BUILDING A 21ST CENTURY ECONOMY

 

Central point: Build sustainability and efficiency in our economic system, embrace economic thinking that can underpin a truly integrated global economy, and lead the environmental revolution.

The Economy Planet

When there are just five individuals living on a huge farm there may be little need for rules of conduct to protect the land from the people but when the same farm has fifty individuals with mechanized farming equipments and high consumption life styles the land needs to be protected as well. The world population has increased ten fold since the days of David Hume and Adam Smith. Our current economic thinking needs to recognize the new stresses human population and its life style is placing on the planet.

Human beings have never had to look at scarcity as applicable to the whole planet; the scarcity we heretofore dealt with always applied to one or another small part of the planet. The far reaches of the planet were still being explored up until the 20th century. North Pole was first reached by men on April 6, 1909. The limits of the planet as it applies to our economic activities were unknown. Global warming was only in the realm of imagination and prophecies.

Up until recently we only needed to find resources and consume it, the overall production facilities of the planet produced more than we consumed and also had huge quantities in store for us to consume, therefore, we just needed to move to new places or to find more stores. That is no more the case: most high value stores are already discovered, and all livable places are heavily populated. We no more have the luxury of low hanging fruits and free space. We use to live on a luxury planet but now we live on an economy planet.

Our dangerous dependence on oil and other fossil fuel

Our, present, human civilization is built on fossil fuel; our food has significant component of fossil fuel, our houses, our factories, and our cities run on fossil fuel. Under the present circumstances if fossil fuel were to be removed from our resources; the planet probably would not be able to support even half of its population. Our rate of consumption of fossil fuel is more than a million times its geological replenishment rate; our rate of consumption of oil exceeds even the rate of its discovery. Yet nations are competing to increase their dependence on oil and other fossil fuel; they call it “development.”

We have explored the whole planet and our rate of finding new oil deposits are getting fewer by the year. A recent oil well, named Perdido’s Tobago, was sunk in the Gulf of Mexico in 9,600 feet of water (three kilometers, 1.82 miles); another, named Tiber, sunk in the Gulf of Mexico in 4,132 feet deep water goes a total of 35,050 feet (10.7 kilometers, 6.63 miles) below sea level to get oil. The new discoveries of oil are increasingly in hard to get places or in rocks and sands which are difficult or uneconomical to extract from. At the current rates of consumption, growths, and discovery, oil, as a staple, won’t last our life time for many of us.

The disconnect between the real scarcity of oil and its supply

Scarcity is an economic concept applied to goods and services that command a price. In fact, scarcity is the economic reason for goods to have a price. Price of a commodity, like corn or shoes, is a function of its scarcity, as reflected in its supply relative to its demand. Since clean air and the atmosphere do not command a price and are freely available they are not scarce as far as everyday economic behavior of individuals and businesses are concerned.

Oil has a price because it has extraction costs, also known as production costs, so it is scarce, like corn or shoes. Reflection of the scarcity of oil in its price is only to the extent of its current supply or availability. The short term availability of oil is reflected in its price but its ultimately finite quantity is not. Since oil’s price does not reflect its ultimately finite quantity, it is, like clean air or clean water, not treated as scarce in that respect.

Current supply of oil does not contain enough information to continue to be a basis for its sustainable pricing. Most importantly, it does not contain information about the increasingly relevant finiteness of the global oil deposits. Critically important scarcity information is missing from the price of oil. No wonder an international cartel, Organization of the Petroleum Exporting Countries (OPEC), has considerable success in increasing the price of oil. This cartel is performing part of a function that our economic system has so far failed to perform. If that was not the case this cartel would not have such success and longevity; fifty years and counting.

When the finite quantity of oil was too huge compared to its consumption it was probably reasonable to ignore its long term scarcity. OPEC did not and could not have existed in the early 20th century. When humans could not pollute the entire atmosphere it was reasonable to ignore the atmosphere’s finiteness. Not so in the age of global warming.

Production costs or demand-supply interplays are no more a sustainable way to distribute or allocate the finite resources of the planet. Current availability or supply is just one part of scarcity; it is like the tip of the iceberg in case of fossil fuel.  We have to figure out a way for the economic system to see or consider the whole iceberg. We have to figure a way to embed the finiteness of oil and other minerals in their current price.

Failure of prices to reflect distant scarcity

Oil is priced according to available supplies which in turn are influenced by pumping, refining, storing and related capacities and operations. The cost of extracting, processing, and marketing oil is the main component of its price. This should be the case if we treat oil itself as free and abundant; the way it was, may be, a century ago. A bottle of water usually costs as much as it takes to package and market, there is relatively little value assigned to the water itself because it is free. It is basically the same with oil; the royalty paid for extracting rights is usually less than 3% of the price of gasoline we pay at the pump.

Oil cannot be produced, it can only be discovered, it is not like corn or shoes; its ultimate scarcity (finiteness) relative to its potential future demand  should be significant part of its economic valuation. If that is not the case then finite resources of the planet will be wastefully consumed, polluted, or depleted and there will be little left for our future needs and that of our future generations, whose needs due to increasing population are likely to be even greater than ours. A clear evidence of the deficient mechanism for pricing oil is the wasteful fuel efficiency of our modern day cars. In spite of huge advances in all kinds of technology the average mileage of cars produced in 2008 was less than that of the most produced car in 1908 (Model T).

