Despite the equation to the right -- annotated in a kind of "field guide" format for when I give presentations on this topic -- this article is a math-free primer on a new piece of economic theory that just might change the world. Allow me introduce you to "Inclusive Wealth."
Technically, Inclusive Wealth is a reform of neo-classical economics, using accounting prices (i.e., substitution prices) to put a monetary value on key capital stocks in nature, the manufactured economy, human welfare, and human knowledge. The core idea: manage all those stocks so that they don't decline over time, and you get sustainability.
Now, some people have a big problem with putting a monetary value on nature or welfare, or with big hairy equations, or with economics in general. But this is the best attempt I've seen yet to fix some fundamental problems in economics that lie at the heart of our current global dilemma.
Fix the economics, and fixing a million other problems in this world that are currently very, very hard to change will get noticeably easier.
First, some background ...
It's an open secret that the world's national accounting systems are screwy. When even China is working very seriously on a Green GDP, you know something must be very wrong with the ordinary GDP -- still the primary number by which the world measures economic progress.
When we speak of a nation's "economic growth," we are usually talking about an increase in the Gross Domestic Product, which means an increase in monetized exchanges in the marketplace. Spend a dollar, a yuan, or a ruble, and up goes the GDP. Plant a potato, mend a sock ... it means nothing in GDP terms, unless somebody pays you to do it. Replacing a stolen car, on the other hand, looks great in GDP terms.
The problems with the Gross Domestic Product have been well known, and mostly ignored, for decades. Efforts to reform the GDP have occasionally made little splashes over the last twenty years, the biggest one back in 1995 by the folks at Redefining Progress (RP), one of a small handful of research efforts around the world promoting some variation on the Index of Sustainable Economic Welfare (ISEW). First introduced by Herman Daly and John Cobb, the ISEW was renamed the Genuine Progress Indicator by the folks at RP. News about it first graced the cover of Atlantic Monthly (If the GDP is Up, Why is America Down?) back in October of 1995. The GPI, which subtracts bad stuff out of the GDP instead of adding it to the total, sends a "things are getting worse" message, showing a downturn since about the 1970s driven by rising environmental costs and social problems. Meanwhile the GDP has been a consistent beacon saying, "Things are getting better and better."
More recently, Canada has proposed reforming its national accounting system, by "diluting" the GDP and making it one among six key indicators. But overall, globally, the GDP is still firmly entrenched as King of All Indicators.
Enter Kenneth Arrow, a Nobel Prize-winning economist from Stanford University, and first author in an international, inter-disciplinary group of world-leading economists and ecologists. After four years of private seminars and debates and drafts, followed by two years of pounding at the door of the mainstream economic journals (who were not so keen on "inter-disciplinary" approaches to economics, even when the world leaders in those disciplines were involved), they finally got the breakthrough paper published.
Are We Consuming Too Much? is a paper that attempts to answer that fundamental question on a global scale, in pure economic terms. It was completed in 2002, but not published till 2004 in the Journal of Economic Perspectives. (It took that long to convince the editorial board to publish an inter-disciplinary paper.) "Are We Consuming Too Much?" also introduces the basic principles of Inclusive Wealth, together with the first attempt to use it with real-world data. For anyone familiar with the recent history of economics and ecology, the list of authors is impressive all by itself: Kenneth Arrow, Partha Dasgupta, Lawrence Goulder, Gretchen Daily, Paul Ehrlich, Geoffrey Heal, Simon Levin, Karl-Göran Mäler, Stephen Schneider, David Starrett, and Brian Walker.
What exactly is "Inclusive Wealth"? It is an attempt to measure the the change in value over time of all the critical capital stocks in an economic system, at constant prices. Natural resources. Ecosystems. Manufactured capital. Human welfare. Human knowledge. Inclusive Wealth is "inclusive" for two reasons: one, because it tries to include everything that actually matters in economic development (which is a first, even for economics); and two, because it includes the interests of future generations. This is a genuine economics of sustainability.
