An integrated ecological macroeconomic model

Karl Seeley Hartwick College March 7, 2013

Abstract Standard macroeconomics minimizes or omits the role of resources in the economy. I argue that this omission rests on: a confusion between land and resources; an overly abstract view of technology that mischaracterizes the relationship between technology and resources; and a tendency to look at the stocks of resources a country has or the ow it produces within its borders, rather than the ow of resources it uses in its economy. I then propose a new theoretical approach for integrating resources into the production function in a way that is both realistic and tractable. The key ideas are: evolving complementarity of labor and resources; supply curves of currently available resources shaped through the interaction of harvest or extraction with innovation and investment; and outcomes being determined by the interplay of resource supply, labor supply, and labor productivity, with resource use playing an important role in labor productivity. I compare the implications of this model with those of a standard non-resource approach, including the eects on output, employment, and wages of a short- or long-term reduction in resource availability. The paper also applies the new model to questions about the role of resources in the history of economic development.
Thanks to Charles A.S. Hall for valuable feedback on an early version of this work and to participants at the Second International Meeting of Biophysical Economics at SUNY ESF in Syracuse, NY. More at http://thedanceofthehippo.blogspot.com

Introduction

Complaints about macroeconomics are nothing new, even from within the eld, and particularly since the nancial meltdown of 2008. Perhaps the best known of these is Paul Krugmans [49] widely publicized complaint in the New York Times Magazine, while Steve Keens [46] critique in the Australian journal Economic Analysis and Policy may be representative of professional critiques with a much smaller audience. Krugman is arguing against the cutting-edge mainstream macro that has left behind some of the tools from after World War II that Krugman still nds useful; Keen is making a case for the inadequacy of the IS-LM structure that Krugman more or less accepts. Herman Daly provided a vivid statement of an even deeper critique of macroeconomics in talking about the emphasis on the circular ow model without consideration of what it is that makes the circular ow . . . ow: It is as if the preanalytic vision that biologists had of animals recognized only the circulatory system and abstracted completely from the digestive tract. . . . The dependence of the animal on its environment would not be evident. It would appear as a perpetual motion machine. [12, p. 256] There is a small minority of economists for whom the fundamental role of resources in economics is self-evident. The simplest statement of this view would be that rich countries are rich because they use lots of resources. The answer from the mainstream is that rich countries use lots of resources because, being rich, they can aord them. The model in this papers arises from the sense that both those positions are true. Its starting point is roughly what Gordon [30] refers to as 1978-era macro, in contrast to the modern macroeconomics developed since then not because thats necessarily a better representation of the economy than are, say, various heterodox alternatives, but because its the workhorse of collegiate textbooks for intermediate macroeconomics. My hope is that building ecology into this particular modeling approachgrafting the mainstream synthesis onto an ecological rootstockmakes it more accessible to other economists and more likely to gain acceptance. It also results in a model that is conceptually tractable for instruction at the intermediate undergraduate level.1
Section 8 will discuss briey how a similar approach may be combined with other macroeconomic perspectives.
1

My core aim here is to improve the performance of Gordons 1978-era macro with respect to the understanding of the role of resources in the economy. The resulting model has additional attractive features: It claries the relationships among resource availability, potential resource availability, investment, technology, labor productivity, labor demand, and output. As mentioned, the model is conceptually tractable for instruction at the intermediate undergraduate level. It provides theoretical insight into consequences of dierent kinds of innovation and investment or various scenarios of changing resource availability. At the users discretion, it allows much or little room in the long term for resources to be replaced by capital, technology, or labor. It illustrates the historical role of resources in economic growth and prosperity. It can generate empirically realistic short- and long-run responses to resource shocks without resorting to sticky prices, though theres no impediment to incorporating sticky prices if an analyst considers such an approach to be warranted. Section 2 reviews the key elements in the existing literature pairing macroeconomics with resources. Section 3 lays out a bare-bones neoclassical synthesis, with business cycles as demand-driven deviations around a long-run trend resulting from supply factors. (This may be skimmed by many readersit is simply there to establish the notation that will be modied later for the resource-inclusive model, and for comparison with that model.) Section 4 makes the case for including resources in macroeconomic analysis, in part by critiquing the reasons for their omission from the mainstream approach. Section 5 is the core of the paper, beginning with the manner in which resources are incorporated, then revisiting the basic model from section 3, rst in its long-run implications, then in the eect on the tools of short-run analysis. Section 6 claries points of divergence and similarity in the policy advice that follows from this model compared to a more standard one, while section 7 applies the new approach to some of the literature on the role of resources in 3

economic history. Section 8 looks at additional potential applications of the model, and section 9 wraps up.