Since the approaching scarcity of fossil fuel is the first such incident (with respect to impact and magnitude) in the history of mankind, the economic system we currently use was not designed to deal with such scarcity. There was no economic commodity like the present day oil in the experience of those who initially helped to lay the foundations of the current system. Our economic system was designed to deal with scarcities and economic events usually shorter than a human lifetime; there was little or no experience of essential commodities disappearing from existence for ever. There was almost no significant instance of direct conflict between the interests of the current generation with that of the future ones.

Our economic system is failing to recognize the ultimate scarcity of oil because it has no concept of balancing the needs of the present generations with that of the future generations. It, in fact, exaggerates and magnifies the demands of the current generations and diminishes the needs of the future ones. For example, there is no reason as to why there should be almost no effect of the potentially exploding future demand for oil and its likely extreme future scarcity, on the current price of oil. If distant future demand-supply likelihoods had an effect on current oil price, OPEC would go out of business.  Our economic system does not allow for much societal foresight or generational vision. We have a highly myopic economic system suited to the pre or early industrial days not the 21st century.

There are two main obstacles against the reflection of ultimate scarcity of oil in its current price: the time value of money, and the relatively short time horizon of human perception. Future values become increasingly small the farther they are in time, due to discounting for interest. Even if we estimated a high value for oil in distant future it would become very small after discounting. We have created an unnatural asset, money, which grows exponentially; for current oil price to reflect its distant finiteness, its expected future price has to increase by more than the growth in money through compound interest. Since the likely time frame for the finiteness of oil to reflect in its supply is many decades away the growth in price has to build for so many decades to effect current price.

For example, if in Year1 the price of oil is $100 a barrel and the interest rate is 8% the expected price of oil has to be $2,172/barrel in Year40 (40 years later) just to offset the effect of present value discounting. If the expected price in Year40 goes above $2,172 it will start to affect the current price through the financial channel. Since the finite scarcity of oil is not likely to affect supply for a few decades its effect on price is almost absent, thanks to present value discounting.

Interest is a practical hurdle against the incorporation of the ultimate scarcity of oil in its price. Interest practically shortens the time horizon of our economic system and therefore will always prevent it from incorporating the finiteness of the planetary resources till its effect is very close, approximately 30 years or less. Our economic system cannot look beyond the vanishing point of time value of money. The time horizon of our economic system needs to be significantly extended to let the finiteness of the planetary resources reflect in the current economic equation.

As stated above, our economic system’s failure to deal with ultimate (finite) scarcity is also due to the relatively short horizon of human perception. If something is finite but available its price usually does not reflect the finiteness of consumables’ quantity if the available quantity happens to be huge or can last for more than a human lifetime. People ignore scarcity beyond their own lifetime. In case of oil, due to huge production (extraction) capacities the finiteness is not likely to be adequately reflected in availability and in price till the scarcity comes in sight, that is, within the current generation’s lifetime, say 30 years.

Under the current system the scarcity resulting from the finiteness of oil reserves is not likely to be significantly reflected in oil price till the ultimate scarcity (finiteness) starts reflecting in availability. Finiteness may reflect in price if the resulting scarcity is expected to affect availability within our expected lifetime or if, assuming there are liquid long futures markets in crude oil, the growth in future value of oil becomes consistently larger than the value lost in discounting due to interest. One likely trigger for such price increases may be a widespread perception that we have crossed the relative or absolute peak of global oil production. The ultimate scarcity of oil at that point will become life threatening; and a question of life, survival, war, and peace. Economics by failing to recognize the reality of finiteness of certain essential consumables is creating a question of the very survival of our civilization.

Making price reflect the ultimate scarcity of an essential commodity, like oil, will give us time to adjust and find alternatives. It will not change the finiteness but it will change its usage and length of availability, both of which will give us time to adapt. It will significantly reduce the risk of war and destruction when the finiteness of the commodity actually becomes visible to human perception.  Preserving peace and the resources of the planet means that we should be able to price fossil fuel so as to reflect its ultimate scarcity.

Therefore market price as we know it needs some help in reflecting real scarcity of planetary resources. Elimination of interest will extend time horizon of our economic system which in turn will allow us to incorporate distant scarcities in the current economic equation. Asset tax, as proposed here, will give us the tool to influence prices to reflect the ultimate scarcity. Further discussion of scarcity and pricing continues in the following sections of this chapter. Detailed discussion of failure of market prices in this respect is discussed in the chapter on interest.

Prices, Private property and other methods of distributing or allocating scarce resources

One of the main reasons Philosopher and Economist David Hume agreed with the idea of private property was because resources were limited. He argued that if resources were unlimited there would be no need for private property. The following is a quote from Wikipedia.

