8.1 Out of equilibrium: crisis and the response offered by evolutionary economic geography
While the current crisis in financial markets has had a terrible impact on economies around the world, sparking mass unemployment, company and government failures, widespread social protest and counter-protest, it nevertheless is a fascinating time to be writing a doctoral thesis on economic and technological change. This is because ours is a society in transition, searching for a new paradigm to make better sense of events around us.
What recent events highlight is the failure of current institutions to sustainably manage the forces of economic change in society. As noted by John Maynard Keynes (1935:383):
The ideas of economists and political philosophers, both when they are right, and when they are wrong, are more powerful than commonly understood. Indeed the world is ruled by little else’.
While this quote from Keynes perhaps overplays the hand of economists as a group, the current crisis represents not just a threat to established organisations. As as households, banks and governments struggle to maintain cohesion in the face of events seemingly outside their control the crisis is is just as much a threat to the established theories and ideologies which informed these agents.
Each person, firm and government agency in the economy carries with them some sort of theory or way of seeing the world which enables them to deal with information and coordination problems and helps enable them to carry out their roles – whether supporting a family, generating profits or pursuing their notion of the public interest. Over the course of time, theoretical constructs have helped inform and build the diverse co-evolving networks of organisations and institutions we observe in the world around us: families, businesses, schools, universities, hospitals, the military and other forms of government all seek to control the elements of the problems that society sets out to solve. Differing theoretical approaches to problem solving and the different objectives defined by each political system go a great way to understand the diversity of social and economic outcomes we observe in the world around us. Faced now with the irreconcilability of events and theory, many of these cognitive anchors have been cast adrift by the force of the crisis.
This crisis is also transpiring at a time when governments are trying to put in place institutional frameworks to manage climate change risks at the national and global levels. As Lord Nicholas Stern and others have noted, the crisis in managing risk in the financial sector and the management of risk in the climate system are inextricably linked. This link is through the co-evolution of institutions and organisations we have to manage risk more generally in society.
There is considerable empirical evidence that people fail to accurately evaluate risk in many arena’s of life (Gigerenzer, 2002; Kahneman and Tversky, 1979). This suggests that it is reasonable to expect institutions to evolve to address this inaccurate assessment of risk. However, as discussed in Chapter 4, a balance must be struck between authoritarian control on one side and respect for non-interference and self determination on the other. The recent crisis suggests respect for the governance powers of self-interested market institutions has suffered a blow; and the pendulum is swinging now towards a more structured approach to regulating market behaviour. However, what is argued for in this thesis is not a return to the old debate of market versus the state – but a more mature recognition that what is needed is not more or less regulation, but better regulation. For while agents may be ‘boundedly rational’ and subject to path dependency, they are also always capable of learning, adapting and innovating to solve the problems of the day. This will be taken up below in the section on policy implications under Brian Arthur’s theme ‘not a heavy hand, not an invisible hand, but a guiding hand’ (1999:2).
This discussion on the importance of the role of economic thinking and teaching in shaping how actors view the world, and engage with it, sets the stage for the aims and motivation of this thesis. Firstly, to articulate a theoretical approach to the study of the economy that provides a synthesis between ‘economic’ equilibrium based neoclassical theory and ‘political’, institutionally rich evolutionary theories. The second aim of this thesis is to show how such a theoretical approach might be set to work to examine the shift to a low carbon economy. Taken together, it is hoped that Parts One and Two of this thesis present a compelling and coherent agenda for the realignment of the mainstream economic paradigm towards greater economic realism and more sustainable growth.
This type of analysis aims to place the focus of enquiry on understanding change in the actual world as it is, rather than in some hypothetical world constructed for the sake of parsimony. Methodologically, it involves a rather straightforwardly descriptive and empirical research programme adopting an amalgam of inductive a posteriori analysis of geographically centred economic trends and commentary on the cut and thrust of politics placed within an historical context (Barnes et al., 2007). This empirical focus is then buttressed by taking a reflexive and pluralistic approach to theoretical conversation with the data by drawing on both equilibrium and evolutionary based perspectives. It is an integrated approach, insofar as it aims to reintroduce political analysis and the normative formation of institutions back into mainstream economics, which tends to take those institutions for granted and as homogenous across nations. It sees economic behaviour as being informed primarily by technologies and institutions, evolving in ways which, while not random, cannot be described fully or perhaps at all by the standard tools of neoclassical logic. Deductive models and theories, when applied, should therefore be context specific.
