The causes of the environmental crisis may be hugely complex, but the most effective way to deal with it in economic terms seems rather obvious. We must use our best scientific understanding of how environmental problems can be resolved as the basis for implementing scientifically viable economic policies and solutions. If this could be accomplished within the framework of the economic theory that we now use to coordinate economic activities in the global market system—neoclassical economics—there would be no cause for concern. But as this discussion will demonstrate, there is a large problem here that should be cause for great concern: Neoclassical economic theory is predicated on unscientific assumptions that massively frustrate or effectively undermine efforts to implement scientifically viable economic policies and solutions.
These assumptions were first articulated by 18th-century moral philosophers (Adam Smith, Thomas Malthus and David Ricardo) who embraced a new understanding of God known as deism that resulted from attempts to understand the metaphysical implications of Newtonian physics. Because this physics assumes that the laws of gravity completely determine the future state of physical systems, the deists concluded that the universe does not require, or even permit, active intervention by God after the first moment of creation. They then imaged God as a clock maker and the universe as a clockwork regulated and maintained after its creation by physical laws. (1)
Smith, Malthus and Ricardo believed that the clock maker created a second set of laws to govern the workings of the clockwork—the natural laws of economics. Smith imaged the collective action of the forces associated with these laws as an "invisible hand," and this construct became the central legitimating principle in mainstream economic theory. Smith claimed that the invisible hand is analogous to the invisible force that causes a pendulum to oscillate around its center and move toward equilibrium or a liquid to flow between connecting chambers and find its own level. Given that Smith's invisible hand has no physical content and is an emblem for something postulated but completely unproved and unknown, why did he believe that it actually exists? The answer is that Smith was a deist and his belief in the existence of the invisible hand was an article of faith.
The Origins of Neoclassical Economic Theory
In economics textbooks, the 19th-century creators of the economic theory now used by mainstream economists (Stanley Jevons, Leon Walras, Maria Edgeworth and Vilfredo Pareto) are credited with transforming the study of economics into a rigorously mathematical scientific discipline. There are, however, no mentions in these textbooks, or in all but a few books on the history of economic thought, of a rather salient fact: The progenitors of neoclassical economics, all of whom were trained as engineers, developed their theories by substituting economic variables derived from classical economics for physical variables in the equations of a soon-to-be outmoded mid–19th century theory in physics. (2)
The physics that the economists used as the template for their theories was developed from the 1840s to the 1860s. During this period, physicists responded to the inability of Newtonian mechanics to account for the phenomena of heat, light and electricity with a profusion of hypotheses about matter and forces. In 1847 Hermann-Ludwig Ferdinand von Helmholtz, one of the best known and most widely respected physicists at this time, posited the existence of a field of energy that could unify these phenomena. This proposal served as a catalyst for a movement called "energetics" in which physicists attempted to explain very diverse physical phenomena in terms of a vaguely defined protean field of energy that fills all space.
The strategy used by the creators of neoclassical economics was as simple as it was absurd—the economists copied the physics equations and changed the names of the variables. In the resulting mathematical formalism, utility becomes synonymous with the amorphous field of energy described in the equations taken from the physics, and the sum of utility and expenditure, like the sum of potential and kinetic energy in the physical equations, is conserved. Forces associated with the field of utility (or, in physics, energy) allegedly determine prices, and spatial coordinates correspond with quantities of goods. Because the physical system described in the equations of the theory in physics is closed, the economists were obliged to assume that the market system described in their theory is also closed. And because the sum of energy in the equations that describe the physical system is conserved, the economists were also obliged to assume that the sum of utility in a market system is also conserved.
In the mathematical formalism that resulted from these substitutions, economic actors allegedly operate within a field of force identified, in both figurative and literal terms, with energy. The natural laws of economics are assumed to operate within this field and to legislate over the decisions made by the economic actors. Because utility–energy in this mathematical formalism is conserved, the creators of neoclassical economic theory concluded that production and consumption are physically neutral processes that do not alter the sum of utility. And this conclusion became the basis for the claim that capital circulates in a closed loop from production and consumption and that the value of any good, commodity or service can only be determined by decisions made by economic actors. The creators of neoclassical economic theory also failed to realize or chose to ignore the fact that market systems are not closed and the conservation principle is quite meaningless in any real economic process. Nevertheless, these assumptions are now used to legitimate the existence of the invisible hand in its current form in the neoclassical economic paradigm—constrained maximization in general equilibrium theory.