Hume does not believe, as Locke does, that private property is a natural right, but he argues that it is justified since resources are limited. If all goods were unlimited and available freely, then private property would not be justified, but instead becomes an “idle ceremonial”. Hume also believed in unequal distribution of property, since perfect equality would destroy the ideas of thrift and industry. Perfect equality would thus lead to impoverishment.[Wikipedia]

Land is a scarce resource. We can grant private property rights over land and other local property to current generations and expect private property rights to deal with the scarcity of land, allow its unequal distribution, and help with thrift and industry. Private property rights will also incentivize proper maintenance, development, and sustainability of the land.

Most produced goods are scarce and prices can adequately take care of their scarcity.

Wheat or corn is scarce but will never vanish it can always be grown; market prices can ensure its adequate supply. Land is scarce but its quantity will not change it is fixed, market prices will allocate it to the best use. Minerals are scarce and they can absolutely vanish for ever, market prices will tend to make most of it vanish as soon as possible.

Clean air may be polluted in many ways, air pollution spreads to the whole world, and the atmosphere may take a very long time to recover. We cannot give property rights over atmosphere or clean air or over oceans and other water bodies; these are not fixed like land, and harm done at one place spreads or travels to other places.  Market prices and private property methods, under the current economic system, don’t seem to have any solution to atmospheric pollution (more discussions later in this chapter).

The idea of private property to deal with limited planetary resources as they apply to mineral resources does not seem to have much relevance. The private property idea as applied to discovered mineral deposits is not yielding desirable results. Pricing minerals like corn or shoes is not working either. The iterations through which prices go to find their stable point do not include the play of invisible finiteness of mineral resources. If the ultimate finiteness is big enough to last more than a human lifetime its finiteness is not likely to be significantly reflected in the actions of the owners of mineral deposits.

Supply-demand based pricing and private property don’t seem to appropriately deal with scarcities of planetary resources. Modern economic systems need to operationally recognize basic differences in the many kinds of scarcity i.e. among produced goods, land, clean air, and finite minerals; and have different methods of dealing with different kinds of scarcities.

Precious metals are minerals and, as will be discussed later in this chapter, are valued mostly because of their high scarcity relative to their demand, particularly as store of value. The “store of value” characteristic may provide some help in making oil and other mineral prices reflect their finiteness; it may change the demand supply dynamics of these minerals. We will come back to precious metals in the later part of this section.

Planetary property belongs to our future generations, and we owe it to them to make the ultimate finiteness of a resource part of the economic equation as it applies to everyday economic activities. Protecting planetary resources for future requires that we incorporate the ultimate finiteness of the resources in its economic value. Taxes can effect everyday economic decisions, particularly if they are on assets or on consumption.  This book proposes asset tax, which will tend to reduce consumption of mineral resources. Asset tax can help protect clean air and water by taxing the pollutants or assets that cause pollution.

All extracted minerals can be taxed directly. That tax will add to the value of the minerals in the earth because they won’t be taxed, which in turn will create economic incentives to leave the minerals in the earth, particularly given that cash is also taxed and there is no interest earning. Since economic incentives to extract the minerals will have to overcome the incentive to leave the mineral in the ground, asset tax will certainly slow down the rate of depletion of resources.

This new form of tax is necessary for better utilization of planetary resources and to protect and preserve those resources for their right full owners: our future generations. Asset tax will try to put a value on preserving minerals for the future. It will tend to favor future generations in today’s economic decisions. This is one kind of tax, the maximization of which may be actually welcomed by people. It will be relatively easy to internationalize the practice of this kind of tax and is suited to form a basis for an international regime of environmental controls.

Elimination of interest will remove the biggest counteracting force, time value of money, against the adequate reflection of the ultimate scarcity (finiteness) of oil and other minerals in their future value, and consequently in current prices. Asset tax will help bring distant scarcities closer, consequently sooner within human perceptions or investment horizons. The following steps briefly explain the steps through which the proposed system will ensure that minerals are appropriately priced.

  1. Elimination of interest will allow the future value of oil to be accounted for without discounting. It will allow extending financial horizons far beyond the vanishing point of time value of money, currently around 30 years. For those of us who want their saving to go beyond 30 years and for those who want it to go beyond 50, oil will work as a tax free store of value. The price of a barrel of oil in 2050 will not need to offset the effects of discounting to be a store of value till then.
  2. Exemption from asset tax will add some value to the minerals left in the ground. Minerals will become a vehicle for preservation of value, the longer the investment the more the tax savings, which in turn will make us extend our investment time horizon. Extending investment horizon would bring the scarcity that is now considered too far away into our economic perceptions.
  3. Our desire to earn a return on investment will push us to restrict current supply in favor of future supply because demand, and consequently price, is expected to rise over time.

Interest and properly structured asset tax are opposite of each other with respect to mineral resources: interest forces their rapid consumption and asset tax will incentivize their preservation. Therefore, elimination of interest is necessary to eliminate the incentive that forces rapid consumption of minerals, and institution of asset tax is necessary to actually incentivize preservation of mineral resources.

There is something instructive about the way precious metals are valued. Both oil and precious metals are finite. Precious metals are small in quantity and oil is huge in quantity. But precious metals do not get consumed, oil does. Precious metals can be easily used as money, oil can’t. Precious metals serve as a store of value. Use as “store of value” gives these metals the value and the stability of value they command, it also prevents these metals from getting consumed rapidly.

