Although GDP is widely used by economists, its value as an indicator of development or wealth creation has been widely criticized. Two points of criticism are of particular relevance. First, GDP doesn't measure sustainable growth, as a country may achieve a temporary high GDP by over-exploiting renewable natural resources. Second, extraction and consumption of non-renewable resources is counted as national income and not (as it should be) as depreciation of capital assets (Repetto et al. 1989; Repetto 1992; Solorzano et al. 1991).

A third criticism of the GDP concept is that it does not subtract activity that produces no net welfare gain, but merely compensates for negative externalities. For example, if a factory pollutes a river, the cost of cleanup adds to the GDP but adds nothing to social welfare. Crime increases the demand for police, which adds to GDP. War destroys people and property, but the military expenditure adds to GDP, as does the postwar reconstruction. This concept is summarized by the self-explanatory titled 'parable of the broken window', created by Frederic Bastiat (Bastiat 2006 [1850]) in his 1850 essay That Which is Seen and That Which is Not Seen1 to illuminate the notion of 'opportunity costs'. It is important to note that in our examples cleaning up the river, catching criminals or winning the war may provide no net (new) benefits, but can constitute important opportunity costs, diverting funds from other more 'productive' (wealth-creating) investments.

Additional concerns are that GDP, as a measure of economic activity, fails to measure well-being and standard of living accurately and doesn't take into account the 'black' (cash) economy, bartering, volunteer work, organized crime, or un-monetized work, such as unpaid childcare, household work by women, do-it-yourself construction or repair work, or subsistence agriculture. There are many more omissions in 'developing' countries, whence international GDP comparisons are potentially misleading. Finally, GDP does not provide information about the disparity of wealth distribution within a country. Certain groups of people within a country might not be benefiting from its economic activity. A high GDP could be the result of a case of a few very wealthy people contributing to the economy, while most of its citizens live at or below the subsistence level. Clearly then, well-being does not necessarily increase as the GDP increases, and we cannot assume that the quality of life is improving just because more money is earned and spent.2

Notwithstanding these criticisms, justified though they are, we continue to utilize GDP as a measure of economic activity - if not a measure of welfare - on the simple ground that 'everybody does it'. Actually there is a better reason: resource consumption, and waste, are intimately related to economic activity of any sort, irrespective of whether it is 'productive' in the sense of creating net new wealth, or simply digging holes and filling them in. Our focus in this book is on the growth of GDP (as activity), not welfare. Limited time and mental resources incline us to let others worry about the vexing problem of how to correct the deficiencies of GDP as a measure of well-being.

In this chapter we expand on the idea that the primary missing ingredient in growth theory (and for that matter in much of macroeconomic theory) is the role of natural resources, materials, energy (exergy) and a thermodynamic quantity known as useful work. It is also curious, in our view, that most neoclassical growth models assume a uni-directional causality, namely that natural resource consumption and use are strictly determined by the level of economic activity, while simultaneously assuming that increasing resource consumption - and its consequences, including declining costs of extraction and processing - do not affect economic growth in return. The origins of physical production in the neoclassical paradigm remain unexplained. The only endogenous driving variables in the original Solow model and its variants were accumulations of abstract labor and abstract capital, plus an exogenous driver variously called 'technological progress' or 'total factor productivity'. In more recent models, the exogenous driver has been endogenized as 'knowledge' or 'human capital', otherwise undefined or quantified. The possibility of a 'virtuous circle' or positive feedback cycle involving the exploitation and conversion of natural resources has, up to now, been neglected.

It must be acknowledged that we see no useful role in this book for optimal - consumption-maximizing - growth theories, for several reasons noted in Chapter 1. Quite apart from criticisms of the usual intertemporal discounting assumption, we distrust the assumption that the economy is always in or very near equilibrium. Nor, notwithstanding 'rational expectations', is the real economy necessarily always in or near a long-term optimal trajectory. In fact, thanks to path-dependence and 'lock-in', there is every reason to believe that the current US economy, and that of the industrialized countries, built as it is on intensive use of fossil hydrocarbon, is nowhere near a sustainable long-term trajectory. Surely the optimal long-term trajectory in these circumstances, must be one that minimizes waste (entropy) generation. That would seem to imply approaching a steady-state similar in concept to the ideas of Herman Daly (1973). However, the implications of such a steady-state would take us too far from the subject of this book, which is economic growth.

Meanwhile, Pigou's observation about the inherent myopia of humans with regard to planning for the future (Pigou 1920) is thoroughly exemplified by the behavior of governments, especially with respect to climate warming. Optimality depends in a fundamental way on the choice of objective function and discount rate. What is optimal for a given nation with a given technology at a given moment in time may not be optimal the next moment, due to unexpected technological or socio-political change. We prefer a semi-empirical approach, with some theoretical support, as will be seen.

Financial End Game

Financial End Game

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