I have been thinking a lot about economic complexity this week. This is all the more relevant as Alberta heads into yet another downturn. And our political leaders head off to Paris with a new “climate change plan”. The perfect storm.
Alberta is one of the least diversified advanced economies. It relies heavily on the extraction and export of energy resources, and in particular on capital spending to achieve this. Argue all you want whether that is good or bad, but recognize reality: extraction and trade of oil and gas does almost all of the heavy lifting to provide well-being for Albertans, and increasingly much of Canada.
If our human civilization is to survive and prosper we must eventually find a way to live in better harmony with nature and its resources. But society and culture are about creating pockets of physical and mental order. Creating order requires a flow of energy. And in Canada, most of this flow of energy is provided by fossil fuels, especially outside regions served by hydro-electric. The reality of our present predicament is that without fossil fuels, most of Canada would need to shut down for four days a week. The good news is that would give each of us lots of time to think about economics. The bad news is… well, let’s start with winter.
The root meaning of wealth is “well-being”. The current interpretation of what we mean by wealth is just that – a human cultural agreement about what types of physical and mental order are desirable. This meaning has changed over time and will continue to do so. But underneath this shifting sand is the underlying concept of well-being, accompanied by a self-organizing process of using energy and natural resources to create it. We call this process an economy.
Describing Economic Complexity
As with most human systems of behavior, an economy is at once simple, complicated and complex.
At its core, an economy is remarkably simple. Humans create a form of order by using and manipulating nature. They obtain food, fuel, shelter and safety from nature for their well-being. How well this works depends on natural abundance and human ingenuity. Humans exchange surplus with others who have similar desires. Trade leads to value, value leads to price, price leads to money. Eventually, humans create forms of well-being that don’t depend directly on natural resources. These are services: heath care, education, haircuts, entertainment, and even consultants. Because we have money we can buy these things, too. And we tend to forget that all of our advanced indirect forms of well-being still stand on the shoulders of the more fundamental use and manipulation of nature. Think of it this way. In the absence of inter-planetary trade, the entire global Earth economy is nothing but natural resources and human ingenuity.
An economy is also remarkably complicated. There are too many parts and relationships to keep track of, let alone manage scientifically. The “science” of economics grew out of efforts to apply models and mathematics from classical physics to human behavior. To make these work, at least in the abstract, required a ton of heroic assumptions and still does. Economics paints a picture of what humans believe happens in equilibrium (another concept from physics) at two different levels. These are the economy as a whole (macro) and at the level of the firm (micro). Since there is a whole big space between micro and macro, and human systems by definition are never in equilibrium, there is still a lot of work to do in making economics into a true science. Arguably, the reductionist program of reducing everything to physics is misguided. But it is the best explanation we have for now. Our efforts to understand the complicated aspects of economics today are sort of like the way humans understood physics before Newton came along.
Finally, an economy is remarkably complex. It is complex because it is a non-linear adaptive system that is fundamentally self-organizing. When you hear a politician talking about “managing the economy” please smile and shake your head. Add together the actions of billions of agents as they manipulate nature (each individually simple) and you get economic complexity that goes far beyond the attempts of complicated economics to understand and manage.
There are only two things that a political process can do in an economy: nudging agents and redefining institutions and meanings.
- Nudge. Political process can change incentives for and place restrictions on the behavior of billions of independent agents (us) in the complex adaptive system we call an economy. This is primarily done through fiscal policy and regulation. Government can apply coercion to the behavior of producers and consumers, either directly or by transferring wealth between them.
- Redefine. Since the economy is something that we as humans have collectively named (somehow), political process can create new meanings and institutions. For example, monetary policy can redefine the value of money. Trade policy can redefine terms of exchange. Environmental policy and courts can redefine acceptable economic activities, and so on.
Whether these nudges and redefinitions will have the desired effects is something that will be sorted out by economic self-organization over time. It is not dependent on political or cultural intent. Economic process is closer in analogy to biological evolution than to a physical machine. But in economic evolution, each cell in the organism has a mind of its own. The good news is that an economy, as an evolutionary self-organizing process, will adapt and try find a new peak of fitness eventually. Otherwise we would not still be here. The bad news is that nothing is guaranteed. There have been and will continue to be many evolutionary dead ends.
So far, human culture and society have eventually found ways to differentiate between nudges and redefinitions that find fitness and those that don’t. That is why we are a complex adaptive system rather than just a complex system.