If there was a way to make the economics of oil similar to that of precious metals we could prevent its wasteful consumption. If oil in the ground does not get taxed, it has a good chance of maintaining or increasing its value; it therefore can act as money or marketable investments in the form of securities. The modern financial markets along with their information and legal infra structure can enable us to trade in goods and property that are still in the ground. To prevent oil and other minerals from getting wastefully consumed we should give it some features of money. Elimination of interest and institution of asset tax, along with some legal and infrastructural changes, may help make oil reserves a convenient “store of value,” particularly if they are traded as tax free assets in our financial markets. Oil reserves in the ground can also provide a good way for the growing savings of some countries to find a home.

The proposed system creates the right economic incentives for the current generation to preserve the resources of the planet and to protect the interests of the future generations. People or their greed are not the problem, it is our myopic economic system.

Government subsidies and carbon tax are not the answer

Government subsidies can add to or strengthen an already existing economic incentive like the one in education, healthcare or agriculture; but it is too much to expect from subsidies to create a new economic incentive that can influence most economic activities.

We need to create a system of incentives that will influence almost every economic decision being made.

In the case of environmental protection, the kind that is needed against global warming, we need new threads of economic incentives that will weave a net of economic incentives in the economy for environmental protection in all economic activities from production to consumption, to investments. The net of incentives need to underlie the structure of markets and to cover the whole global economy. Subsidies cannot be given on such a massive scale in a free market economy. Some form of it may be possible in a socialist economy. The new set of incentives will also need to make clean energy commercially viable.

Subsidies have to be financed mainly through taxes therefore it can only be applied to a small part of the economy. Energy production, fossil fuel, environmental and other resource protection, and related economic activities directly or indirectly cover almost the whole economy. There has to be a much larger part of the economy able and willing to pay for the subsidies in the form of taxes. It is redistribution of wealth which in itself can only take place if there are other areas from where to redistribute from.

Government subsidies can handle small irregularities in the play of economic forces; they cannot change the nature of those forces or add a new force in the overall character of the economy. For example, subsidies won’t change our economic system from the one that exploits the resources of the planet to the one that protects the planet. The scope and extent of the environmental challenge and its economic consequences are so great that it cannot be handled through government subsidies.

Carbon taxing to finance the subsidies to clean energy industries won’t work because very soon we will need to give subsidies to low income households and many important industries to help them pay for their energy bills. It will kill jobs without adequately replacing them. Even today the US and many other countries, including India and China, subsidize oil and other fuels for consumers. Even if carbon taxing was possible in developed countries it would not be possible in developing countries. Therefore taxing fuel to pay for clean energy will not work either politically or even economically. If we tax carbon too much we will slow the economy and consequently won’t get enough revenue to pay for subsidies; and taxing too little will have the depressing net revenue effect and will require higher subsidies to make clean energy competitive. Taxes and subsidies are not the tool to deal with the global nature of the environmental challenge we are facing now.

Carbon tax and subsidies can theoretically protect the planetary resources and promote clean energy resources but they won’t succeed because of the following reason:

  1. The interest based system will continue to work against it
  2. The task is too deeply rooted in day to day economic decisions to be handled by a system of patchworks. It needs an integrated approach or a well woven net.
  3. The task is too big to be handled by the political system. It will destroy the fiscal health of the government and its currency. If we try to do this through the political system, socialism will start to look attractive.
  4. Internationally it has no chance of working
  5. It will create too many unintended consequences to be handled again by another set of patchworks.
  6. The body (global economy) has outgrown the old dress (economic system), patchworks won’t work any more. We need a new dress.

We therefore need an economic system that has a built in mechanism or the capability to translate environmental benefits into financial benefits and environmental costs into financial costs for businesses and entities that provide those benefits or accrue those costs respectively. We need an economic system that helps us move in the direction of preserving the planetary resources and the environment, not the one that forces us the other way.

We need an economic system where fossil fuel and other finite resources reflect their scarcity, even if the scarcity is more than a lifetime away, in their direct or indirect prices. We also need an economic system where infinite resources, like wind and sunshine, show their abundance in low prices even if they take a lifetime to payback the capital cost to harness the resource.

Structural consumption of fossil fuel and fossil fuel-based products

A significant part of our consumption is structural. We drive cars every day for hours not because we like to, but because we have built our cities that way. We consume so much packaging material every day not because we enjoy throwing paper, foil, and plastic in the trash but because our products are sold and marketed that way.

As we all know, our structural consumption had its origins in the originally cheap fossil fuel. We built a society based on the assumption of a cheap supply of fossil fuel; consequently, our societies, way of life, and living and working spaces require us to consume fossil minerals in one form or another. Most of our fossil mineral consumption is not a matter of individual choice but a requirement of the structure within which we live and work.

Fossil fuel is not only a major part of the economy in developed countries but it is also a major part of everyday life in these countries. Fossil fuel is so much part of our life that we can’t function in our homes, schools, and even in recreational places without consuming fossil fuel. We need to consume fossil fuel even when we workout. In other words fossil fuel is not only a major part of our production cost structure but also a major part of our consumption structure. A significant component of our wages goes to pay for fossil fuel; however, the same cannot be said about wages in China.