Literature

21 years ago Herman Daly laid out four principles for macroeconomic policy that acknowledges the environment [11]. First, limit human scale (throughput) to a level within carrying capacity. Second, technological progress should be eciency-increasing rather than throughput-increasing. Third, renewable resources should be exploited on a sustained-yield basis, not driven to extinction. And fourth, nonrenewable resources should be exploited at a rate equal to creation of renewable substitutes. Ten years later, Jonathan Harris in [39] restated traditional macroeconomic goals, and emphasized the importance of an ecological perspective in meeting them. He rst lists economic stabilization which, as he observes, is often mistakenly considered to be the only appropriate task for macroeconomic policy. The next two are distributional equity and broad social goals (such as income security and universal health care). The last is providing a stable basis for economic development, in which he is careful to rephrase growth as development. While Daly and Harris are both clear on the economic importance of resources and ecological considerations, their focus is more on policy objectives than on analytical tools for clarifying the role of resources. But the inclusion of the environment in our understanding of the economy has a long history. In the writings of the classical economists, land is one of the three fundamental factors of production, along with labor and capital; Thomas Malthus even (unintentionally) gave his name to the idea that resource limits are a binding constraint on prosperityat least, prosperity for the unwashed masses. The marginal revolution of the late 19th century dropped land from the analysis and focused on labor and capital. Ever since, questions of resources, pollution, and ecosystems have been sub-disciplines, sideshows, and quests reminiscent of Ahabs pursuit of the great white whale. (A good overview of this history is provided in [35, Ch. 4].) The jump in oil prices following the Arab-Israeli War of 1973 seems to have caused a spike in interest in resource questions, and among the early fruits were some work in which a conventional growth model has been tweaked to include a nonrenewable resource. For example, Koopmans [47], Stiglitz [71] 4

and Hartwick [41] are all trying to dene the optimal path for the extraction and use of a nonrenewable resource. They all depend on what Toman [72, p. 31] refers to as the simple capital-resource substitution story in the natural resource depletion models of the 1970s. A dierent tack looked at sustainability in the context of standard models of growth or trade, often with endogenous growth, but replacing the optimal exhaustion of a nonrenewable resource with the optimal or feasible transition to a sustainable level of using a renewable resource. (In some, the renewable resource is the environments capacity to absorb wastes or recover from damage, but that doesnt change the basic math.) Examples include Smulders and Gradus [67], Ulph and Ulph [73], and diMaria and Smulders [25]. They also tend to portray environmental protection as a cost that limits growth, because the ability to harvest resources or use the environment as a sink is portrayed as an input in the production function. These works, like the ones mentioned earlier on exhaustible resources, are either normative or in the nature of possibility theorems. They dene an outcome or path that is optimal or possible, in terms of a highly simplied specication of resources and/or pollution. A large part of the eort to measure the sustainability of economic growth comes under the umbrella of the environmental Kuznets curve, or EKC. This extensive literature starts with Grossman and Krueger [33], who make the claim that, at least for some pollutants, environmental impact rst increases with increasing wealth, then reaches a turning point and starts to decrease with further increases in wealth. The research since then suggests an EKC eect as a pollutants impacts are more localized and as substitutes are available at moderate cost. For instance, CO2 shows at best a weak EKC eect, which is consistent with both the global impact of CO2 and the diculty of substituting away from energy use. The entire line of EKC research is questioned by Stern [70], who claims that the econometrics behind EKC estimates are not robust. A dierent line of work focuses not on a specic question such as sustainability or the optimal path of nonrenewables extraction, but aims rather to restore resources to their former place at the core of economics, bringing them in from the intellectual ghetto. Part of this impetus came from ecology, as exemplied by Howard Odum in [58], a book that analyzed energy ow in ecosystems, whether human or non-human. About the same time, the economist Nicholas Georgescu-Roegen [27] emphasized the importance of sources of low entropy for the economic process. The two strains were brought together in [34] (the rst author, Charles A.S. Hall, had been a 5