Several well-known mid–19th century scientists told the economists that there was no basis for substituting economic variables for physical variables in the equations of the theory in physics. But the economists did not appreciate how devastating this criticism was and proceeded to claim that they had transformed the study of economics into a scientific discipline comparable to physics. In what is surely one of the strangest chapters in the history of Western thought, the origins of neoclassical economics were forgotten, the claim that neoclassical economic theory is scientific was almost universally accepted, and subsequent generations of economists disguised the existence of the unscientific axiomatic assumptions in this theory under an increasingly complex maze of mathematical formalism.
This misalliance between economic thought and a 19th-century physical theory explains why the neoclassical economic paradigm is predicated on the following unscientific assumptions:
- Market systems exist in a domain of reality separate and distinct from other domains.
- Capital circulates in these systems in a closed circular flow between production and consumption with no inlets or outlets.
- The lawful dynamics of closed-market systems legislate over the behavior of economic actors, and the actors obey fixed decision-making rules.
- The dynamics that operate within closed market systems, if they are not interfered with by the external or exogenous agencies such as government, will necessarily result in the growth and expansion of these systems.
- Market forces will resolve environmental problems via price mechanisms, along with more efficient technologies and production processes.
- The resources of nature are largely inexhaustible, and those that are not can be replaced by other resources or by technologies that minimize the use of the exhaustible resources or rely on other resources.
- The environmental costs of economic activities can only be determined by pricing mechanisms that operate within closed market systems.
- There are no biological or physical limits to the growth and expansion of market systems.
One does not have to a scientist to realize that these assumptions make no sense at all in scientific terms. In these terms, markets are open systems that exist in embedded and interactive relationship with environmental systems. Natural resources are clearly exhaustible, and our over-reliance on some of these resources, particularly fossil fuels, could soon result in irreversible large-scale changes in the global climate system. The natural environment is not separate from economic processes, and wastes and pollutants from these processes are already at levels that threaten the stability and sustainability of virtually all environmental subsystems. Last but not least, the limits to the growth of the global economy in biophysical terms are real and inescapable, and the assumption that market systems can perpetually expand and consume more scarce and nonrenewable natural resources is utterly false. (3)
A Green Thumb on the Invisible Hand
When mainstream economists are confronted with the charge that there is no basis in neoclassical economic theory for realistically assessing the environmental costs of economic activities and internalizing these costs in pricing systems, they typically deny that this is the case by appealing to the work done by environmental economists. This orthodox approach to resolving environmental problems is taught in universities and practiced in government agencies and development banks, and the solutions are almost invariably embedded in the mathematical formalism of general equilibrium theory.
When environmental economists calculate the environmental costs of economic activities, they assume that the relative price of each bundle of an environmental good, service, or amenity reveals the "real marginal values" of the consumer. The creators of neoclassical economics conceived of the construct of marginal values after substituting utility for energy in the equations borrowed from the theory in physics. In the resulting formalism, a marginal value essentially represents how much more a consumer is willing to pay to acquire incrementally larger amounts of a good, service or commodity. Note what the writers of a textbook on environmental economics have to say about the dynamics of this process:
"The power of a perfectly functioning market rests in its decentralized process of decision making and exchange; no omnipotent planner is needed to allocate resources. Rather, prices ration resources to those that value them the most and, in doing so, individuals are swept along by Adam Smith's invisible hand to achieve what is best for society as a collective. Optimal private decisions based on mutually advantageous exchange lead to optimal social outcomes." (4)
In environmental economics, the presumption that optimal private decisions "based on mutually advantageous exchange" lead to optimal social outcomes for the state of the environment is a primary article of faith. The environmental economists also assume that the mechanisms of the market system will resolve environmental problems when "prices are right." The right price in neoclassical economic theory is a function of the prices that economic actors have paid, or are willing to pay, to realize some marginal benefits of environmental goods and services.