Trends in Economic Complexity
What concerns me most are the increasing gaps and discontinuities between the simple, complicated and complex aspects or understandings of economy.
For example, Alberta perfectly demonstrates a gap between how we use wealth versus how we create it. In brief, Alberta can only create wealth cyclically, with booms and busts. The private sector adjusts to these cycles quite easily, albeit painfully. The public sector cannot do the same because the public and the politicians want to see a steady supply of services like health care, education, social support and so on. Economically, the private sector finds order through adjustment while the public sector finds order through stability. At one time, Alberta saved money from boom times to subsidize public sector spending during the busts. Gradually, we have spent down this rainy day fund; it’s gone.
Most regional economies in the the world are what we used to call “mixed economies”. This means some combination of private and public efforts at ensuring wealth or well-being. Private efforts tend to proceed through markets. Public efforts tend to proceed through policy. Markets adjust quickly, policy adjusts slowly. Markets are comfortable creating and destroying wealth or well-being. Policy does not create wealth, it just moves it around. However, markets have traditionally not been able to address wealth beyond those things to which we have been able to assign a price. So, if you think of wealth more broadly, you can readily figure out why societies have added policy and markets together in an attempt to bring about economic, social and environmental “well-being”.
As another example, most people have long forgotten the difference between creating wealth and redistributing it. Today’s cultural focus is mostly about redistribution. If you take the simple definition of economics and add up the proportion of the workforce that creates wealth (adjusted for trade) you would arrive at the following conclusion: In Canada, as with many advanced countries, far less than half of the workforce creates the wealth upon which our overall well-being depends. Just ask yourself or your friends: “What did you do create the foundation for our well-being today?” Most people don’t get it.
In Alberta, most people working in non-traded sectors no longer see that their ability to provide valued services (such as health care, education, retail and food service sales) is totally dependent on the traded sectors. In Alberta, these traded sectors are mainly oil and gas, but also agriculture, tourism, forestry and petrochemicals. Without the success of these traded sectors, there would be no foundation for the rest. Too many people have lost sight of this connection, which is so fundamental and so remarkably simple. Or at least it should be.
I have no philosophical or ideological problem with our culture and its political leadership deciding to shut down or limit the traded sectors of our economy. Just a practical one. And I guess I can live with an enduring loose connection between our ability to create wealth versus its use. At least up to a point.
But I do have a problem if we choose to blindly do these things based on ignorance of or indifference to what will inevitably follow. My purpose in writing this article is to stimulate more coherent discussions about economic complexity, through which people can better understand and explore the possible consequences of their beliefs and actions.
What are the key points?
- Economy is the process through which humans use energy to create a form of order that we call well-being.
- At some point, well-being moves beyond what is objectively required (e.g. food, shelter, safety) for sustainability, into what is subjectively desired or preferred by a culture. Lots of choices are available. Political efforts (selection of and agreement to means and ends) to achieve these choices may work or may fail. Evolution is an uncertain process.
- Economic complexity exists because economic processes are only partially understood. Traditional economics is not really a science, simply the best we have been able to do so far in organizing our understanding of its complicated nature.
- Given these limitations, we must remember the simple aspects of our economy that have actually worked (leveraging natural resources and trading) to provide our foundation of well-being. These must be recognized, cherished and preserved until such a time that we are actually ready to abandon them and move on to some different foundation for our well-being.
What we call human civilization has been around for 10,000 years. For 98% of this time, the energy used to create our well-being came from sun, wind and water directly or through biomass indirectly. Dependence on fossil fuels began in earnest about 200 years ago (coal) followed by massive use of oil and gas about 100 years ago. You can argue about the finer points of reserves, extraction methods, and prices that lie ahead. But even in the absence of climate debates and environmental policies, the odds are good that human civilization will have to end its short-lived dependency on fossil fuels before it is another 2% older.
There is a lot of certainty that Alberta’s economy (and most others) will look a lot different in the near future. It has been 70 years since the Leduc discovery. In political time, that’s 20 elections since Alberta’s fossil-fuel economic dependency began. Somewhere between 15-30 elections into the future, our reserves will have been depleted or become uneconomic (because of increased cost or reduced value). I won’t be around that long. But my grandchildren will be. At some point soon, we collectively need to start adapting to a future without shooting ourselves in our present day feet.
So the real question is about what we should be doing soon to help our grandchildren in their self-organization of the complex system we call an economy, while still preserving the simpler parts of the economy that enable them to put bread on the table while they are adapting.