A significant part of this programme is therefore to investigate the processes of belief formation that informs the behaviour of individuals, firms and governments in the economy. For a complex issue, such as the shift to a low carbon society, the role of politics is central to this task. In most cases, societies learn about themselves through politics, and the process of public debate and discussion, is itself, central to driving change in society (Schön, 1973). Indeed, it can be argued that prices in markets can be seen as being determined as much by the clash of competing narratives of the world as by the interaction of demand and supply (Kay, 2011).
8.1.1 Positivist versus normative ideas in economics
Our theories and ways of seeing the world are built on and shaped by our shifting values: of war and peace; of the relative importance of work versus leisure; our acceptance of collective control over individual freedom; our ideas of justice; of equity and social mobility; and, at the centre of enquiry for this thesis – of our relationship with technology and the natural environment.
Some may argue that it is not the economist’s place to interrogate such normative matters; that they are better left to other disciplines such as philosophy, politics or sociology to deal with. From this perspective, some have made the point that economics should concern itself only with the description and explanation of economic phenomena. “Positive economics is in principle independent of any particular ethical position or normative judgments” (Friedman, 1953). It describes “what is”, as opposed to normative economics, which deals with “what ought to be” (Keynes, 1890).
Thus from the position of positive economics, individual preferences are taken as given, or as exogenously determined. Thus, while changing preferences may have a significant effect on economic outcomes they are only considered insofar as they are reflected or revealed in market transactions – the ‘laws of demand and supply’ rule.
On one level, this approach has appeal because it attempts to divorce economics from subjectivist influences and pushes it towards establishing a set of universal laws or truths with a limited set of axioms based on rational behaviour and competitive markets. Thus, as shown in Chapter Two, different elements of the economic system can be separated out, and their relationships studied. For example, the response of a quantity of a good or service supplied to changes in prices of that or other goods and services; or the relative desirability of carbon taxation over emissions trading under different types of uncertainty.
However, economics is not just the study of the interactions of particles in a controlled experiment, as might be the case in physics or chemistry. Its use as a way of understanding the world is not separate from the evolutionary processes shaping the social institutions we put in place to solve social problems. For example, policies that aim to correct for ‘market failure’ have embedded in them the implicit objective of recreating a state of perfect competition in the economy – a condition that almost certainly does not exist in the actual economy. Thus when arguments are made for ‘letting the market decide’, or for an ‘optimal policy’ this language and its institutional outcome is a product of neoclassical logic. Thus theory does not only have the power to describe phenomena, but also, through the political process and evolution of regulations, it influences the nature of institutions and the behaviour of organisations themselves. We are now confronted with a situation where these theories have created institutions and organisations which can no longer control change in the actual world. This has been revealed by the current crisis and defines the exigency for a new approach.
8.2 Summary of research conducted in this thesis
Chapter One begins by articulating an integrated approach to economic and political change developed by drawing on theories which have been influential in human geography including form political geography; institutional economics; evolutionary economics; innovation studies; the neo-Schumpeterian school; neoclassical economics and behavioural economics among others. Theoretically, the contribution that this thesis makes most significantly is towards to advancement of evolutionary economic geography, a field which to draws together several theories in economic geography and related disciplines, under an active openness to engaged pluralism Barnes and Sheppard (2010). Here this agenda is pursued in the context of the policies and processes inherent in the shift to a low carbon economy.
This approach builds on the research project set out by authors such as Joseph Schumpeter (1933, 1942), Nathan Rosenberg (1976, 1982), Chris Freeman (1987, 2001), Robert Nelson (1992), Frank Geels (2002, 2004) and others to place particular emphasis on the role of 363 technology in driving economic change and its intersection with decision-making, both individually and collectively. This perspective is then brought to bear on the question of the low carbon transformation of society and the analysis of the processes by which the economic landscape – the spatial organisation of economic production, distribution and consumption – is transformed over time (Boshma and Martin, 2007:539).
