What drives an economy in the very long run?

Just a few weeks ago, the Royal Swedish Academy of Sciences announced the decision to award this year’s Nobel Prize in Economics to Paul Romer “for integrating technological innovations into long-run macroeconomic analysis“. He pioneered endogenous growth theory in the early 1990s, with the clear objective of explaining technological progress through economic incentives: he wanted to integrate scientific investigation and technology development into economic theory, rather than just accepting technological change as something important, but external. Almost thirty years later, this initially exotic idea has become the accepted standard description of technology’s role in and impact on economics. This groundbreaking work truly transformed economic thinking and thus showcases a successful innovation in the field of macro-economics.

Triggered by this recent announcement, I’ll endeavour a sweeping look over the last ten millennia and the development of human economic activity. The question is: How did our economies evolve in this very long-term perspective? Or: How did technological change itself change?

Let’s start with Paul Romer then. In his 1990 article on Endogenous Technological Change, he framed technological change as “improvement in the instructions for mixing together raw materials“. This description is very apt for my purpose, in particular as it is perfectly timeless. And it’s clear that technological change is much more than dealing with the tangible world alone.

Still, in order to discuss changes in technological change, I need a little more granularity. That’s what the five economic fuels can offer: raw material, energy, human skills, information, and knowledge. Taken together, they give us the colours to create a vivid picture that fits in Romer’s wider frame. It is this picture that changed over time as the composition of colours changed. Hence we can investigate long-term shifts in technological change by searching for the dominant economic fuels at a given time.

As a temporal yardstick, I’ll employ the Agricultural Revolution, the Industrial Revolution, and the (ongoing) Digital Revolution. These Grand Revolutions act(ed) as gateways that deeply transform(ed) human societies. Inspired by Ian Morris’ “Foragers, Farmers, and Fossil Fuel Users“, I’ll try to depict the basic economic realities prior to each of the Revolutions, and dare an outlook for the future of technological as we go through the Digital Revolution.

The foraging economy

Well before the Agricultural Revolution, humankind had spread across this planet to occupy every inhabitable space. Of course, ideas like money, labour, or capital hadn’t been invented yet, so an economy in any modern sense couldn’t exist in a community of hunter-gatherers. Still, our distant ancestors pursued some economic activity, even though limited to the exchange of food, raw material, and goods. All human activity was powered by human muscle, which of course depended upon food intake. Food was the energy source for this kind of proto-economy, and energy was the dominant economic fuel of that era.

People were where their food was; they stayed close to the sources of their daily meals. And they migrated with those sources, following the seasons in annual cycles. The availability of food and the associated need for mobility constrained population sizes. While populations went through local boom-and-bust cycles depending on food availability, annual population growth rate remained negligible at a global scale.

Overall, the foraging economy was sustainable as it relied entirely on renewable sources. This was the original, the natural state of a human community, where people lived and died in harmony with nature. Or in the words of Thomas Hobbes: Life of man was poor, nasty, brutish, and short.

The farming economy

Around 8,000 BCE, the domestication of food crops and livestock brought about the Agricultural Revolution that transformed the cornerstones of human societies over the course of several generations. Most notable was the tremendous increase in food availability, not just in quantity, but more importantly in predictability. The increasing certainty that food will be available gave rise to the basic concepts of surplus, of storage, of debt and investment; it spawned the general idea of planning for the future.

Of course, the more predictable food supply triggered considerable population growth, but at the same time it promoted (and depended upon) significant changes across human communities. Where foragers lived a nomadic life to follow the seasonal itineraries of their food sources, farmers built permanent settlements. Freed from the need for mobility, and forced to “work the land” to earn their living, farming communities grew in size and created new forms of organisational their affairs. Larger groups supported and promoted specialisation, which reduced waste and improved overall efficiency. However, a specialist of one trade depends on specialists in many other trades to fulfill his daily needs. This increase in interdependencies lead to growing complexity of farming societies.

Energy still was the main economic fuel, but with a twist: human muscle was increasingly supported and complemented by animal muscle. In addition, trading of material and goods gradually gained in relevance. Concepts like money, the zero, and later on double-entry bookkeeping were all essential to expand trade further. Still, technological change was hardly visible, and for millennia, every-day life remained largely unchanged.

While the farming economy supported a tremendous population growth, living conditions for the individual didn’t change very much. They stagnated just barely above subsistence level. Farmers were caught in the Malthusian Trap, where any productivity increase in a society doesn’t benefit the individuals, it is just eaten up by more hungry mouths. No wonder then that globally speaking, the largest economies were those with the largest populations, given that productivity per capita was largely equal –and equally low– all over the globe.

At first glance, the farming economy would seem sustainable, given its reliance on renewable sources. However, it had unprecedented impact on the face of the planet as more and more fertile land was turned into pasture and farm land – and societies that didn’t manage their energy supply and their environment well had to bear the consequences. In his account of “The Collapse of Complex Societies“, Joseph Tainter discussed the energy constraints that limit a society’s sustainability, while Jane Jacobs eloquently argued the importance of preserving the economic habitat in “The Nature of Economies“.

