How can we achieve a sustainable economy?

Ida Sognnaes

How can we achieve a sustainable economy? This was the question posed at Rebuilding Macroeconomics Sustainability hub’s pre-discovery meeting on 28th November.

While the availability of cheap fossil fuels has brought with it unprecedented increases in living standards in some parts of the world, it is the primary cause of dangerous climate change. To avoid this we need to transition from a fossil-based economy to a renewable economy. This means the net availability of energy will decrease. The reason for this is that renewable energy requires a higher input of energy for each unit of energy output. In fact, the same is true for the fossil fuels that remain in the ground today.

What are the implications for this on economic growth? Michael Kumhof from the Bank of England told us that the answer to this question depends on the economic theory we use.

Mainstream economics tells us that while it is difficult to substitute other factors for energy in the short run, we can in the long run. This is because a decrease in energy supply will result in higher energy prices, which in turn will stimulate substitution from one to the other. Energy is rarely, however, featured directly in mainstream economics.

On the other hand, the biophysical approach challenges the mainstream view of the idea that capital and labour can (pretty much) function without energy. Moreover, by suggesting energy needs to be modelled as a real constraint to economic problems, this approach argues that in the long-run it actually becomes harder to replace energy with other factors of production, not easier.

The conclusion? We don’t really know the impacts of energy constraints on economic growth. The participants, however, seemed to agree that energy availability is likely to be of first-order macroeconomic importance in the coming decades. Yet, currently, there is not nearly enough research on the topic.

Ultimately, Doyne Farmer from the University of Oxford argued we need to consider what macroeconomics is really about. It should better describe both long-term growth and technological progress. As of today, we don’t know the macroeconomic implications of a low-carbon transition, as we don’t have a good model to analyse this question.

The participants had several points to add following these introductions. Partially because the “true production function” is unknown, we don’t have a good understanding of economic growth. A simplifying assumption often made is production depends on labour-augmented technological progress and capital, where capital can be seen as a proxy to energy. Whilst convenient, using a proxy neglects modelling the unique issues energy introduces into production and productivity.

So far we had discussed the relationships between energy, the environmental constraints associated with it, and the macroeconomy. It is also important, however, to consider the role of human action and motivation in sustainability. For example, whilst pursuing a desire to consume may be individually rational it is not necessarily socially optimal.

What can we learn from psychology and neuroscience about human motivation and cognition? And how might this inform models of economic decision-making relevant to the task of achieving a sustainable economy? These were the questions posed by Dennis Snower from the Christian-Albrechts University of Kiel, and by Dan Nixon from Perspectiva.

The first point, made by Dennis Snower, was that mainstream economics neglects a role for social interaction: macroeconomics, by focusing on aggregates; microeconomics, by assuming preferences as given. In reality, we know that people’s preferences are affected by many things and change from stimuli around us, e.g. advertising is explicitly designed to alter preferences. If preferences are modelled as able to change, and that society as a whole could gain from influencing preferences, would this change the way we think about, say, politics.

Overall, both physics and psychology (individual and social) entered the conversation many times. A point that was repeated throughout was the importance of bringing these two spheres more centre stage in macroeconomic models. As one participant pointed out, however, the entire field of psychology is relevant to the questions asked, and we therefore need to know exactly what it is that we want from this field and exactly how we want to incorporate it into macroeconomics. Another question was the extent to which these kinds of psychological matters can be quantified and used in empirical models.

Despite all the questions asked, one thing remains true: technology plays a crucial role. On the one hand, technology is the single most important factor for long-term productivity and economic growth. Technology, however, is also what has caused all our current environmental problems; and it’s the one thing that is most often called for in solving them. Understanding the process of technological change and its relationship both to economic growth and sustainability is a crucial task so far neglected in mainstream macroeconomics.

The process of technological change, if modelled in its detail, is enormously complex. It is impossible to tell exactly what technologies will be available to us in the future. Yet, robust patterns of technological change can be identified when looking at the historical data. For instance, costs tend to decrease at certain rates, diffusion tends to follow distinct patterns, and much of technological development can be understood by looking at infrastructure and cluster effects. Given the critical role of sustainability for economic performance, it might be time to better model these challenges: in the coming decades, do economists really want to be asked again, “why didn’t you see this coming?”