Placing technology as the central force driving change in the economy, rather than simply modelling it as responding to shifts in factor prices is particularly relevant for the study of greenhouse gas mitigation. This is because emissions are largely a function of various technologies that are employed in the generation of energy. These technologies are also characterised by increasing returns, path dependency and behavioural biases that make low carbon investments often unresponsive to carbon price signals alone. Indeed, it is suggested that a possible answer to the question posed by Ayres (1962:xvii) as to which is the dog and which is the tail when considering price versus technological competition in securing competitive advantage, may relate to the degree to which increasing returns characterise the system under analysis.
Here it is important to note that ‘technology’ is not just seen as embodying a particular object, such as a light bulb or certain type of power source, but also the associated knowledge and behaviours which must be employed for it to be used in society (Searle, 1995, 1999,2001).
In Part Two, this approach is used to provide a broad theoretical setting for the exploration of several case studies regarding the shift to a low carbon economy. Chapter Four sets out to investigate transformation within the market for lighting through the adoption of energy efficient CFLs in Germany and the impact of the phased ban on inefficient incandescent lamps. Germany was chosen as a country to base the case study as it is one of the global technological leaders in lightbulb manufacture, combined with having a relatively tech-savvy and environmentally conscious consumer population. This research also focused on Germany as a result of a research sabbatical undertaken at the Institute of Psychology, Department of Personality and Social Psychology, at the University of Otto-Von-Guericke, in Magdeburg, which facilitated part of the work.
In Chapter Five, the realignment of ‘the market’ in order to incorporate greater environmental values is investigated through a discussion of the case for emissions trading in CO2. This Chapter’s main contribution is to establish emissions trading within the logic of an evolutionary institutional approach as part of a suite of policy options targeted at different stages of the innovation chain (Grubb, 2004).
In Chapter Six the political economy of climate change and greenhouse gas mitigation in Australia is investigated. Australia represents an interesting case study on the shift to a low carbon economy for several reasons. Firstly, it has one of the highest per capita carbon emissions in the world and an economy heavily reliant on the extraction, use and export of fossil fuels. Secondly, climate change has been a heavily contested issue in Australian politics especially leading up to the 2007 Federal election which saw a change in government and significant shift towards stronger action on climate change. Australia also has a modern, dynamic economy with strong democratic institutions which suggests that, if successful at reversing emissions growth, it could act as a positive showcase to the world.
The final chapter of Part Two investigates the political economy of climate change and greenhouse gas emissions in Russia. This case study is particularly significant given that, in addition to Russia being the world’s third or fourth largest national emitter of GHGs, Russian emissions fell by around 51% between 1990 and 2008. One important message from this case study is that it reflects the general conclusion taken from the widely discredited Washington Consensus that institutions matter. While, according to theory, the deregulation of the state-run economy and subsequent shift to a market economy should have boosted the economy, it led to ten years of economic collapse with painful social, economic and political consequences.
Over this period, state assets were cannibalised and sold off for short-term profit as political networks which supported central planning were disbanded creating gaps in the highly coordinated production network. This precipitated what has been termed the disorganisation of the Russian economy, coordinated in significant part by the rise of an armed oligarchy. Theoretically, this Chapter also vividly highlights one extreme case of economic transition and how broader political and economic forces can significantly affect GHG outcomes and drive changes in the structure of the economy. It presents a compelling case study of how the naïve implementation of a policy agenda based on ‘market triumphalism’ with little reference to historical and geographical context sent one of the world’s great superpowers into a spiral of economic decline which was only stopped with the election of Vladimir Putin and reassertion of the security apparatus in 1999.
8.3 Recommendations for policy makers: ‘Not a heavy hand, not an invisible hand, but a guiding hand’
A significant aim of this thesis has been to look at flexibility and stability in the economy within the broader context of the political economy of energy and climate change and integrate equilibrium ideas from standard welfare economics into a evolutionary framework. In Chapter One, the overarching framework of this approach was encapsulated in Figures 1.1, 1.2 and 1.3, emphasising the wide diversity of policy tools available and the need for a clearer sense of policy timing and sequencing to combat the negative effects of lock-in. Now, in this conclusion, a summary of the main insights of this analysis will be drawn out for policy makers. While focusing on energy and climate change, these recommendations have high degree of relevance for other domains of public policy.
