other basic services on the next rung up.

Conclusion

I started with a few interesting stories about housing and banking to illustrate the degree to which we are still very much in the clutches of the old story.  With every passing day, week, and month that we continue to waste valuable time perpetuating the old story, we put ourselves at greater risk of a sudden and shocking crash of our economic system.

Without a functioning economy, all of our technological dreams, hopes, and desires will not come to pass.  We will not fetch the last oil from 35,000 feet under the ground, we will not have ceramic batteries in every garage, and we will not seamlessly transition to a new economy.  We will have none of that.  Instead, we’ll most likely have a steadily worsening economy that sometimes slumps frighteningly, paralyzing our minds and sapping our will.

All of this will happen, unless we develop a different framework for understanding the way the world really works.  In my mind, we could do worse than to simply focus on the energy flows, and, while we're building that story, conserve what we use and become careful stewards of what remains.

Energy is everything.

This is why, in my own life, I am focused first and foremost on getting my energy use and flows as redundant, resilient, and as low as I can.  I think it’s the right thing for the world, but I also think it’s going to prove to be remarkably good economics for myself as well.  We must become the change we wish to see.  I figure if I can't change my own life, then there's no point in writing or talking about it as something other people should consider.

When I had the chance at the UK Parliament talk, I gave one “solution” (more of a ‘response’, really, but people like the word solution) – I proposed that we create a national or even international organization to study net energy and energy flows.  It should be extremely well-funded and attract our best and brightest, so that we can answer such simple questions as, “Should we retroactively insulate existing structures, or should we build a new light rail system?”  Because we only know the economics of that question, we can’t answer the most important question of all:  "Which offers the higher energy returned on energy invested?"

I've come away from my UK trip with a vital and fresh perspective on our predicament.  I am even more firmly convinced that our best chance at foretelling the future rests with a reasonable understanding of how the economy is organized as a complex system and the role of energy in keeping it that way.