Reconciling Ecosystem Services with Economic Theory and Policy


Implied Curve of Trade-Offs Between Temporal and Spatial Scales

In Brief

Neoclassical economic theory, which has come to dominate much of the policymaking world, reduces the factors of production to labor and capital. Yet, the classical economists as far back as Adam Smith considered land to be perhaps the most important factor of production. The link between land – or more generally natural capital and ecosystem services – with the economy has effectively been severed by neoclassical economic thought. In that aftermath, both policymakers and academics understandably struggle to synthesize economic theory and the environmental sink in a systematic fashion. This paper is intended to serve as a policy guide that attempts to link economic theory with other issues that are either ignored or not yet synthesized into mainstream economic thought.


Key Concepts

  • Neoclassical economics dominates the policymaking world including Federal Reserve monetary policy decisions. Over the past century, economics has favored math-laden models that discard key components in the interest of theoretical simplicity.

  • Classical economists such as Adam Smith featured land or natural capital as integral to their theoretical frameworks. Since the effective exclusion of natural capital occurred with neoclassical frameworks, policymakers too often fail to appreciate that without ecosystems, there is no economy.

  • Both policymakers and academics struggle to develop an integrated framework for economic theory that both addresses sustainability and resonates with the public at-large.

  • Policymakers would benefit from an interdisciplinary approach to economics that explicitly incorporates natural capital and ecosystem services into decision-making processes.

Conventional economic models fail to incorporate a full picture of long-term drivers of economic activity and societal benefit. In the quest for a false sense of precision, the models have become ever more complicated and essentially incomprehensible to policy makers1. Perhaps not surprisingly, the methodologically rigorous models are subject to wholesale modification and revision in the wake of a financial crisis.

A fuller picture of the drivers of the economy in the 21st century that includes more interdisciplinary and comprehensive approaches to understanding and monitoring would better benefit policymakers. Too many economics-related schools of thought have become disconnected from the physical world. Land, or more generally natural capital, figured prominently in the thinking of classical economists such as Adam Smith and David Ricardo. Starting in the 19th century, land was de-emphasized in favor of labor and capital as areas of primary focus. Monetary analysis also became more prevalent2. In fact, mainstream economic training no longer requires study into properties of natural capital and ecosystem services relative to other areas.

Part of the dilemma is related to the role of the history of economic thought as opposed to economic history – two different subjects. The general belief that economic thought has evolved from classical political economy elaborated by Francois Quesnay (1694-1774) and Adam Smith (1723-1790) to more sophisticated forms such as neoclassical and neo-Keynesian may be misplaced. Recent events, such as the financial crisis of 2007-08, merely highlight the more general failure of economic policies based on a too-limited conception of the economy.

Neoclassical economic anomalies have come under scrutiny by behavioral economists such as recent Nobel Prize winner Richard Thaler in an attempt to connect theory with what humans actually do in the real world. Even so, economists continue to favor abstract models. The resulting lack of robustness handicaps policymakers and is a disservice to society as a whole3. Currently lacking is a more complete framework.

This paper is intended to serve as a policy guide that attempts to link economic theory with issues that are either ignored or not yet synthesized into mainstream economic thought, and bridge the gap between oversimplification on the one hand, and unmanageable complexity on the other. Further, microeconomic, macroeconomic, societal and environmental drivers remain compartmentalized from a policy perspective and would benefit from greater interdisciplinary approaches to analysis.

 
Environmental Sinks
Recent work suggests that the most important environmental issue that nations will face in the future is not availability of non-renewable natural resources, but rather the environmental sink – the ability of the earth to absorb waste and regenerate renewable resources (or ecosystem services). A closely related issue is what level of ecosystem services can be consumed at or below the regeneration rate of renewable natural capital. O’Hara4 argues that economic production functions are largely irrelevant outside societal and physical (environmental) contexts. Yet, too often the economy is interpreted as its own world, which merely overlaps periodically with society and the environment, as depicted in Figure 1.
 

Source: O’Hara 2015
Figure 1. Partial Sustainability

Figure 2 more aptly demonstrates the position that economics occupies in the grand scheme. The economy is necessarily nested within natural and human-based systems. In addition, many economic-like activities occur outside of the purely economic sector and, as a result, do not show up as gross output. Such activities include household-provided goods and services, community support systems, or many aspects of ecosystem services derived from natural capital5. This paper attempts to develop a more comprehensive, yet concise, approach to economic policy than that offered by neoclassical or neo-Keynesian approaches.
 