8.3.1 A shift in analytical framing: from equilibrium to evolution
The problem of climate change and policy choice is most often seen through the logic of neoclassical economics and the theory of externalities which descends from the standard welfare economics of Edgeworth (1881), Dalton (1920), Pigou (1932), Hicks (1939) and others. Under this approach, policy intervention is usually framed in terms of “correcting for market failure” where the objective is to nudge the economy back towards its natural and ideal state of perfect competition. At the core of this paradigm, so well summarized by Gary Becker (1976) and cited by Kay (2011) are: “the combined assumptions of maximazing behavior, market equilibrium and stable preferences, used relentlessly and consistently, form the heart of the [that is, their] economic approach”.
What I wish to argue here is that the dominance of this approach in economics has unhelpfully constrained the scope of analysis of the shift to a lower carbon economy and our approach to policy choice in general. It does this by focusing attention on too narrow a set of problems, most obviously in the climate context – the perennial policy chestnut, ‘to tax or to trade’. This approach has too limited a scope of analytical tools at its disposal in order to rigorously evaluate other forms of regulation, such as the decision to phase out incandescent light bulbs, which requires an assessment of behavioural and path dependent barriers and requires both qualitative and quantitative analysis in an out-of-equilibrium setting.
In addition, the mainstream approach has a relatively uniform view of the policy requirements across the various stages of the innovation chain, with the focus being on price-based policy in a demand and supply framework. As Acemoglu et al. (forthcoming) have argued, this reliance on a carbon price alone may lead to unnecessary price inflation in energy supply in the short term, as clean energy alternatives are too immature to compete in the market.
It is suggested that a way forward is to adopt an approach which brings the ‘political’ back into the analysis of economy and positions the neoclassical view of the world as an appropriately contextualised and relatively short lived ‘stable state’ within an overarching evolutionary paradigm. This alternative view sees economic behaviour as being primarily influenced by organisations, technologies and institutions, of which the price mechanism is but one (albeit important) institution. These technologies and institutions co-evolve in a way which is highly sensitive to their historical features, so careful description of prevailing conditions is an essential analytical feature of this approach. Therefore all theoretical models, including the standard welfare approach, which can help connect observed phenomena to broader narratives and make sense of large amounts of information, must always be context specific when applied.
Regarding such an evolutionary paradigm, Giovani Dosi (2011) writes:
… such a perspective attempts to understand a wide set of economic phenomena – ranging from microeconomic behaviours to the features of industrial structures and dynamics, all the way to the properties of aggregate growth and development – as outcomes of far from-equilibrium interactions among heterogeneous agents, characterised by endogenous preferences, most often “boundedly rational” but always capable of learning, adapting and innovating with respect to their understandings of the world in which they operate, the technologies they master, their organisational forms and their behavioural repertoires.
And on methodological grounds, it is far from disdaining formal modelling and statistical analysis. The research programme is, however, largely inductive, taking very seriously indeed empirical regularities at all levels of observation as discipline for the modelling assumptions.
The dominance of the neoclassical paradigm has led to the framing of policy choice and ‘action on climate change’ in particular ways. A pre-requisite for action under the standard mainstream approach is to first identify policies in terms of their respective ‘costs on society’ which are put alongside the benefits of the intervention (e.g. Stern, 2006). Importantly, this assumes the foundation of a competitive equilibrium exists and can be used as a reference point. It can be argued that this analytical logic has created an unhelpful narrative in the public domain based on its assumptions in a way that is misleading and may bias decision-making against action to reduce emissions. This problem was recently brought out in the 4th Arrow Lecture of the Committee for Global Thought at Columbia University (2011) in the discussion following Partha Dasgupta’s presentation ‘Persons and time in the welfare economics of climate change’. In response to Dasgupta’s lecture, Jeffery Sachs comments:
The climate change problem does not have to be posed in terms of trading off today versus the future because another thing that is possible is to think about it as a question of what kind of capital society today is going to have in the future. A little more physical capital, or a little more natural capital. So consumption could be held constant in this generation and still take into account climate change. There is no real issue of intertemporal tadeoff between the present generation and the future but rather a question of us as stewards for nature and whether the future would prefer more built buildings and factories or a safer climate. In this case the discount rate is irrelevant, the only rate that matters is the marginal productivity of capital and the damages that would be incurred or avoided on the natural capital side. It is not absolutely clear that the future need pay for this; but our role as stewards for the future is inescapable. Stewardship doesn’t necessarily mean a decline in present consumption. It could mean a different way of effectively leaving capital for the future.