Environmental economists often use cost-benefit analyses to place a value on environmental externalities, or environmental goods and services that are "external" to market systems in the sense that they are presumed to exist outside of the closed market system. The problem that these accounting procedures are intended to resolve is that "real marginal values" can only be determined by dynamics that operate within closed market systems. Given that the vast majority of the damage done to the natural environment by economic activities cannot be valued in these terms, environmental economists have developed indirect methods designed to estimate the "use-value" of these resources. (5)
For example, contingent valuation methods are used to assess the economic value of recreation, scenic beauty, air quality, water quality, species preservation, bequests to future generations and other nonmarket environmental resources. The methods are intended to assess the willingness-to-pay function of economic actors who would prefer to preserve natural environments (preservation or existence values), maintain the option of using natural resources (option values), and bequeath natural resources to future generations (bequest values). (6) Most contingent valuation surveys seek to determine the maximal amount that individuals are willing to pay for an increase in the quality of an environmental resource and the minimal amount they are willing to accept as compensation to forgo this increase.
For the sake of argument, let us assume that contingent valuation studies are capable of revealing maximal social outcomes of environmental policy decisions. Are we then to believe, as one such study showed, that reduction in chemical contaminants in drinking water was not important in economic terms because the value of a statistical life associated with a reduction in risk of death in 30 years was only $181,000? (7) Is $26 a measure of the real marginal costs of pollution because this is the average price that a household is willing to pay annually for a 10 percent improvement of visibility in eastern U.S. cities? (8) Is the value of a whooping crane the $22-per-year average that one set of households was willing to pay to preserve this species (9) and that of the bald eagle the $11-per-year average that another set of households would spend to preserve this apparently less valuable species? (10)
Mainstream Economics and International Treaties
One reason why the international community has not been successful in forging agreements that could resolve the environmental crisis is that countries involved in the process of negotiating these agreements routinely invoke the legal principle of state sovereignty to protect their economic interests. There is, however, another major reason why these agreements have not been effective. The economic interests that the representatives of nation-states are seeking to protect are based on unscientific assumptions about the dynamics of market systems in neoclassical economic theory. Another related problem is that these assumptions are embedded in the mathematical theories that serve as the basis for making cost-benefit analyses and the results of these analyses almost invariably indicate that the costs of implementing scientifically viable economic policies and solutions are greater than the benefits. The unfortunate result is that the scientifically viable economic policies and solutions are typically nothing more than distant memories when the terms of a final agreement are approved.
This explains why the United Nations Framework Convention on Climate Change (1992) failed to protect the climate system, why the Convention on Biological Diversity (1992) did not even begun to reduce losses in biodiversity, and why the U.N. Convention to Combat Desertification (1994) did not slow, much less reverse, this process. The U.N. Convention on the Law of the Sea (1982) and a host of other international agreements intended to reduce ocean pollution, prevent overfishing and protect endangered species failed to meet any of these objectives. Nonbinding principles that would promote more sustainable management of forests were agreed to at the U.N.'s Earth Summit (1992) but negotiations broke down prior to the point where a general framework convention could be articulated. A U.N. Convention on the Non-Navigable Uses of International Watercourses has been negotiated, but it has not gone into effect because some sovereign nation-states perceived this agreement as a threat to their economic interests. (11)
Scientific evidence may play a supportive and enabling role in some negotiations, but only as a minimum condition for serious consideration of an environmental issue. But what is not widely known is that these agreements made a mockery of the scientifically based solutions. In the vast majority of negotiations on a great range of issues, such as commercial whaling, hazardous waste trade, loss of biodiversity, conditions in the Antarctic, and ocean dumping of radioactive waste, the scientific evidence was not given serious consideration. When this evidence was perceived as a direct threat to the perceived economic interests of particular nation-states, it was either systematically ignored or explicitly rejected by the representatives of these states. (12)
Recent Developments in Mainstream Economic Theory