graduate student of Odums). The logical endpoint (for now) is the portrayal of an economy as being like an ecosystem, not merely in its necessary obedience to the 1st and 2nd Laws of thermodynamics, but in its structure, organization, and ways of developing ([4, 64]). Documentation of the kind of relationship between resources and the economy described in [34] can be found in Cleveland and Hall [10], or Brown et al. [8], or Ayres et al. [2], or by combining data on ecological footprints from the Global Footprint Network [28] with GDP per capita or with a broader measure of well-being such as the Human Development Index from the United Nations Development Programme. In a slightly dierent direction, there are extensive computer-based simulations of an economy with resources integrated and playing a major role, such as Meadows et al. [54] or Idenberg and Wilting [43]. Simulations grounded more in Hall et al.s vision of the economy in [34] can be found in Hall et al. [36]. Within the discipline of economic history, there is a considerable literature arguing over the role natural resources in growth, both historically in the rise to dominance of the worlds rich countries and currently in the developing world. For instance, Pomeranz [61] portrays a pre-modern world in which China is ahead of Europe, with Europe able to catch up and then far surpass China because of the resource windfall represented by its colonial control of the transatlantic world. In response, [45] and [19] relegate resources to at best a secondary role in this process. Mokyr in [55] and Wood in [74] take a similar position more generally, with non-resource factors being the key determinants of economic history and development. In addition to the connection between resources and long-run growth, there has been considerable focus on business cycles and resources, specically the role of oil prices as possible drivers of economic uctuations. James Hamilton has made seminal contributions to this literature, starting with [37] and continuing with many more works through at least [38]. A common approach in his work and others following him is some sort of vector autoregression model or error-correction method, with an indicator of the business cycle as the dependent variable and a measure of the oil price on the right. Early eorts simply looked at changes in GDP and changes in ination-adjusted oil prices, but the quest for more robust estimation led to allowing asymmetrical eects of price hikes vs. declines, and then increasingly subtle ways of incorporating the oil price, such as only looking at levels that were new highs compared to the previous three years. This literature often doesnt specify a production function; the theoretical 6

motivation for including oil prices is verbal and rests on some combination of oils role in production, the eect of high energy prices on disposable income, stickiness in labor allocation that has been necessitated by the uneven eect of oil prices on dierent sectors, and possibly counterproductive responses from policy-makers. Some, however, do have an explicit production in which case it is characteristic that resources and labor are substitutes, as in [6] (and in contrast to the current paper, as will be explained in section 5.2). In [52] and [14], sectoral impacts are the main transmission belt from higher oil prices to lower output. In [63], the reliance is on imperfect competition and the resulting markups. Rasmussen and Roitman in [62] implicitly emphasize the demand-side eect, in which a growing global economy pushes up the price of oil, rather than a supply eect, in which inadequate growth in oil supply pushes up the price, in turn slowing economic growth. And [9] focuses on the role of the eciency wage. Within this literature, Daniel [13] is notable for treating the quantity of resource use as a component of what is usually lumped together as technology, as with the Solow residual, but there doesnt seem to be be a theoretical basis for the determination of the quantity of resources used. Even closer to my work is Moroney [56], who econometrically relates resource use to labor productivity, though as with Daniel [13], there isnt a model that explains how the economy chooses the quantity of resources to use. Gordon [31] includes resources as a type of supply shock in the context of a Phillips-curve analysis, one of many possible scenarios that can cause an upward shift in the tradeo between unemployment and ination. This will turn out to resemble one implication of my work (see section 5.5), though Gordon reaches it by a dierent route. There are some existing models in which resources and labor are allowed to be complements rather than substitutes, examples being Aghion et al. [1] and Natal [57]. But these have signicant dierences from the model in this paper, as will be discussed in relevant places later in the paper. Hall and Klitgaards recent textbook [35] is a thoroughgoing resourcebased treatment of the economy, adapting the approach of [34] to the macro classroom. But Hall and Klitgaards want (with some justication) to replace standard macroeconomics, as opposed to my program of improving standard macro by the inclusion of some basic ecological realism. In contrast, the thread started by Heyes [42] bears a stronger resemblance to the present work, to the extent that it aims explicitly at bringing resources into conventional textbook macroeconomics. The theoretical approach, however, is markedly 7

