Is it possible that traditional macroeconomics and ecological economics (or sustainability theory) are converging?

Two articles published Sunday morning, April 12, taken together, suggest to me that these fields share an emerging understanding of debt and its essential elements: collateral and leverage. Through these lenses, debt's charge on the future is coming to be understood as never before.

Money & Sustainability

In 1936, John Maynard Keynes observed, "Money and its significant attributes is, above all, a subtle device for linking the present to the future; and we cannot even begin to discuss the effect of changing expectations on current activities except in monetary terms."

In 1987, the World Commission on Environment and Development's Brundtland Report defined "sustainable development": "Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs."

Properly understood, debt links not just the present but the past to the future. By definition it compromises the ability of future generations to meet their needs.

Warsh on Geanakoplos

The first article I read was by David Warsh, "This Time They Are More Interested." (1) It appeared on his invaluable website, www.economicprincipals.com. Mr. Warsh draws on "Leverage Cycles and the Anxious Economy," by John Geanakoplos of Yale University and Ana Fostel of George Washington University in the September 2008 American Economic Review, and a lecture Mr. Geanakoplos gave at the National Bureau of Economic Research last week.

According to David Warsh:

For at least a century, Geanakoplos said, economists have been accustomed to thinking of the interest rate as the most important variable in the economy – lower it to speed things up, raise it to slow them down. Yet especially in times of crisis, collateral demands – alternatively, margin requirements, loan-to-value ratios, leverage rates or "gearing" – become much more important. Everybody knows that when interest rates go down, prices rise. Less widely recognized is that when margin requirements go down – say, the down payment on a house – prices rise too, often even more. Without some form of control, leverage becomes too high in boom times, and asset prices soar disproportionately. When they crash, leverage crashes with them, and then prices suddenly are too low. This is the leverage cycle, Geanakoplos says, and the current crisis is the result of a particularly virulent specimen.... **** And the fundamental insight – that a single loan requires not one but two terms to be negotiated, and that one may become much more important than the other in certain situations was clear enough to Shakespeare four hundred years ago. Wrote Geanakoplos: "Who can remember the interest rate that Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed upon as collateral. The upshot of the play, moreover, is the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral." The trick, Geanakoplos says, is to recognize that the tendency to increasing leverage is part of the process – and that collateralization generates bigger and bigger effects on assets prices as the cycle rolls on, until, in due course, for one reason or another, participants eventually become uneasy with the situation, and the cycle comes to a crashing halt. Then, he says, the Fed, like Shakespeare's judge, should sometimes decree different collateral levels....

Zencey on Ecological Economics

Now consider Eric Zencey's April 12 New York Times article, "Mr. Soddy's Ecological Economy."

Mr. Zencey's piece springs from the insights of Frederick Soddy, an all-but-forgotten Nobel Prize-winning nuclear chemist (1921) who abandoned science for economics:

He offered a perspective on economics rooted in physics – the laws of thermodynamics, in particular. An economy is often likened to a machine, though few economists follow the parallel to its logical conclusion: like any machine the economy must draw energy from outside itself. The first and second laws of thermodynamics forbid perpetual motion, schemes in which machines create energy out of nothing or recycle it forever. Soddy criticized the prevailing belief of the economy as a perpetual motion machine, capable of generating infinite wealth – a criticism echoed by his intellectual heirs in the now emergent field of ecological economics. A more apt analogy, said Nicholas Georgescu-Roegen (a Romanian-born economist whose work in the 1970s began to define this new approach), is to model the economy as a living system. Like all life, it draws from its environment valuable (or "low entropy") matter and energy – for animate life, food; for an economy, energy, ores, the raw materials provided by plants and animals. And like all life, an economy emits a high-entropy wake – it spews degraded matter and energy: waste heat, waste gases, toxic byproducts, apple cores, the molecules of iron lost to rust and abrasion. Low entropy emissions include trash and pollution in all their forms, including yesterday's newspaper, last year's sneakers, last decade's rusted automobile. **** Following Soddy, Georgescu-Roegen and other ecological economists argue that wealth is real and physical. It's the stock of cars and computers and clothing, of furniture and French fries, that we buy with our dollars. The dollars aren't real wealth, but only symbols that represent the bearer's claim on an economy's ability to generate wealth. Debt, for its part, is a claim on the economy's ability to generate wealth in the future. "The ruling passion of the age," Soddy said, "is to convert wealth into debt" – to exchange a thing with present-day real value (a thing that could be stolen, or broken, or rust or rot before you can manage to use it) for something immutable and unchanging, a claim on wealth that has yet to be made. Money facilitates the exchange; it is, he said, "the nothing you get for something before you can get anything." Problems arise when wealth and debt are not kept in proper relation. The amount of wealth that an economy can create is limited by the amount of low-entropy energy that it can sustainably suck from its environment – and by the amount of high-entropy effluent from an economy that the environment can sustainably absorb. Debt, being imaginary, has no such natural limit. It can grow infinitely, compounding at any rate we decide. Whenever an economy allows debt to grow faster than wealth can be created, that economy has a need for debt repudiation. Inflation can do the job, decreasing debt gradually by eroding the purchasing power, the claim on future wealth, that each of your saved dollars represents. But when there is no inflation, an economy with overgrown claims on future wealth will experience regular crises of debt repudiation – stock market crashes, bankruptcies and foreclosures, defaults on bonds or loans or pension promises, the disappearance of paper assets. **** One way to stop this cycle, suggests Herman Daly, an ecological economist, would be to gradually institute a 100-percent reserve requirement on demand deposits. This would begin to shrink what Professor Daly calls "the enormous pyramid of debt that is precariously balanced atop the real economy, threatening to crash."

What Professor Daly suggests is not just increased collateral, but his concept is close enough and directed toward the same end.

Economics: Coming Together

Whether we understand "debt" in the terms of macroeconomics or of environmental economics, it is the same debt created from the same transactions. These understandings could help us mitigate the massive sustainability deficit the leverage binge – which lasted more than 20 years – has left for the future. Separately, they just make interesting reading.

Warsh and Zencey have much more to say than what I've quoted. And, they're worth reading.

Notes

1. I've read David Warsh for at least 20 years. He was a business reporter for The Boston Globe, then its economics columnist. Today he is the proprietor of an essential website and author of a must-read weekly column. He is a first-rate translator of very complicated ideas. He is unfailingly thoughtful, thought-provoking and for someone of my politics, at times, simply provoking. If you do not subscribe to www.economicprincipals.com, log on and then wheel out that credit card.