The deadly wisdom of economics

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The war in Ukraine highlighted Western Europe’s dependence on Russian energy exports, and a group of mainstream economists decided to examine what might happen to the German economy if Russia reduced effectively 10% of Germany’s energy supply.

Their conclusion, in a working document entitled “What if? The macroeconomic and distributional effects for Germany of a halt in energy imports from Russia” (in German, with an appendix in English), were comforting: a 10% drop in energy would not reduce GDP than one-sixth as much: “economic losses from a -10% energy shock could represent up to 1.5% of German GNE… GNE losses from a Russian energy embargo are small. (Bachmann et al. 2022a, p. 2,8).

In a Vox op-ed, Bachmann and his co-authors observed that there had been “public fear campaigns about the catastrophic consequences of an energy embargo by pressure groups and affiliate reflection”. But they dismissed this “fear campaign” because it “does not meet academic standards” (Bachmann et al. 2022b).

This is unfortunate, because empirical data shows that globally, the relationship between the evolution of energy and the evolution of GDP is 1:1. Figure 1 plots the annual change in energy against the annual change in global GDP between 1970 and 2017, and one fits like a glove. If energy falls by 10%, then, based on historical data, GDP will fall by the same amount.

Figure 1: Graph showing the relationship between the change in world energy in percentage per year and the change in world GDP in percentage per year. The two series are virtually identical. (Steve Keen)

So who are you going to trust – the empirical evidence or the assurances of economists that contradict the empirical evidence?

This situation reminds me of the old Marx Brothers phrase “Who are you going to trust?” Me, or your lying eyes? and the comment on economists by a former chairman of the US President’s Council of Economic Advisers, Walter W. Heller, that “an economist is someone who says, when an idea works in practice, ‘let’s see if it works in theory'”.

Bachmann rejected the claim – confirmed by empirical data – that the relationship between energy and GDP could be one-to-one, based on mainstream economic theory: if the dominant theory applies in reality, then the relationship between energy and GDP could not be one-to-one. He said it this way (I’ll explain the lingo – italicized below – shortly):

Whether markets are competitive so that factor prices equal marginal productsthis then implies that the price of energy also jumps to 1/a and the prices of the other factors fall to zero… this then also implies that the share of expenditure on energy increases to 100%, while the share of expenditure on other factors falls to zero%. We consider these predictions to be economically absurd.

Epoch Times Photo
Figure 2: Author’s graph showing the standard neoclassical model with a high level of substitution between energy and other production inputs, compared to the situation where there is no substitute for energy, zero energy to 100% of current energy supplies. (Steve Keen)

Factor marketsdesignate the markets which fix the wage rate of the workers and the rate of profit of the capitalists. “Competitivemeans that there are no trade unions or employers’ associations involved in wage bargaining or price setting. “Factor pricesdenotes wages and the rate of profit. “Marginal products” means the amount that the last worker (or the last machine) adds to production – if the last hired worker increases production by $1,000 per week, then the wages of all workers will be $1,000 per week. The Greek symbol “arepresents the fraction of GDP that is involved in energy production, and it’s just 4%.

The rest of the paragraph indicates that, according to neoclassical theory, if these assumptions were true, and the neoclassical model of production and distribution is correct, and there was a 1:1 relationship between the change in energy and the change in GDP, so all GDP would be spent buying energy, and wages and profits would be zero.

Since these last two results are obviously false – wages and profits are not zero and energy expenditure is not equal to GDP – Bachmann concluded that, therefore, there could not be a 1:1 relationship. between energy change and GDP change.

Only there is, as shown very clearly in Figure 1. So something else must be wrong. The only two choices are (a) the assumption that “factor markets are competitive” and (b) the model of production and distribution used by mainstream economists.

In fact, both are wrong. The assumption that there are no unions involved in wage setting is wrong. However, unions are much weaker today than they were 40 years ago, so perhaps you could argue that the labor market is “competitive”.

The real problem, however, is the neoclassical theory of production and distribution. It has more holes than Swiss cheese, so I can’t cover them all here (I’ll discuss them in more detail in a technical article). The key to this article is that the neoclassical model assigns a trivial role to energy in production. Bachmann notes that in the simplest version of the model, the so-called “Cobb-Douglas production function…a drop in energy supply by…10%…reduces output by…0.4%”.

This is pure nonsense. In the real world, energy is essential. Energy allows workers and machines to turn raw materials into useful products, and without energy, nothing will happen. As I said in an academic paper, “work without energy is a corpse; capital without energy is a sculpture” (Keen, Ayres and Standish 2019). You can’t replace energy either: if you don’t have energy, you can’t use anything else to run the machines.

Ironically, the production model Bachmann is making fun of – the so-called “Leontief production function”, which generates the dashed blue line in Figure 2 here (it’s Figure 1 in Bachmann’s paper) – matches the empirical data presented in Figure 1. So what Bachmann inadvertently showed is that the neoclassical model of production and distribution is wrong.

Concretely, this means that if Russia blocks Germany’s energy supply, there will be a substantial drop in German GDP. And in general, if a neoclassical economist predicts something, expect the opposite.

Steve Keen

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Professor Keen is a Distinguished Researcher at University College London, author and recipient of the Revere Prize from the Real World Economics Review. His main research interests are in the development of the complex systems approach to macroeconomics and the economics of climate change. He entered politics as the lead candidate in New South Wales for Australia’s new political party The New Liberals. His main research interests are in the development of the complex systems approach in macroeconomics and in the economics of climate change. In an unusual step for a retired academic, he entered politics as the lead candidate in New South Wales for Australia’s new political party The New Liberals.
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