The fossil fuel economy

Only 250 years ago, the Industrial Revolution pushed human development in a whole new direction. Epitomised by the steam engine, coal became the main energy source that powered human activities, in particular in production and transportation. As a consequence, fossil fuels –initially coal, later on oil and gas– became the main driver for the economy.

With this new energy source, food availability increased further and allowed the dramatic population increase we have seen in industrialising countries since the early 19th century. Even more importantly, the economy expanded, as production and trade gained speed and reach. Overall productivity improved faster than populations grew, and as a result, the fossil fuel economy escaped from the Malthusian Trap: average living conditions improved well beyond subsistence level, and national wealth began to grow independent of population size.

Looking at economic fuels, at first glance energy maintained its dominant role. But the exchange of horses for steam-driven horse powers transformed nearly every aspect of life. The focus of human labour gradually shifted from farms (and food production) to factories (and industrial production). New organisational patterns emerged, just think about the factory floor, mass production, or standardisation. While technological change largely originated from a new form of energy, that triggered changes in the use of raw material and required human skills that by themselves gave rise to further technological change: technological change picked up speed.

This acceleration gave the early adopters of steam power a head start; they gained the economic edge that allowed them to race ahead of the rest of the world. First Europe, and later on North-America, benefited from this development, as economic conditions took off in two different directions. Clearly, the fast adopters in the North took advantage of the new technologies for their home economies. However, a large part of their progress depended on resources, such as labour force and raw material, extracted from regions outside their home territories. These regions in many cases were subject to formal colonial rule by the European powers, and were excluded from the technological and economic development that their masters enjoyed. Living conditions in those colonies remained at or near subsistence levels, while the resources extracted from their soil boosted the wealth and quality of life in the industrialised empires to unprecedented levels.

Even without the grave political and economic tensions it created, the fossil fuel economy is unsustainable by design, as it depends on non-renewable sources of energy as essential drivers. In addition, the use of fossil fuels released and continues to release pollutants of many forms that jeopardise the very foundation of all human life on this plane: the biosphere. For all these reasons, and despite the tremendous progress it unleashed, the fossil fuel economy stands to be replaced with a more sustainable way of handling our economic affairs, sooner rather than later.

The information economy of the future …

The Digital Revolution started only about 40 years ago; most of it is still in the future, and little can be known with certainty. It would be presumptuous to pass final judgement on developments that are only just emerging. Still, some of the challenges and opportunities ahead are already clearly visible, as information becomes the next dominant economic fuel.

The significance of this shift from fossil fuels to information can hardly be over-estimated. For two reasons: one is inherent to economic transformation, the other originates from the characteristics of information as a resource. And while the first has already shaped human progress through the Agricultural and Industrial Revolutions, the second is the unique hallmark of the Digital Revolution.

How economies transform

As Jane Jacobs explained (see my short summary of her ideas here), any economy essentially runs on three processes that compete for the available resources: economic expansion (in other words: growth), economic development (what we usually call innovation), and economic self-refuelling (or self-sustainment). While growth and innovation are at the very heart of every economic textbook, economic self-sustainment receives little attention. And that is understandable, as this process runs quietly in the background for most of the time. However, during transformative events such as the Grand Revolutions, the challenges of self-sustainment take center-stage.

Jacobs frames self-sustainment along two basic considerations: (1) self-refuelling itself burns resources, and (2) you need to have the appropriate means to make use of those resources that are available to you. Both considerations have biological connotations. The first represents an economic equivalent to your physiological base rate: Even at rest or asleep, your body burns a few calories to uphold basic functions. Without that minimum energy supply, you will die. For the second, think about your digestive system: You cannot live on just any kind of fuel; for example, you cannot eat coal (regardless of its impressive energy content). The same applies throughout the animal kingdom, carnivores cannot live on a vegetarian diet, and vice-versa.

Against this backdrop, let’s think about an economy that encounters a new type of resource, a new economic fuel that promises lots of potential for future progress and prosperity (like coal in the 18th century and information just a few decades ago). In that situation, you have the promise of and hope for the future, while you are faced with the hard constraints of today:

  • You do not have the equipment, the tools, the processes, the technologies to make use of that new resource immediately – regardless of all its future promise.
  • No matter what you do, you must at all times ensure that your baseline demand is covered with a type of resource that you already have the right equipment for.

Circumstances do not allow you to make the giant leap you’d prefer; but they will let you take incremental steps in that promising direction. And as you go about developing the novel equipment, tools, processes, and technologies required to make use of that new resource, you are faced with a substantial innovation demand.

Now recall Jane Jacobs’s three economic processes: self-maintenance, growth, and innovation. If self-maintenance must adjust to have the appropriate equipment available in the long run, that adjustment must be prepared in the near-term by allocating more resources to innovation. Consequentially, during such periods of massive transformation of an economy, growth will necessarily suffer: You’ll observe slow and negligible growth, potentially stagnation or even recession. Transformation and growth cannot occur in parallel. The growth missed during transformation presents the flip side of the investment necessary to develop and master the new tools, processes, and technologies required to employ that new resource to its full potential.