The framing logic of the standard welfare approach is clearly brought out in Dasgupta’s response:
Jeff Sachs is quite right, of course, but the model needs to be articulated if we as stewards want to think about what they [future generations] would like in the form of the capital mix. Jeff Sachs was thinking of a world which is inefficient, where you don’t have to give up anything to alter the mix; and that is fine – it is a win-win situation. In the pristine form that I was presenting the problem, we are not in a win-win situation; there has to be some trade-off.
This exchange clearly highlights the profoundly different conclusions that adopting an outof-equilibrium, evolutionary view of the world (a state of inefficiency, in Dasgupta’s words) can have versus one based on the efficient world of a model, where there has to be tradeoffs.
A practical manifestation of this, which was discussed in Chapter Four, is the ongoing debate around the Porter Hypothesis (Foxton, 2011c). Based on his research in strategic management, Porter (1991) and his colleagues (Porter and van der Linde, 1995a, 1995b) argue that the competitive advantage of firms lies in their capacity for innovation. Neoclassical economists generally assume that, for firms operating in competitive markets, forcing those firms to meet regulatory standards will necessarily push up their costs. However, Porter argued that well-designed environmental regulation can trigger innovation giving rise to economic benefits that may offset the costs of compliance, so called ‘innovation offsets’.
In this case, these offsets could lead to both reductions in environmental damage and boost the competitive advantage of firms undertaking the innovation. For example, advantages could accrue to firms that are first movers in developing a new product or service that is then widely taken up – especially if such products and services significantly increase firm efficiency. Likewise, firms in countries that have strong environmental legislation promoting innovation are likely to have an advantage in that they will be a good position to export the results of that innovation when other countries introduce similar legislation. The Danish wind energy sector is a good example here (Karnøe, 2012).
The counter arguments to the Porter hypothesis (e.g. Palmer et al., 1995:119) essentially start from the assumption that firms typically operate at or near the ‘efficiency frontier’ (perfect competition) minimising private production costs. Furthermore, critics argue that even if efficiency improving investments exist, they argue that requiring firms to undertake these through regulation may ‘crowd out’ other more productive investment. Finally, the critics highlight that there is no reason why governments better understand the potential for efficiency than firms themselves.
This debate is one where inductive arguments based on empirically grounded case studies, (e.g. the ‘Factor Four’ arguments of Amory Lovins (e.g. von Weizsacker, et al., 1997; Hawken et al., 1999) are set against logical statement of deductive equilibrium-based modelling (Jorgenson and Wilcoxen, 1990; and Hazilla and Kopp, 1990).
Research in systems theory has pointed out that ‘regulation’ can either be ‘good’ or ‘bad’ at promoting vibrant profitable industry and what is needed is not ‘less’ or ‘more’ regulation, but better ‘well-designed’ regulation (Ashford, 1993; Porter van der Linde, 1995; Foxton and Kemp, 2006). This body of work has identified several criteria for well designed regulation including: setting strict standards to promote innovation, but with flexibility as to the means; keeping the regulatory focus on desired environmental outcomes, not particular technologies; the use of market incentives to promote continuous environmental improvements; making regulatory processes more stable and predictable, in order for firms to be able to undertake long-term planning; the use of phase-in periods, to enable firms to make investments in new technology in line with normal capital turnover; and promoting innovation at the source of the emissions through input substitution, product reformulation or process redesign (Foxton, 2011c:133-134).
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