For the big-name team of economists and ecologists who thought this up, sustainability can be defined this way: the value of your wealth, in all its forms, should not decline over time. The next generation must inherit watersheds that still work, infrastructure that isn't collapsing, a store of knowledge (and healthy people who know the knowledge) that's getting bigger and richer instead of smaller and stupider, and so on. You measure sustainability by figuring out whether all those capital stocks are maintaining or increasing their value, continuously. If they aren't, it's time to change your course ... or perhaps to learn to fiddle, so that you are ready for when Rome starts to burn.
The important distinguishing feature of this method is the use of accounting prices, or what might be called the "real price" (though economists do not call it that, preferring the more obscure term "shadow price"). Such prices reflect the actual cost of replacing the asset, and do not vary with changes in valuation by the market. "We are looking for the value of changes in assets," writes one research team about its field project, "and not for the changes in the value of assets."
"Are We Consuming Too Much?" includes a fascinating chart that compares 30 years of traditional economic growth figures (GDP) in a number of countries, with Inclusive Wealth calculations for those same countries, using World Bank and other data. Not surprisingly, the world picture looks very different indeed through this new lens. Middle Eastern and African nations have lost serious ground, in terms of their sustainable wealth, though they have had zero-to-positive GDP growth. India's average of around 3% economic growth over 30 years contrasts with a near-0 figure for change in Inclusive Wealth -- which may help to explain why the rich were so surprised when the poor voted the previous Indian government out of office. The slum-dwellers weren't realizing the benefits of increased GDP from the Bangalore IT sector.
So, assuming you accept my assessment that Inclusive Wealth is a beautiful new theory that fills in some gaping holes in economics and seems to reflect reality better than the current orthodoxy ... what does it mean in practice?
Currently, research teams based at prominent institutions are pursuing region-scale projects in Sweden (Stockholm County) and Australia (Goulburn Broken Catchment, a region of Victoria) to test it in practice. They expect it to take a few years to work out the numbers, since putting a genuine substitution price on everything is no piece of cake. How much would it actually cost to replace the pollinators, for example? How much is local knowledge worth?
At the global scale, if we truly had good measures of changes in our real wealth over time, and could see on our balance sheets how much natural systems or human wellbeing were genuinely worth, we would make very different investment decisions. Indeed, that's already happening, here and there, in a fragmented way, as when insurance companies start tallying up the cost of global warming.
Inclusive Wealth marks the best current effort to integrate such thinking into the mainstream of economics, in a fully integrated way. Could it replace the GDP? Actually, it shouldn't; the GDP does a marvelous job measuring what it measures, which is the level of monetized economic activity. But when Inclusive Wealth matures, it could become the "balance sheet" to GDP's undifferentiated "cash flow statement", and tell us something we desperately need to know: whether our economies are headed in a sustainable direction.
more a question than a comment...
what does it take to get brilliant new measures like this adopted on the broader scale?
Should a campaign be mounted to change the name of the GNP to GFP (gross financial product) -- as that seems to be what it actually is!
Absolutely brilliant, Alan.
I wonder, though, if this definition of sustainability -- "the value of your wealth, in all its forms, should not decline over time" -- doesn't perhaps unintentionally downplay the idea that doing things better might actualy increase the overall stock of welath available to humanity?
That is, I wonder if not declining is the best we can do, and if increasing our wealth in all its forms might not only be a conceivable goal, but one which would be more inspiring?
I know we're a long way off from that day, but still, the goals we set often determine the paths we choose, so why not set the bar higher?
Great post Alan, and I very much liked your comment Alex. This is a somewhat technical comment. Alan, I'm so glad to see an economics term expressed as a sum over time. Information is only in stocks, never in flows. Yet economists routinely express optima as the point where derivatives (rates of change) equal zero - a maximum or minimum. That's nonsense; we need to monitor changes in stocks over time to know what a system is doing. Obtaining information always has a built-in delay. In the case of the planet, that delay can be decades, far too long to try to live in a "just-in-time" economic system. Too much stress, perceived too late, equals overshoot and collapse. It seems that alternative measures of wealth need to include resiliency. Not only must the value of your total wealth not decline over time, but your margins of safety - your resilience - must not decline over time. That is, your odds of catastrophe should not go up - or even better, should go down over time.