A fair number of economists over the past two decades, including such luminaries as Kenneth J. Arrow, have expressed doubts about the efficacy of neoclassical economic theory. However, the most direct challenges to axiomatic assumptions in this theory have been made by the game theorists. For example, these theorists have challenged the assumption that economic actors are supremely rational, obey fixed decision-making rules and are incapable of making bad decisions. In conventional neoclassical economic theory, the natural laws of economics allegedly determine the optimal outcome of an economic process and economic actors are devoid of all distinctly human characteristics. This theory also assumes that the realm of the economy is stable and unchanging and that economic actors are supremely rational entities who do not talk back. In opening the box of human subjectivity, the game theorists have been obliged to posit an increasing number of ad hoc variables to account for the decision-making of individual economic actors. And this explains why the history of game theory is marked by a continual regression into the staggering complexities of language and culture. As the economist R. Sugden puts it:
"There was a time, not long ago, when the foundations of rational-choice theory appeared firm, and when the job of the economic theorist seemed to be one of drawing out the often complex implications of a fairly simple and uncontroversial system of axioms. But it is increasingly becoming clear that these foundations are less secure than we thought, and that they need to be examined and perhaps rebuilt. Economic theorists may have to become as much philosophers as mathematicians." (13)
These criticisms and revisions of assumptions in neoclassical economic theory do not mean, however, that mainstream economists are in the process of developing a new theory predicated on a different set of assumptions. Virtually all of the advanced theoretical work in this discipline is premised on the assumptions that market systems are closed, self-correcting and self-sustaining. And the primary impulse in these theories is to disclose the hidden dynamics that move market systems toward optimal states of equilibria with the use of increasingly more sophisticated mathematical techniques.
The Two-Culture Problem
In my view the greatest obstacle to implementing scientifically viable economic solutions for global warming and other menacing environmental problems is not the claim that neoclassical economic theory is scientific. It is the two-culture problem famously described by British physicist and novelist C. P Snow in 1959. Snow was concerned that the single intellectual culture that existed prior to World War II was splitting into two cultures with social scientists on one side of the divide and scientists on the other. As it turned out, the two-culture problem was not resolved; each culture's members became increasingly isolated from the other's, and the divide eventually became a yawning chasm.
The schism between the two cultures of mainstream economists and environmental scientists is painfully apparent in the institutional frameworks and processes we now use to develop and implement economic solutions for environmental problems. The members of these cultures perform very different tasks and have virtually no contact with each other. This problem is further complicated by the fact that the language used on one side of the divide is virtually incomprehensible to those on the other, and the cultural differences are large. These differences range from alternate worldviews to disparate research methodologies and rules for gathering evidence.
The most expedient way to deal with this two-culture problem is also the most efficient way to begin the process of developing an environmentally responsible economic theory. The solution is to create institutional frameworks and processes for developing scientifically viable economic policies and solutions for environmental problems that require mainstream economists and environmental scientists to work closely together during every stage of the process. This idea is not as radical as it may first appear and there has already been some movement in this direction.
After Nicolas Stern, an internationally known development economist and former chief economist at the World Bank, was asked by the British government to prepare a report on the economics of climate change, he did something that no other mainstream economist with a similar reputation had ever done. He crossed over the divide and took an extended course on the science of global warming from environmental scientists at the Hadley Center in London. The 700-page report that resulted from this collaboration contained the first realistic assessment of the costs of reducing global emissions of greenhouse gases to levels where the most disastrous consequences of global warming are unlikely to occur.
But in order to make this assessment, Stern and the other economists who worked on the report were obliged to use methodologies that violate foundational assumptions in neoclassical economic theory. In a lecture that Stern gave to a group of economists a few months before the "Stern Review on the Economics of Climate Change" was released on October 30, 2006, (14) he explained why it was necessary to violate these assumptions. Stern began this lecture with a brief overview of the science of global warming with particular emphasis on the fact that the interactions between human and environmental systems are nonlinear and cannot be represented or described in the linear equations used by mainstream economists.