Fossil fuel is a much bigger part of the basket of “wage goods” or consumer goods in developed countries than it is in developing ones. In fact a good measure of development of a country could easily be its per capita consumption of fossil fuel (or energy). It is not just that we have built a very fossil fuel dependent structure of our economies and societies, but that we continue to make ourselves more dependent as we “develop.”  Economic progress and development is no more the unqualified good that it was as recently as the 20th century; it therefore needs major redefinition.

Redefining progress and development in light of the growing needs and demands of the global population and the constraints imposed by the environment and the dwindling resource base will require some fundamental changes to the components that constitute a particular standard of living. Given obesity and other health problems in developed and in some developing countries, standards of living needed some redefinition anyway. Such redefinition will gradually happen in the public consciousness if we have an economic system that has a set of economic incentives that promote healthy living, both for people and for the planet.

After such redefinition all the business, economic, and physical structures will gradually conform to healthy living habits and habitats of people. Structural consumption of fossil fuel is not as much an individual choice as it is a result of political or collective choices and a failure of social and economic policies. Free Capitalism enables us to make the right collective and individual choices for our future and that of the planet.

Necessity for an environmental revolution

To move away from the fossil fuel model, our living and working spaces would have to be restructured, redesigned, and realigned to use as little fossil fuel and energy as possible. Energy conservation would have to be built into the infrastructure of the towns and cities we live in; it also would have to be a major requirement inherent in the factories we build and the work spaces we design. This redesign and restructuring of our homes, offices, vehicles, towns and cities will create a large number of jobs and will significantly increase investments.

Most of the world has become aware of the need for adopting lifestyles that don’t harm the environment. Eventually, when the developing nations and the rest of the world start to keep up with the evolving needs for environmental protection, fossil fuel-based products will be replaced by environment and planet friendly goods and products.

Making products environment friendly will also require huge amounts of investment in research and development. Since making environment friendly products will require extra work and new and additional processes it is likely that producing environment friendly products will also drive a huge amount of investment in additional production facilities and research and development activities. An environment friendly economy, as proposed in this book, is likely to be a bigger economy, certainly in terms of employment, than the present pollution intensive kind of economy.

The changes brought about by environmental and resource constraints would be so huge that it would reflect in every thing we do and use and in all of our surroundings from homes and offices to roads and cities. The scope and scale of the environmental revolution will be comparable to that of the industrial revolution. It would change all the environments we encounter in day to day living. We need the right economic system to drive the environmental revolution. If we didn’t have an interest based economic system environmental revolution would already be taking shape.

Making life healthy and environment friendly

We need new kinds of industries to serve the economic needs of a growing global population on a resource constrained planet. It is obvious that these industries will consume fewer natural resources per product or bring into use resources that are left unused so far. Wind and solar energy and locally grown fruits and vegetables are good examples of industries that will help both the planet and its inhabitants.

The resource constraints may also be a blessing in some cases where we may get better products not just suited to the planet but also better suited to human beings. Protecting the planet may involve a diverse set of new products and services that may also cater to the evolving health and happiness needs of the planet’s inhabitants e.g. consuming less fast food and more wholesome and healthy meals, consuming more organically grown foods and less processed food, providing more and personalized child care, preparing better teachers and providing better education etc. etc. Some of these products will become commercially viable because of reduced competition from fossil fuel and also due to elimination of capital costs (interest). These products tend to be labor intensive and therefore will provide more employment. Elimination of interest will allow employment of more labor and thus improve products that require more individual attention, like child care and education.

The phenomenal growth of the fast food industry and that of suburban living are examples of the influence of fossil fuel that altered human life styles, health and happiness. Fast food competes effectively with all other practices and businesses that can serve meals, including home cooked meals. In the absence of fast foods we may be able to have healthier human beings and healthier families. Fast food not only took business away from other businesses but also from families, probably making them less effective in influencing the quality of their outcomes: children.

Cheap fossil fuels lead to the development of vast localities of suburbs all around the country. They not only cause pollution they also effect our life, our health, and our families. Commuting takes up most of our time and leaves us with little time for life and family. It helps to atomize individuals and atomize communities. Since suburbs don’t have enough public transportation systems most of the time we have to drive around children and other people e.g. soccer moms. Suburban living makes a car driver out of most of us.

Since this is not a book on human health and happiness, we would not go beyond giving a few unsubstantiated examples to make the point that our excessive dependence on fossil fuel is costing us dearly in many ways. A whole range of new products and services need to evolve or be developed to shift our dependence away from fossil fuel. Most of these new products and services are likely to provide low financial returns, at least initially, because they provide services that cater to the long term, generational, well being of individuals and the planet and also because they may be more labor intensive. The major challenge therefore is in translating long term human and planet well being into financial benefits for providers.