Thanks heaps for this post and links Alan. INteresting stuff.
I'd been thinking that the positions of weak and strong sustainability were actually intertwined. Now this project says similar: their outcome is a blend of weak sustainability by allowing substitutions, and strong sustainability by constraining substitutability of critical resources.
When valuing total capital to allow substitutability within and between different types of capital, manufactured capital with relatively enduring and genuine welfare-enhancing values should be distinguished from the bulk of manufactured capital that has very short-term values. (This short-term use problem could be mitigated of course if capital were recovered and reused efficiently, cradle-to-cradle style). This notion of time needs to strongly influence present-day valuations, which in turn influence substitutability between manufactured and natural capital - particularly given increasing rate of technological advances and the fickle nature of consumer demand which compound problems of rapidly diminishing value over time of most manufactured capital.
If all goes well with the inclusive wealth trials, they (we) still have to get public policies in place that address externalities by allocating a market price or otherwise protecting important natural resources for which markets can't work. Hopefully their self-confessed 'conservative' approach will find better acceptance.
Governments are slow to introduce prices on the direct and indirect use of natural capital, partly because they expect it will disadvantage their economy by increasing costs. I imagine a future where some nations form new sustainability-based free trade agreements and erect trade barriers that discriminate against products/nations that don't satisfy minimum sustainability measures.
David FYI risks, resilience are mentioned in this project description, p11
Alan, I'm a physicist not an economist, so I'm probably missing some basic stuff here, but I do have a question about the equation you displayed in the image - it bothered me when I read their paper yesterday.
Why is it that the derivative of the "Intertemporal Social Welfare" (V) with respect to a given capital stock (K_i) at a given time is equal to the "shadow price" (p_i) at that time? Is this a matter of definition, or does it represent some profound underlying equivalence not obvious from definitions?
Could someone post a link to a legible picture of the equation? I'm on 1280x1024 and it's way too small for me to read.
Icelander - just follow the "Are We Consuming Too Much" link - http://cesp.stanford.edu/publications/20397/
that'll get you the full paper, which includes the equation in question (footnote 2). Footnote 2 also, I now see, answers my question: it's a matter of definition of accounting or shadow price. But I don't quite understand why something defined in terms of future utility (the "intertemporal social welfare") ends up defining a price. Maybe somebody with more economics background can explain? Is this a standard definition?
Perhaps I was confused by Alan's use of the same term here: "The important distinguishing feature of this method is the use of accounting prices, or what might be called the "real price" (though economists do not call it that, preferring the more obscure term "shadow price"). Such prices reflect the actual cost of replacing the asset, and do not vary with changes in valuation by the market."
-- in what way does this definition of price based on derivatives of intertemporal social welfare relate to replacement cost? It doesn't seem obvious to me that they're related?!
In economist's parlance, "Shadow Price" is not the replacement price. It's the price you'd be willing to pay for a good whose price may be free or grossly undervalued. For instance, trying to put a value of wilderness and recreation, economists say that the "shadow price" of going fishing is what you'd pay if you had to be an access fee to the trout stream.
Technically speaking, Alan's explanation of the equation terms is not quite accurate. But the "gestalt" of his explanation is, and I think it's this: distinguish stocks from flows. When a flow into the human economy depletes a stock of natural capital faster than it's regenerated, human welfare is going down. When we consume a non-renewable resource faster than we can find substitutes, our wealth is diminishing. When we emit pollutants faster than natural systems can absorb them, our welfare is going down. Our national accounts need to reflect this.
I appreciate very much the comments here, and accept, of course, David Foley's corrective note and confess that I've oversimplified (as usual, I'm tempted to say) in explaining shadow prices. I further confess that I do this relatively often in writing or presenting to general audiences, partly because economic terms are already so obscure for some people that compromises sometimes must made to get even the basic idea across, and sometimes because I think there are confusions and inconsistencies inherent in the concepts themselves. It's not clear yet to me, for example, whether the folks doing "Inclusive Wealth" are consistently using "shadow prices" or true "substitution prices," or whether they are using the best available methodology for a given context. And frankly, despite my background -- some modestly advanced training in economics, plus a stint running an economic policy institute, where real economists tried to explain things well enough to me that I could write grant proposals and make speeches -- I often have trouble keeping up with the fine points myself. "I'm not an economist," I sometimes joke, "but I play one on TV."
