You Are Energy Blind

It's not your fault. Economists lied to you.

Photo by David Underland on Unsplash

The Production Function

There's a little equation, that many people probably don't know about, that has quietly been guiding our lives for about 200 years. Technically it's a function, not an equation, but the function leads to an equation, so I called it an equation. Stop being so pedantic.

The production function is very simple, it predicts how much output you will have (q), based on the capital you put in (K) and the labor you put in (L). Here it is in all its glory.

                                                            q = f(K,L)

For those who forgot their high school math, that reads as output is a function of capital and labor. Capital in this instance is the input of machinery or whatever technology you're using to produce something. It does not stand for money in this instance. Labor is our physical labor.

This function, this formula, this equation worked pretty well. Until it didn't, which is now. If we are being honest, it didn’t work very well from the beginning, but we just didn't notice it.

It didn't work very well from the beginning because it leaves out one big piece of the equation that was always there but never thought to be there until very recently. That's something is energy. But we'll get to that in a second.

The History.

Energy is missing from the production function. How do those laborers get the energy to work? Where does the energy come from to turn that turbine, that steam engine, that machine that does the work?

The production function that's been in economics textbooks for well over a century assumes all you need is a machine and labor. Energy is needed to make that machine and to keep the machine running. Energy is needed to make that labor and keep that labor running.

In this sense, for well over a century economics and in turn our view of the world and of our place in it has been wrong. As Nate Hagens puts it, we are energy blind. I first heard the term energy blind from Nate Hagens, so he gets all the credit. I’m just passing along the message.

If you're not familiar with Nate, he runs a great podcast called The Great Simplification which I highly recommend. Nate focuses on energy and talks to some of the leading lights in economics, science, ecology, geopolitics, and other important disciplines.  He recently had on economist Steve Keen, one of the first economists to realize that our economics was energy blind. Keen has taken a crack at fixing the production function so that it includes energy. I recommend listening to Nate's podcast with Steve. It goes into much more detail than I will. It is about an hour and a half long. It is not for the economic faint of heart. I got lost a few times myself, but Nate does a good job of guiding you through it.

The father of modern Economics, Adam Smith, in his Wealth of Nations, focused on labor as the source of value, largely ignoring the “free gifts of nature” of the sun, coal, water, and other inputs without which, the system could not function.

Hagens and Keen discuss that this was the beginning of our energy blindness. While Smith was writing in an industrializing Scotland, across the English Channel in France, the thinking of the day saw the land as the source of value, as French society was far more agrarian. The bounty from the land in France came of course from the free “gift of nature” of the sun, along with water and the soil.

Smith spent time in France, but it is clear that the energy inputs into a system didn’t register with him as much as did labor.

Keen gives Smith a break, because the laws of thermodynamics, which help us understand the energy use and loss of any system, wouldn’t be well understood for another century. Smith couldn’t have known that there was such a thing as the law of the conservation of energy. The math behind energy inputs just wasn’t on people’s minds in Smith’s time.

By the late 19^th century, Capital (K in the formula) had been added to labor as the main creator of value. The mistake of not including energy as an input in the economic system continued. Error was compounded upon error, getting us to a system today that is just beginning to admit that energy needs to be accounted for.  

What does it mean?

Keen sums things up nicely when he says he realized a simple way to explain why energy needs to be included in the production function:

“Labor without energy is a corpse. Capital without energy is a sculpture.”

This means that we have created an economy and a culture over the decades and for over a century that didn't feel the need to put energy into math. When the reality is if you don't have energy there is no math. Without energy, as Keen says, all you have are corpses and sculptures.

What GDP is, is energy transformed into useful work. The growth in our economies since the Industrial Revolution is primarily explained by increased use of energy, not productivity, capital, or labor.  They all play a part, but it is the massive increase in energy use that was doing the heavy lifting all along. The increasing use of energy is the primary reason we have what we have – from nifty AI chatbots to climate change.

As Keen says, “Fundamentally, human civilization only exists because we exploit energy.”

All labor and capital do is harness energy to produce output.

Some implications.

If our companies and leaders are energy blind, and they don’t include energy in the production function, it is easier for them to claim more credit for output. If that output is only said to come from machinery and labor, (and labor is weighted much higher in the production function) then that labor deserves more of the reward. If the “free gift of nature” is seen as the main reason for an increase in production, then it is harder for a CEO to justify a huge salary. A mistaken production function that doesn’t give energy the credit it deserves leads us down a road of gross inequality. If a significant reason a company grows is just “using more energy”, well no one gets to take credit for that. Putting energy into the production function may just lead to a more egalitarian distribution of wealth. We can’t have that, can we? Energy didn’t have a representative at the table.

If energy had a representative at the table since the beginning of the Industrial Revolution, maybe we would have treated energy a little better, and by energy, I mean nature, where the energy came from. Capital and labor have gotten all the credit since the Industrial Revolution, so they have gotten the rewards. If we had correctly realized for all that time, that the “free gift from nature” or energy was the main driver of our good fortune, maybe we would have developed a culture that valued nature more, and even gave nature some of the rewards for her work, such as reinvesting some of the profits into protecting nature. You don’t protect something you don’t value.

Leaving energy out of the production function also leaves us blind to the negative externalities of not properly accounting for energy. If energy is a “free gift from nature” that we don’t bother measuring, then we aren’t going to bother measuring the negative externalities. We have bent over backward for the past few decades to argue that such externalities don’t exist or are minimal. It is only now, when many of these externalities (climate change, mass extinction, plastic pollution, etc.) are too big to ignore, that we start seeing them.

What to do?

Going forward, we need to be diligent about including all relative inputs into our math. Just as we need to make sure we're diligent about addressing all the externalities that have come from that bad math we've done in the past.

We need our economics to take the world as it is into account. The world as it is includes energy, externalities, and nature. It has been convenient to just ignore those things for about 200 years. But now, that bill is coming due.

As for what we do with economics, tune in next time. If you’ve waited 150 years, you can wait three more days.