Source: Kakovitch and O’Hara 2013: 6
Figure 2. Sustainability

More recently, dynamic stochastic general equilibrium (DSGE) models have been developed by central banks to attempt to capture the complex nature of modern economies from the bottom-up. These models seek to forecast not only a single quarter into the future, but also to an infinite time horizon. Such an approach requires approximations and computer simulations to solve even simple DSGE models1. The mix of variables continues to shift as central bank economists attempt to refine the process, but examples include real GDP, private consumption, total investment, exports, imports, a GDP deflator, a consumption deflator, employment, nominal wages, nominal interest rate, real exchange rate, etc. However, conceptually important variables that are difficult to represent numerically are not included6.

Despite the wide range of indicators used to try to forecast economic growth and the impact of shocks to general equilibrium, the ultimate weakness of DSGE models is the focus on the closed system of inputs and outputs, underpinned by the neoclassical belief that manmade capital can be substituted for natural capital (weak sustainability), and by extension for ecosystem services. The strong sustainability approach establishes a clear distinction between natural capital and built capital7.

Prior to the 21st century, the use of a closed system could perhaps have been justified because the world was less crowded than it is now. Nonetheless, a more realistic approach was developed in the 1970s by Nicholas Georgescu-Roegen, which proposed variables that neoclassical economics neglects.
 


The levels of complexity associated with ecosystem services goes well beyond the classical economists and figures nominally, if at all, in neoclassical theory. Yet natural capital and ecosystem services are deterministic drivers of human economic activity that largely continue to be depleted and degraded10. Without critical ecosystem services, humans and animals cannot survive.

Extending the analysis, Figure 3 maps the implied spatial/temporal curve of ecosystem service regeneration based on analysis by Fremier et al.11, which suggests that as spatial scale of impact increases, temporal scales increase much faster – up to a point. In other words, the larger the geography impacted by waste entering the environmental sink, the longer the period required for ecosystem service regeneration.
 

Adapted from Fremier, et al. 2013
Figure 3. Effective Management of Ecosystem Services—Lags Between Production and Consumption. (Solid gray line indicates increasing importance of management/payment for ecosystem services. Dotted gray line suggests spatiotemporal trade-offs of sink functions and ecosystem services.)

The curve highlights how the more numerous impacts tend to be local and can be remediated in shorter timeframes than larger scale impacts such as climate change and ocean acidification. From a public policy standpoint, there has been a failure to develop a comprehensive framework that visually portrays the numerous, disparate impacts of non-recycled waste on the environmental sink, and thus contributes to the general lack of awareness of the range of accumulating pressure on natural capital to regenerate ecosystem services.
 

Figure 4. Implied Curve of Trade-Offs Between Temporal and Spatial Scales

 
Gordon’s Inflection Point: 1870
By incorporating patterns that can be derived from a more systematic look at the panorama of economic history we can better understand why so many economic models fall down on the job. In particular, the history of economic thought and technological development that derives from its origins is relatively short. The study of economics dates back only to Quesnay (1694-1774). Just a century later, around 1870 with economics still in relative infancy, unprecedented change began to take place that had implications for society and the environment which remain underappreciated.

Robert Gordon notes that essentially no economic growth occurred in the eight centuries between the fall of the Roman Empire and the Middle Ages. From 1300-1700, things were only marginally better, when real output per person in Britain only doubled over that 400 year interval. By contrast, during the twentieth century in the U.S., output per person doubled every 32 years.

Gordon’s ultimate thesis is that the inventions and innovations in terms of quality of life between 1870 and 1970 were transformative in an unparalleled fashion, with significant implications for the twenty-first century. Of particular note is the fact that the transformation which occurred in the U.S. and most of the developed world cannot be repeated. Those gains have been taken and future productivity increases will be dependent on other new innovations.

A significant part of the increase in standards of living, equality and economic productivity was the result of the networked home and business – something unheard of in all the previous centuries of human existence. These networks consisted of five components that are all too familiar now, and yet to which modern economies are oddly disconnected from or even oblivious to, short of some natural disaster that disrupts them: electricity, gas, telephone (which now includes the internet), water and sewer12. Most residents of developed countries live far better than kings and nobles just two centuries ago. Yet, this too is often forgotten in the hustle-bustle of consumer society that increasingly taxes ecosystem services through escalating depletion and degradation.