dierent. Heyes added an environmental constraint to the existing goods-market and money-market equilibrium lines of the standard IS-LM model, producing an IS-LM-EE framework. The model looks at a generic pollutant and considers the pollution intensity of production. Three features of Heyes construction are important here. First, pollution intensity and capital are assumed to be substitutes. Since a lower interest rate allows the creation of more capital, it also enables a higher level of output without exceeding the environments regenerative capacity. This shows up as a downward-sloping EE curve added to the standard IS and LM curves plotted in r Y space. Second, there is no automatic adjustment process to keep society on the EE curve; rather, policy makers must be cognizant of the new curve and its meaning and must adjust their combined scal and monetary policies accordingly. Third, a more diminished environment regenerates more slowly (in this case, the regeneration rate is a linear function of the state of the environment). A promising feature of the model is that a diminishment of the environment reduces regenerative capacity and thus moves the EE curve left, resulting in a more stringent constraint for maintaining environmental equilibrium. Institutional and regulatory factors can reduce the intensity of environmental inputs in production, shifting EE to the right. Nonrenewable resources are not included. Pushing back the other way, a short-term equilibrium to the right of EE thus shifts the next periods EE curve to the left, and has the intuitively sensible result that short-run economic development beyond the ecological carrying capacity reduces the long-run sustainable development of the economy. [42, p. 7] Lawn ( [51]) extends Heyes framework by adding a parameter to capture spillover of environmental eects and a parameter of technological progress which makes it easier to substitute capital for environmental inputs. To convert the Heyes framework into practical policy, Lawn introduces the idea of permits for a limited amount of throughput, along with liability bonds against the possibility that economic activity will have environmental impacts not suciently accounted for by the throughput limitation. Sim ( [65]) takes this structure further, citing evidence that environmental damage does in fact impede growth, as environmentally provoked sickness reduces worker productivity; Sim argues that this represents a plausible automatic equilibrating mechanism. He modies the Heyes/Lawn structure by adding an output gap, but instead of the conventional measure comparing observed output to potential output indicated by long-run equilibrium, this 8

output gap compares observed output with the level that is environmentally sustainable. In addition to the losses of productivity due to environmental harm, there is assumed to be an increase in regulation in response to excess output. These (semi-)automatic adjustment mechanisms are incorporated into the equation of the IS curve, ensuring that the economy will be at the intersection of all three curves (IS, LM, EE), even without the policy makers having and using the extensive information necessary to achieve environmental equilibrium in Heyes and Lawns versions. While the work of Heyes, Lawn, and Sim is interesting, it implicitly equates macroeconomics with the IS-LM framework and thus with a shortterm, demand-side approach (analogous to how [39] observed that economic stabilization is often taken to be the only legitimate goal of macroeconomic policy). The crucial dynamics of resource availability and use over the long term are neglected, and even within the terms of the models, the representation of resources and the adjustment mechanisms around them are not very convincing. The model that follows aims to capture some key aspects of resource availabilityfar less than are reected in the complexity of something like [54] or [43], but with greater realism than in work such as [47] or [67]and incorporate them into a model that will feel familiar to a broad selection of macroeconomics instructors. But rst I summarize the model Im modifying, both to establish a common baseline and to make clear the notation before I start changing it.

The standard approach

The standard neoclassical approach to macroeconomics combines a long-run model based on supply factors, with deviations around the long-run trend, driven by forces of demand. Gordon deals handily with the inadequacies of modern macro in handling the relationship between nancial meltdown and the real economy.

3.1

The long-run, full-employment model

The long-run model is built around a production function, where aggregate output Y is a function of capital, K, labor, N , and some technological parameter, A. The most common way of combining these factors is a Cobb-Douglas function, such as 9

Y = K (AN ) .