Thomas Friedman of the New York Times writes in one of his articles that we all need to do “extra” to justify our higher wages compared to the Chinese, for example. He mentions the term “artisans” and suggests we need to produce high quality, enriched, distinctive, and even personalized products that deliver value. These kinds of services can easily become part of our life if we don’t have to worry so much about capital cost, which is time related. Capital cost, interest, forces us to do things quickly, which is in direct conflict with the artisan approach suggested by Mr. Friedman. If capital costs were significantly reduced human labor will not be pressured and therefore can choose to take the artisan pace. If we need to further incentivize these kinds of economic activities we can have asset tax working for us as well.

Promoting long term health of people and that of the environment will therefore need some help from the economic system and from the society. Eliminating interest will provide that help from the economic system, and the right asset tax structure will provide the help needed from the society. An economy that is more in tune with the present and better geared for the future has a much better chance of growing than the one rooted in the past.

Higher income and employment from clean energy

It can be pointed out at this point that the same product produced using naturally flowing environmental sources of energy has more value added than the one produced using fossil fuel. That additional value will go to workers, entrepreneurs, and governments in case of clean energy whereas in case of fossil fuel based energy that value, which is not our value added, goes to fossil fuel exporting countries. In other words products produced using clean energy will have higher component of overall wages and profits. The same product produced without the use of fossil fuel will give us more income. The income that we currently provide to foreign oil exporting countries will remain with us and with our environmental energy producing companies.

Developing competitive advantage

Not only clean energy provides more income per product it can also help reduce costs and therefore provide some cost advantage in competition. If we eliminate interest it will be easy for a natural resource rich country like the US to provide very cheap electricity from sources like wind, solar, hydro, etc. Even nuclear energy will become very cheap because of reduction in capital costs involved. We all know that energy prices are part of almost everything we buy and sell. Therefore, one obvious candidate for gaining competitive advantage is reduction in the cost of energy; and eliminating interest will certainly help in reducing clean energy prices. If we have cheap clean energy in the 21st century we will have some cost advantage.

However, the main competitive challenge of our time is to gain technological, cost, marketing or other advantages over fast developing countries. We can gain technological advantage through higher investment in research and development and through higher capital intensity, both of which again can be achieved by eliminating interest. We can also gain overall cost advantage through eliminating interest.

Once we have developed new industries we will be able to retain advantage long enough to pay back our investment with returns in many forms. Besides the usual first mover advantage, it is also important that our new industries have some inherent competitive advantages so as to make their migration a very slow process. Our low capital cost may be one such advantage. No other country can match our ability to raise capital at zero or negligible prices.

The strategic advantage will come from the fact that we have more capital and better access to capital; developing countries have less capital and more need for capital in catching up with us. They will need most of the capital and resources they have available for catching up with us. The time they use to catch up with us we will use to develop new industries and move ahead. Effective and efficient use of the available capital and the ability to attract international capital is the answer.

The developed world, particularly the United States, is not likely to come out of the present economic slump without the current system undergoing a change that will systematically and significantly reduce the cost of capital, at least for new capital intensive industries.

Currency devaluation is not a sustainable strategy to increase competitiveness

America and the rest of the world have been trying hard to get the Chinese to revalue their currency, or to increase the price of their currency and consequently the price of their goods. This sounds counter intuitive and probably for a good reason. If we take the perverse economic conditions away we will see that it is unwise to ask a seller to increase his price. What would you think about a buyer who asks the seller to increase his price?

Whatever we buy from China will cost us more and consumers will be worse off and our standard of living will be affected. Why would we want to do that? The only reason is that we want to sell them our products as well and at the current exchange rate our products are expensive to them. That is a reality we should face and try to address directly rather than ask China to increase its prices. If we want to compete in the market we should reduce our prices.

One of the strategies suggested in this book to reduce prices or increase competitiveness is to reduce capital costs. The U.S. with its dollar as the global reserve currency has a definite and lasting advantage in reducing capital costs. As stated earlier capital costs work their way into the cost structure of almost all goods and are a very significant part of the price we end up paying. Reducing capital costs will lead to development of a range of new age industries and their downstream and upstream companions. We have to remember that the bulk of the economy runs on doing simple things which basically require the same level of skills as that available in some developing countries, therefore to have a higher standard of living we have to develop a non-wage cost advantage to counter their wage advantage. Our low capital cost is a cost advantage that cannot easily be matched by developing countries. Low capital costs will lead to other advantages in technology, marketing, and skill and know how development, and similar other advantages in new industries.

Currency revaluation effort to increase our exports will lower our standards of living and lower standards of living in China. Our standards of living will go down because we will be paying more for everyday items we import form China. Our imports will go down and will cause unemployment in China and thus lower their standards of living. Our exports may not go up because the kinds of items we want to export takes time to catch hold and become everyday use. If Chinese see waste in using high value items from us our exports may not go up by much. Chinese culture and their government may play a role in limiting our exports. We should not count heavily on our exports of luxury items to significantly offset our trade deficits. We also have to remember that China produces almost everything it needs if there is demand for something in their domestic market they will produce it themselves. They have a huge market they can produce everything. So the benefit we seek from revaluation may be an illusion.

Given the difference in the wages between China and the US I think a 10 – 15% appreciation in Yuan would not change the trade deficit picture much to our liking. China may not be able to sell as much but may still be able to bill us the same because of higher prices. Most of the things we import from China are everyday items which have good retail margins. Part of the increase in price may have to be absorbed by the retail trade in the US. By asking China to increase its price we may hurt our retail trades more than we increase our sales to China.

