What economics gets wrong

Yesterday we looked at the astonishing growth in prosperity since the Industrial Revolution in the 18th century - world gross domestic product (GDP) has increased by almost 9,000% since 1820. That sounds impressive, but is it? GDP is the most common measure of economic growth - it calculates the total market value of all finished goods and services produced in a country in a given year. When a country’s GDP is going up it is considered to be performing well, and when it is going down then something is wrong.

There are a few other things that need to be taken into consideration though. The first is that our population has increased by almost 600% in the same period, so some of that growth has simply occurred because there are more of us. To take population growth out of the equation we can look at GDP per capita - figures from our World in Data tell us that from 1820 to 2018 world GDP per capita grew by 1,281%.

That’s still an impressive figure, but as we previously covered at the same time as our prosperity has increased, so have a number of metrics that measure environmental degradation. So how can it be that such rosy economic numbers mask the true cost of that growth?

According to Johan Rockström, Director of the Potsdam Institute for Climate Impact Research:

We are today a "big world on a small planet" where the economy exerts phenomenal pressure on Earth. There is no free natural capital left. All remaining biodiversity, freshwater, atmosphere, coral reefs, oceans, forests and ice sheets play a direct role in regulating the stability of Earth and thereby the economy.

The trouble is, our economic system was developed, from Adam Smith to Keynes, when we were still a "small world on a big planet". When there were no frontiers and the idea of the global economy affecting the planet was seen as ridiculous. We could emit greenhouse gases for free, empty oceans for free, pollute polar regions for free, without risking invoices being sent back from Earth.

This is no longer the case. In the 1980s the first invoices started coming back – the ozone hole, collapse of fisheries, tipping points in freshwater lakes, accelerated ice melt, shifts in heatwaves and storm patterns. And, as geopolitical fuel, the polluters are seldom the victims.

The issue with using GDP as our primary measure of prosperity is that it fails to take into account environmental degradation - instead the exploitation of natural resources is incentivised in the pursuit of short term gain. In economic theory environmental impacts like pollution are simply considered externalities - a byproduct of another event occurring and generally no cost is assigned to the polluter. In 2013 a report attempted to quantify the cost of top 100 environmental externalities and estimated the economic costs at $US4.7 trillion a year. World GDP in 2013 was $US101.27 trillion so those externalities represent almost 5% of the total.

Sharing natural resources also exposes another issue known as the tragedy of the commons:

The ecologist Garrett Hardin popularized that term in a 1968 essay based on a 19th-century pamphlet by William Forster Lloyd, an English economist. In the pamphlet, Lloyd explained that any individual farmer had an incentive for his cattle to eat as much grass as possible in any field that the community shared. But if all the farmers did so, the field would be ruined. The solution is for the farmers to agree on a set of rules that benefit all of them in the long run.

Delivering the Royal Economic Societypublic lecture in Manchester, Sir Nicholas Stern said “the problem of climate change involves a fundamental failure of markets: those who damage others by emitting greenhouse gases generally do not pay".

So what can we do to try and more accurately reflect the cost to nature in our economic data? Economic theory does provide for a number of corrective instruments in cases of market failure, for example command and control, taxation, and permit markets, but these are not well utilised in practice.

The United Nations Environment Programme has proposed measures including replacing GDP with an Inclusive Wealth Index, accounting for natural capital so countries can track environmental assets like water and energy resources.

As we enter the Fourth Industrial Revolution we need to recognise that the world we live in has changed, and the way that we measure our prosperity must too. We can no longer be consumed by infinite growth - the natural world has only finite resources and we must find a way to decouple economic progress and environmental degradation.