There is such a flood of information on this topic of valuation. Sweden alone, for example, has a database of projects whose purpose is to put a monetary value on the nation's natural assets. It has dozens of entries, and they're all using variations on a small bushel of methodologies. We are definitely in the "hundred flowers blooming" period for this work. But the critical thing is, to quote the old saw, "getting the prices right." That is, if you are going to play the monetization game, the price should be as close to "reality" (that is, how much money would actually have to be laid on the theoretical table, and not how much folks "feel like" spending) as possible.
To Arthur's question: I'll probably get this wrong, and I recommend that you pose the question to Partha Dasgupta (if you can get his attention) or another economist-author of the paper on "Are We Consuming Too Much?" But my understanding is that the prices are being used to derive intertemporal welfare, rather than vice-versa. So yes, it is a matter of definition. More than that, I cannot say, and I'd be glad to hear from others whether I'm right or wrong on this.
You'll note that I have made a theme, in this comment, about treading into economic territory where non-mathematicians and non-economists fear to tread. I stick my neck out on these topics because I think we must. We must cross disciplinary boundaries (my actual training was in philosophy), and especially into economics and economic policy, which drives so much of the world. Physicists, for example, are enormously well equipped to at least comprehend the language of economists, and one of the best critical books I've read on economics recently was written by a prominent plate tectonics geologist. (The book is Economia, the writer Geoff Davies, the URL is http://shop.abc.net.au/browse/product.asp?productid=159924.) He holds economics up to the standards of science and notes that it is decidely mediocre: theories are not tested, or untestable, or not discarded when disproved, etc. etc. etc. We need more such talk about the dismal-yet-powerful science.
Finally, to Alex -- I couldn't agree more with your comment. The equation would of course reflect improvements in all capital stocks as increases in intertemporal welfare ... and it's a sign of the times that people are still more likely to define sustainability in "de minimus" terms, rather than in lovely bright green hard core optimism. But maybe that's what sustainability is -- not screwing it up = "sustainable development" -- and when things get a lot better, that's something else. "Really wonderful development," perhaps.
I'm continuing my own explorations into Inclusive Wealth, getting some clients interested, and most of all trying to get more economists and government leaders interested, so I welcome this interest, and -- since I'm in contact with the two leading research teams -- will post updates on what I learn.
-- Alan AtKisson
PS One more, in answer to the first question ("what does it take to get brilliant new measures like this adopted on the broader scale?"): A lot of time, patience, many bricks in the wall of research. Definitely not a campaign, at this stage ... Campaigns for the GPI, for example, didn't work because the measure was too new and not "robust" enough to survive the critique of mainstream economics. In my view, what's needed is more and more questioning about economic growth as the purpose of human life. But that's another topic ... and part of what I plan to speak about at a pre-G8 seminar in Edinburgh next week. More on that later.
Hi Alan, thanks for the clarification as far as you can! At least from the paper "intertemporal social welfare" is nominally defined in terms of an integral over future utility (which makes sense from what it's supposed to mean) and the price then seems to be derived from it, relative to the dependence of this social welfare number on each component of capital stock. But I agree they don't really seem to be using these definitions in the comparative tables that make up the most interesting portion of the paper; mostly with caveats about the prices as you point out.
I can see how future utility could be pretty impossible to determine now anyway - who knows what will be useful in the future. So does this somehow boil down to a sophisticated justification for something that makes sense, but actually means something quite different? Might be worth bothering the authors about that... I just wish I understood the stuff behind it better...
The problem is when you start adding in other factors you also have to add those factors all over again into the very products and services your rilling against.
What is the VALUE of a large car to someone with leg or back pain or reduced range of motion?
What is the VALUE of movement?
What is the VALUE of entertainment.
blah blah blah.