A whole host of inventions and innovations that constitute routine aspects of urban planning – which defines in large measure how we live today – did not become widely available until the early twentieth century. It’s worth noting here, for example, that the term infrastructure dates back only as far as 1875. There were no U.S. corporations in 1870, and the average factory at the time employed less than ten people13.

The first age of globalization began in the 1870s with export-led growth in commodities from developing countries to the industrializing Western world14. As the scale of industry and cities increased, new theories were developed in an attempt to explain them. Neoclassical economics traces its roots back to the 1870s15 16. For simplicity and due to the assumption of substitutability of natural capital with built capital, after about 1880, Anglo-American economists took nature out of economics altogether17, as explicitly postulated by Robert Solow18.

Another example of progress that substantially raised standards of living was the germ theory of disease in the 1870s that set the stage for increased average longevity. The other two key developments that had huge increases in life expectancy were marked decreases in infant mortality, and the use of antibiotics. Since then, virtually all medical innovations have been highly incremental in nature for society as a whole in terms of increased longevity.

Other examples abound of how unusual the great inventions of the late 19th and early 20th century were. The prototype electric kitchen exhibited at the 1939 World’s Fair looks remarkably like modern kitchens19. Air travel by jet was introduced in the 1950s and has not improved significantly since20. And travel by automobile has improved only incrementally since the earliest days of mass production.

Marc Levinson makes the case that the Golden age of productivity growth between 1948-1973 is giving give way to a prolonged period of ordinary economic performance21. Indeed, all of the above events occurred near the end of the most technologically dynamic epoch in the United States22. These developments suggest that western economies may be experiencing an extended period of limited total factor productivity growth.

Perhaps most significantly, measures of happiness in the developed world have not improved noticeably in the past 50 years since the widespread adoption of the five network connections identified above23-25. Increasing wealth no longer appears to increase happiness and well-being26-30.

Generally speaking, a happy life requires relatively few straightforward elements and is similarly defined by several authors. Methods used to describe a full or satisfying life include as few as four basic components: family, community, faith and vocation31. Maslow identified five needs: physiological, safety, love, esteem, and self-actualization32. Skidelsky and Skidelsky30 list seven aspects: health, security, respect, personal autonomy, harmony with nature, friendship, and leisure. However one may be inclined to quibble with the definitions, what is clear is that most of the developed world has access to all of them. Yet a consumer-oriented society still drives people to clamor for more, irrespective of concerns about environmental sustainability.

 
Future Jobs
Neoclassical belief that the economy can expand indefinitely into an essentially infinite universe might have turned out to be (and may yet become) a workable concept had space travel become as commonplace as envisioned. The idea of earth travelers routinely visiting nearby planets, asteroids and stars once seemed a near certainty based on the work of science fiction writers featured as far back as 1865, when Jules Verne wrote From the Earth to the Moon. H.G. Wells penned his first novel in 1895, and the serialized science fiction publications such as Amazing Stories began to appear in 1926. But space travel and many other engaging technologies turned out to be more problematic puzzles to solve than first believed. As another example of unfulfilled technological optimism, the Mr. Fusion device powering Dr. Emmett Brown’s DeLorean in Back To The Future – fed by discarded trash: banana peels, stale beer, and aluminum cans – appears to be a long way off as well.

In the case of human lifespans, any upturns on the scale accomplished between 1870 and the end of the 20th century (an increase of 33 years for the average person) appear unlikely12. So many of the future breakthrough technologies envisioned in the early part of the 20th century have failed to materialize, in contrast to the way transformative inventions such as electricity, motorized vehicles, and motion pictures did in the latter part of the 19th century.

In the absence of game-changing technological advances, maintaining the infrastructure that supports the quality of life achieved over the 20th century will dominate public policy discussion. Rebuilding the aging US infrastructure as proposed by the Trump administration, for example, only maintains current living standards. From a functional standpoint, reconstructing or upgrading existing infrastructure does nothing particularly new.

This paper posits that the world has reached the point where, for the foreseeable future, the overriding goal of developed nations will be to simply maintain the standard of living achieved over the past century and a half. If true, such a controversial paradigm begins to answer the question of what new jobs in the future will look like.

In the broadest terms, many people will be employed to maintain sufficient regenerative capacity in ecosystem services necessary to provision a global population of 10 billion or more. There will be ample opportunity for increases in research and development into nascent areas such as fusion power and gene therapy, though public policy in this direction remains uncertain. Depending on the speed of planetary warming and the impact of climate change, resilience and mitigation planning will engage large segments of the workforce as droughts, hurricanes, typhoons and other events become more prevalent. These will be important jobs that will certainly challenge human intellect and creativity, but again serve – at best – simply to maintain existing standards of living.