Joseph A. Massey and Lee M. Sands write the following in a New York Times article titled “The Yen’s Lesson for the Yuan” published on August 23, 2010.

“… The question of whether de-linkage (of Yuan with the dollar) would actually have any effect on the trade deficit. On this, the United States’ 40-year history of pressuring Japan to let the yen appreciate against the dollar is instructive. It indicates that de-linking the Yuan would make barely a dent in America’s trade deficit.

With Japan — whose yen was fixed at 360 to the dollar — Nixon played hardball, temporarily imposing a 10-percent surcharge on imports and banning soybean exports to the country.

The strategy worked. That December Japan and nine other countries agreed to let their currencies fluctuate against the dollar within a narrow range of exchange rates. The yen shot up to 315 by the end of the month.

Still our trade deficit with Japan continued to grow. At the end of 1970 it stood at $1.2 billion; by the end of 1972, with the yen at 302 to the dollar, it was $4.1 billion.

Thanks to changes in the global economy, the multilateral currency agreement soon failed, and this allowed the value of the yen to continue rising. By 2006 it stood at 119 to the dollar — more than three times as expensive as in 1971 — and yet the deficit hit an all-time high of $90 billion.

What happened? Whatever effect yen revaluation might have had was outweighed by two far more potent forces: American consumers’ insatiable demand for Japanese products and Japanese producers’ ability to cut their costs and stay competitive. There is no reason to believe that things would be any different with Chinese goods today.”

We have to produce things that the Chinese need without forcing them to buy those things. If they want to keep their currency under valued it is their choice we should benefit from it. Their huge saving should provide us the capital we need to do things that needs to be done and has value in the present and future.

We want higher standard of living than that in China we, therefore, have to produce goods and services that are highly valued by everybody including the Chinese and the Indians. We have to set up new industries that produce things that China and the rest of the world want. In the globalized world that we have helped create that is the way to compete and contribute to the overall wellbeing of all participants in the global markets.

If we let our clean energy and our environment and space related industries prosper we may have enough to sell to the rest of the world. They would be willing to pay our price if we offer things that they cannot produce at significantly lower costs. Additionally replacing oil imports with clean energy will also allow us to address our trade deficit.

All that we need to do is to get rid of interest and allow new industries to emerge. That may also dampen the Chinese appetite for our bonds because it won’t grow by itself and they may also try to spend more. We have to let our new industries to take the lead and develop expertise, facilities, and technology to be able to supply China and the rest of the world with products of the environment and space age.

Emerging views and actions on using market forces

The following are two separate excerpts from an article titled “Blaming China Won’t Help the Economy” in the New York Times of September 26, 2010. The writer Anatole Kaletsky makes certain points which are worth noting with respect to the recent currency market related actions of Japanese and the Chinese governments and emerging views about markets and facts about governments’ role in economics.

1st excerpt

The decision to break with free-market ideology and spend government money to control the yen’s value against the dollar was mainly driven by Japan’s relationship with China, not America. Japanese companies including Sony and Toyota that had demanded government action devaluing the yen were not concerned primarily with their competitiveness against American rivals. The motivation was a fear of being undercut by exporters in China, Korea, Singapore and Taiwan — all countries that aggressively manage their exchange rates.

With Chinese economic policy now serving as a model for other Asian countries, Japan was faced with a stark choice: back United States criticisms that China is artificially keeping down the value of its currency, the renminbi, or emulate China’s approach. It is a sign of the times that Japan chose to follow China at the cost of irritating America.

Japan’s action suggests that, in the aftermath of the recent financial crisis, the dominance of free-market thinking in international economic management is over. Washington must understand this, or find itself constantly outmaneuvered in dealings with the rest of the world. Instead of obsessing over China’s currency manipulation as if it were a unique exception in a world of untrammeled market forces, the United States must adapt to an environment where exchange rates and trade imbalances are managed consciously and have become a legitimate subject for debate in international forums like the Group of 20.

Market fundamentalists who feel that government interference with free markets is anathema should be reminded that, by today’s dogmatic standards, Ronald Reagan is one of the great manipulators of all time. He presided over two of the biggest currency interventions in history: the Plaza agreement, which devalued the dollar in 1985, and the Louvre accord of 1987, which brought this devaluation to an end……..

2nd excerpt

If market forces cannot do something as simple as financing home mortgages, can markets be trusted to restore and maintain full employment, reduce global imbalances or prevent the destruction of the environment and prepare for a future without fossil fuels? This is the question that policymakers outside America, especially in Asia, are now asking. And the answer, as so often in economics, is “yes and no.”

Yes, because markets are the best mechanism for allocating scarce resources. No, because market investors are often short-sighted, fail to reflect widely held social objectives and sometimes make catastrophic mistakes. There are times, therefore, when governments must deliberately shape market incentives to achieve objectives that are determined by politics and not by the markets themselves, including financial stability, environmental protection, energy independence and poverty relief.