Stern then explained why global warming is not "a standard externality" problem and must be viewed as "international collective action problem." He also explained why the methodologies used by mainstream economists to evaluate the costs of economic activities are incapable of realistically assessing these costs. During the course of this lecture, Stern repeatedly told his fellow economists that any viable economic solutions for the problem of global warming must be predicated on our best scientific understanding of how this problem can be resolved. Equally remarkable, he also said that the resolution of this problem will require the very active involvement of governments and that the ethical dimensions of this problems extend well beyond the framework of any economic theory. (15)
If we do manage to create the institutional frameworks and processes required to develop an environmentally responsible economic theory, many mainstream economists and environmental scientists may be reluctant to cross over the two-culture divide and work on this project. But this resistance could be overcome if they realized that this is a once-in-all-human-lifetimes opportunity. The opportunity is to protect the lives of the 6.6 billion members of the extended human family and the future existence of their descendents by resolving the crisis in the global environment. If the opportunity to work on this project is understood in these terms, perhaps mainstream economists and environmental scientists will realize that there is no other work they could possibly do in their lifetimes that serves a greater good or answers to a higher calling.
Robert Nadeau is a professor at George Mason University. His most recently published books are The Wealth of Nature (Columbia University Press, 2003) and The Environmental Endgame (Rutgers University Press, 2006).
(1) Bruno Ingrao and Georgio Israel, The Invisible Hand: Economic Equilibrium in the History of Science, tr. Ian MacGilvray (Cambridge, Mass.: MIT Press, 1990).
(2) Philip Mirowski, Against Mechanism: Protecting Economics From Science (Lanham, Md.: Rowan and Littlefield, 1988); Mirowski, More Heat Than Light (New York: Cambridge University Press, 2003); Robert L. Nadeau, The Wealth of Nature: How Mainstream Economics Has Failed the Environment (New York: Columbia University Press, 2002); Nadeau, The Environmental Endgame: Mainstream Economics, Ecological Disaster, and Human Survival (Piscataway, N.J.: Rutgers University Press, 2006).
(3) Robert Nadeau, The Environmental Endgame; pages 81–145.
(4) Nick Hanley, Jason E. Schrogren, and Ben White, Environmental Economics in Theory and Practice (New York: Oxford University Press, 1997); page 358.
(5) W. Michael Hanneman, "Valuing the Environment through Contingent Value," Journal of Economic Perspectives 8 (Fall 1994); page 19.
(6) Mark Sagoff, "Some Problems with Environmental Economics," Environmental Ethics 10 (Spring 1988); page 55.
(7) Robert C. Mitchell and Richard T. Carson, "Valuing Drinking Water Risk Reduction Using Contingent Evaluation Methods," paper prepared for Resources for the Future, (Washington, D.C.: U.S. Government Printing Office, 1986).
(8 ) George Tolley et al., "Establishing and Valuing the Effects of Improved Visibility in the Eastern United States," paper presented for Environmental Protection Agency (Washington. D.C., 1986).
(9) James Bowker and John R. Stoll, "Use of Dichotomous Choice Nonmarket Methods to Value the Whooping Crane Resource," American Journal of Agricultural Economy 23, No. 5 (1987); pages 943–950.
(10) Kevin J. Boyle and Richard C. Bishop, "Valuing Wildlife in Benefit-Cost Analyses: A Case Study for Endangered Species," Water Resources Research 23, No. 5 (1987); pages 943–950.
(11) James Gustave Speth, Red Sky at Morning: America and the Crisis in the Global Environment (New Haven: Yale University Press, 2004); pages 77–98.
(12) Gareth Porter, Janet Welsh Brown, and Pamela S. Chasek, Global Environmental Politics, 3rd edition (Boulder: Westview Press, 2000).
(13) R. Sugden, "Rational Choice: A Survey of Contributions from Economics and Philosophy," Economic Journal 101 (1991); page 783.
(14) "Stern Review on the Economics of Climate Change," www.sternreview.org.uk