 
Policy Implications
What may come as a surprise to many is that world population is set to level off somewhere between nine and twelve billion people between 2050-2070, and then almost certainly begin to decline – assuming the planet can continue to sustain such large numbers until that time33. Upcoming demographic shifts will have significant implications for elderly care, traditional rural labor surpluses from developing countries and future population migration patterns. Continued global migration, for example, will enable developed countries to address declining population.

Another issue that classical political economy or a more ecologically-oriented view of economics will be better able to address has to do with the tendency of industrial economies tend to overproduce – whether capitalist, communist, socialist, social democratic, or capitalist communist. Oversupply of commodities – agricultural products (e.g., beef, dairy, eggs) or copper and oil, or housing – have frequently caused price deflation. All industrialized economies have regularly demonstrated the ability to become efficient and overproduce. This propensity to overproduce is partly a function of ever more efficient automation, but also stems from the ability of firms to utilize “free” ecosystem services and natural capital that are underpriced relative to long-term value. Current price mechanisms for ecosystem services simply do not reflect full replacement costs. Preliminary work has been undertaken that demonstrate the value-added ratios using current pricing for industrial activities such as solid waste combustion, coal-fired electric power generation, and sewage treatment are negative from an air quality standpoint alone. A full set of environmental accounts would encompass not only air, but also water pollution, solid waste, and hazardous waste as part of the national economic accounts system34.

With a world population estimated to be 9-12 billion before the end of the 21st century, the earth is on track to become a much more crowded place. A planet that full of people will have to be managed very differently. Pressure on limited resources and ecosystem services – exacerbated by growing inequality – will generate greater instability, resulting in political conflict and broad institutional changes14,35.

Yet once the peak occurs, global population will almost certainly begin to decline, at least gradually by the mid-to-late 21st century33. This novel scenario will present its own set of fresh challenges for future economists. Gradual global population decline on its way to some kind of steady-state may be as difficult to navigate as the more densely populated earth in the decades ahead. A political economy addressing naturally occurring population decreases has not been articulated. Similarly, a departure from growth-only economics has no precedent in industrialized economies.

In the meantime, societies will confront important choices in the years ahead. Jared Diamond outlines two strategies that have prevented ecological and societal collapse in various geographies throughout history. The first is long-term planning, and the second is the willingness to reexamine societal core values36. Both of these items will present non-trivial challenges for developed countries to address.

Long-term planning is not the hallmark of most industrialized societies that often lurch from one election to the next. In the corporate world, the planning horizon is often shorter, from quarter to quarter.

Reexamining core values will not be an easy prospect either. Since the advent of consumer societies – in many ways driven by relentless depletion of ecosystem services – the basic components of what is needed for happiness has been largely lost. Instead, the more likely scenario is that the lifestyle to which the developed world should probably aspire will instead be forced upon it.

Perhaps one day fusion energy, space-based solar power or cost-effective space travel will expand the feasible boundaries of the planetary ecosystem. However, for now, available ecosystem services provided by a finite planet with a surface area of 510 million square kilometers are all humans have with which to work. In so many ways, planet earth will continue to get smaller in the years and decades ahead.

 
Primary Conclusions:

  • Long-term planning should figure more prominently into the policymaking decision process.
  • Core societal values emphasizing consumer-oriented culture will not be sustainable and must be reexamined in favor of attributes that incorporate happiness and well-being, as opposed to material wealth exclusively.
  • Standards of living are poised for only marginal improvement in the decades ahead. This likelihood implies that rebuilding aging U.S. infrastructure should become a national priority in order to avoid a decline in overall standards of living.
  • Conventional, continuous-growth economic models will no longer maintain validity by the end of the 21st century. Economic models must be modified to incorporate viable steady state or no-growth frameworks.
  • All industrialized society ideologies drive overproduction by overharvesting and overburdening ecosystems. Industrialized economies should explicitly acknowledge the need to remedy the burden increasingly placed on deteriorating ecosystem services.
  • Current market structures underprice industrial processes. More research should be undertaken to properly price products and services according to their fully allocated costs.
  • Long-term oriented research and development will be necessary to create a next generation of breakthrough technologies.

 
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