During the Digital Revolution

We have only just entered the Digital Revolution, and the transformation of our economies has barely started.  The integration of information as the dominant economic fuel will take decades, and while the exact duration and outcome of this stormy period is uncertain, it is nevertheless obvious that technological change takes a new form and direction. Through this period of transformation, innovation will necessarily be focused on building bridges from the old to the new, from fossil fuel economies to information economies. These bridges are essential to ensure continuity as we gradually move away from our legacy systems. And at the same time, these bridges have only temporary utility and value; they are like crutches that you want to get rid of as soon as you possibly can.

Under these conditions of high risk and little certainty, innovation will favour fast experimentation over detailed planning, looking for revolutionary solutions rather than evolutionary adaptations of well-established ideas. Consequentially, we should expect more disruptions, but also more failures. Successful innovation will pursue rough effectiveness rather than maximum efficiency, it will ensure basic functionality rather than optimal performance. That is what you can observe in Silicon Valley: basic functionality wrapped in a scalable business model, quickly tried and tested in the market. The result is either fast success or sudden death, and there’s not much time to think. From the point of view of the fossil fuel economy, with its established markets, industry sectors, and business models, this fast-paced approach seems inappropriate, even flawed. But if you consider that your new product or idea will only have temporary value, and and take into account the wide-open, uncharted landscape of the digital economy, this logic is compelling: Don’t optimise one idea when you can experiment many.

This new mindset of trial-and-error, of fail-fast-and-often is well adapted for times of transformation, but it doesn’t answer the question where to aim: What’s your target? Conceptually speaking, there are only three possible innovation targets: the supply, the use, and the distribution of a resource.

  • For the first innovation target, supply, you might agree that we have already come a long way to generate an incessant stream of information. Today’s social media already made everybody a source of information, and the advent of the Internet of Things will transform everything into such a source. So on the supply side, there’s no shortage. And while our information supply is certainly far from perfect, it is definitely the best developed of the three innovation targets.
  • The second innovation target, use, is work in progress. We are learning, only gradually, how to utilise information for good effect. And we have only begun to understand that our first ideas were not particularly smart. Just consider the advertising-driven business models of the major social media platforms, which promote and abuse addictive behaviours of their users, and the detrimental consequences for our social fabric. Again, this situation is not ideal, but these challenges slowly receive the attention they deserve.
  • Still, I believe that the third innovation target, distribution, must be in the very centre of our innovation efforts. Distribution is more than just the connection from supply to use. Distribution includes all questions of storage and transformation, and those are the essential building blocks to create the bridges from the old (fossil fuel) economy to the new (digital) economy. How to transform information so that it can generate added value in an economy that is essentially built for the production and consumption of tangible goods? And of course: How to gradually adapt that economy to depart from the consumption of tangible goods and venture into the realm of intangible information-based services?

These questions are particularly challenging due to the very nature of information, and its fundamental differences to energy and raw material, the main drivers of our economies so far.

Information – An abundant resource

Food, raw material, and to a large extent even energy are physical, tangible resources. And they are depleted when used: You can use every unit of such a resource only once, and then its gone. That’s the key feature of a rival resource. Along the same lines, these resources are excludable: If you have control over them, then you can exclude anybody else from using it. In essence, these rival, excludable resources are more or less scarce, as there is competition over their use. This competition of course has a direct effect on their value and price, and that’s part of the DNA of our economies so far.

Information, however, has none of those features. Information is neither rival, nor excludable; it is not bounded by physical availability, and it not subject to scarcity either. On the contrary, because you can easily multiply information, and send it around the planet at lightning speed, information is actually an abundant resource. And now, for the very first time, we try to build an economy upon a resource that is not subject to scarcity. This simple reality challenges our century-old convictions about how an economy works, how resources, products, goods, and services are valued and priced, and how those values and prices are likely to develop in the near future.

How do our traditional concepts of resource use, for example, “efficiency” or “waste“, how do those concepts apply to information? What is efficient use of information? Could information be wasted? In addition, the information resource poses entirely new questions that we must find answers for, for example: How can we effectively “delete” or “erase” information? In the end, I wouldn’t expect that abundance is better or worse than scarcity. But for sure, abundance is fundamentally different from anything we have dealt with so far. Time for some very focused innovative thinking.

Finally, according to our economic theory that evolved together with the Industrial Revolution, we understand capital as either land or labour. Both are rival, excludable resources, both are subject to scarcity that essentially defines their value and price. How could we incorporate non-rival, non-excludable resources like information in our economic analysis? Could an abundant resource serve as capital? And how would we make smart investments of such a resource? Well, that might be worthy of another Nobel Prize then.

Outlook

With the information economies of the future, sustainability could come within our reach again. Provided to we learn a few essential lessons: we must find ways to be independent of non-renewable energy sources, we must end the pollution of our environments and clean up the mess we’ve collectively piled up since the Industrial Revolution, and we must achieve all of that with –and for– about 9 to 10 billion people on this planet.

In the following post, I’ll look into the current diversity of the economic landscape around the globe, and the different economic trajectories countries might take into the future.

 

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