This doesn’t necessarily mean that governments get bigger. The new model of capitalism evolving in Asia and parts of Europe generally requires government to be smaller, but more effective. Many activities taken for granted in America as prerogatives of government have long since been privatized in foreign nations — even in what so many Americans view as socialistic Europe.

In France, Germany, Japan and Sweden, water supplies, highways, airports and even postal services are increasingly run by the private sector. For home mortgages to be backed by government guarantees would be unthinkable anywhere in Asia or Europe. Tax systems, too, are in some ways less redistributionist in Europe and Asia than they are in the United States.

The current financial crisis and many episodes before that have amply demonstrated that markets can do certain things and cannot be relied upon for others. Unrealistic expectations from the powers and players of the market will lead to failures and disappointments. Former Federal Reserve Chairman Alan Greenspan made such expectations and realized after it was too late. He said the following while giving testimony to the House Committee on Oversight and Government Reform: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.” He further said “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.”

In simple words, he relied on market forces (self interest) to regulate the market, but they didn’t. Markets are run by self interest; but there are limits to what self interest can do on its own, and there are excesses that self interest can do if left to its own. Markets can only function best when they are well organized and do things that they are best suited for. If you build a road, open a bank, build a warehouse or any of many other things, the market, its efficiency and things it can do, changes. As individuals we need to understand the markets to get the most from it; but as societies we need to build or design markets so that everybody gets the most possible from it. We need to decide the function that we would give to the market, and the task we won’t.

A produce bazaar in Kenya is a market and the New York Stock Exchange is also a market. Societies have been building markets, making rules for markets and structuring the flows of markets. There are rules for trading and there are also rules against trading e.g. insider trading, front running, speculation, etc. Markets are great in allocating resources and enhancing efficiency but they are only as great as the structure or design enables them to be. Markets are a product of society, they serve specific purpose, and they are structured for the purpose they are supposed to serve.

The challenges of this century require achievement of new economic objectives that are very public in nature e.g. protecting the environment, energy independence, preserving resources and similar other objectives. Markets will help in protecting the environment only when economic incentives are so structured that environmental benefits result from actions of market participants working for their own benefits. In other words, we need markets to achieve some specific public benefits by channeling private interests and enterprise into areas or activities that help achieve those public objectives. The proposed system by structuring incentives for public good within the framework of the market will achieve public benefits through market participants who act in their own self interest.

The reason markets are probably the best avenue to achieve these goals is that markets are the place where products and services, that harm the environment, deplete resources and cause other public damages, are bought and sold. A good and effective way to help the environment is to favorably influence the payoffs or profits towards the environment or other objectives. If we try to use some other avenue like government subsidies it will overwhelm the resources of the government or make the government too big and unwieldy.

The basic function of a financial market, that is enabling people to exchange capital, will become freer because of reduction in the government’s role in the markets. The government involvement in the financial sector will be significantly reduced because the financial system will be able to run without government help. The mortgage and other guarantees, the deposit insurance, the lender of the last resort, and the guarantor of financial stability functions that the government performs today may not be required if the financial system is properly structured as part of free market, and the incentives of its institutions and participants are arranged to achieve the best possible results for all of us.

No harm will be done to market efficiency if a wind farm is allowed to borrow at a cost lower than that by a coal plant. The market will operate as efficiently with the embedded public objectives as it does without them. Given the enormity and the collective nature of the environmental and other challenges it is inevitable that the role of government, in restricting some kinds of economic activities and promoting other kinds of economic activities, will increase. Collective choices have to be implemented by collective institutions. The basic question to ask is: Do we want governments to meet environmental and resource challenges through political means and institutions or by structuring market forces and incentives?

The proposed system by providing a tool for exercise of collective choices has minimized the chances of increasing the size of the government. The best way to keep government small is to have a healthy economy and one that can function on its own. Economic failures are the surest way to increase government size.

Trade deficit, national security and imported fossil fuel

The need for a non fossil fuel engine for economic growth is further strengthened when the cost of imported fossil fuel is factored into the trade deficit picture. In 2008 our trade deficit was $696 billion and our import of oil was $475 billion; in 2009 these figures were $381 billion and $265 billion respectively. Cutting down our oil import bill will almost solve our trade deficit problem. Most oil exporting countries are not very friendly to the US; our reliance on them for the life blood of our economic life is a serious risk that is materializing in many forms.

Our reliance on foreign oil is also seriously compromising our national security. Most financing for terrorism seems to originate from these countries. As long as we remain dependent on imported oil, our involvement in the Middle Eastern region is likely to remain high, which creates resentment against the US in the region and increases the potentials for conflict.

The religious extremists and other terrorists have found a good business model which is to obtain financing from oil rich countries against peace and stability in those countries. The rulers and elites in those countries are happy to provide those financings also because the terrorist organizations provide an outlet for the violent segment of their population. High price of oil keeps the financing easy to provide. We will remain potential targets for terrorist attacks as long as the price of oil is high and we are heavily involved in the Middle East. We have to significantly reduce our dependence on oil to protect our economic independence, to reduce the monetary costs of our national security, and to maintain the openness of our society.

 

 

Chapter 8

Table of Contents