(1)

The production function yields a marginal product of labor (MPN), which in turn is the basis for labor demand, N d , which is a function of the real wage, w. Demographics and peoples leisure/labor preferences determine labor supply, N s , which is also as a function of the real wage. Equilibrium in the labor market is dened as the wage w such that N d (w ) = N s (w ), (2)

leading to equilibrium labor input N , as shown in Figure 1. (Figure 1 here) Using that quantity of labor in the production function yields potential output Y : Y = Y (N ). (3)

The equilibrium level of employment in a sense tells us the natural rate of unemployment, u , which is also related to the concept of the non-inationaccelerating rate of unemployment (NAIRU). Potential output grows along with capital, technology, and the labor supply. Output per worker y grows along with capital and technology.

3.2

The short-run

The long-run or full-employment equilibrium determined above can be thought of as potential output, the amount the economy should produce when all markets have had time to clear. This level of output serves as a kind of anchor for the short-run analytical tools, which are used to explain deviations from potential output over the course of the business cycle. Well look at three workhorses of standard business-cycle modeling: the IS-LM framework; aggregate supply and aggregate demand; and the Phillips curve. The IS curve represents all the combinations of output Y and the real interest rate r for which the output market is in equilibrium. Higher output requires higher expenditure in order for equilibrium to be maintained, which in turn implies a lower real interest rate. The slope is thus determined in part by the interest-rate elasticities of investment demand and any exchange-rate 10

eects passing through to gross exports; the tax rate also aects the slope. Lateral shifts come from changes in autonomous consumption, autonomous investment, changes in gross exports not related to the exchange rate, and changes in government expenditure. The LM curve traces the combinations of Y and r for which money supply and liquidity demand are in equilibrium, where liquidity demand is a function of the nominal interest rate i and expected ination e , or of the real interest rate expressed as r = i + e . Theres generally a positive relationship between Y and r, with dierent slopes depicting a range of possible monetary regimes.2 Planned expenditure, or aggregate demand, is determined by the intersection of the IS and LM curves, and it can deviate from potential output because of changes in any of the components of either curve. Figure 2a shows a pair of IS and LM curves in levels of output, but quarter by quarter, potential output is shifting to the right, so one of the curves could be increasing, but not by enough to keep up with growth in potential output. Thus it is sometimes more useful to show the IS nd LM curves in terms of percentage of potential output. In such a representation, as in gure 2b, an economy with stable growth would have relatively static IS and LM curves. (Figure 2 here) The IS-LM framework feeds into the model of aggregate supply and aggregate demand. Output is plotted on the horizontal axis against either the price level or ination on the vertical axis. Aggregate demand, or AD, is the planned expenditure level indicated by equilibrium in the IS-LM model. This slopes down like a well-behaved demand curve; when youre representing AD in terms of the price level, this is because higher prices reduce the real quantity of money, shifting the LM curve to the left and bringing the level of planned expenditure down with it; if youre treating AS-AD in terms of ination, then the negative slope of the AD curve is grounded in the idea that the monetary authority will respond to ination with a more restrictive policy, again shifting the LM curve to the left. Figure 3 illustrates a basic AS-AD structure, in this case with ination on the vertical axis. (Figure 3 here) There are two dierent types of stories that can be told to explain the upward-sloping aggregate supply curve. The rst type goes from higher prices
See, for instance, Brad DeLongs classication at [18], including one that slopes down rather than up.
2

11

or higher ination to greater output. It relies either on sticky wages, or else on exible wages but with workers who incorrectly perceive higher nominal wages as higher real wages. In either case, a higher price level or an increase in ination results in a lower real wage, thus higher employment and higher output. The second type of explanation for the upward slope of the AS curve works in the other direction, from higher planned expenditure to a combination of higher output and higher prices or ination. In this story, changes captured in the IS-LM model cause households and rms to spend more. The economy generally responds to this expenditure with a less than onefor-one increase in output, whether because rms dont think that increased output is worth the risk, or because they cant increase output as much as expenditure. Whatever the reason, an increase in expenditure that isnt fully matched by an increase in output will lead to an increase in ination or the price level. To the extent that there is at least some increase in output, this in turn gets partially respent (the basis of the Keynesian multiplier) and this expenditure in turn leads possibly to a further expansion of output, and so on. The fully Keynesian AS curve is horizontal (output can change but prices are sticky), while the classical curve is vertical (prices are exible but output is determined on the input side). In the real world of the 1978era model, the AS curve is neither perfectly at nor perfectly vertical but has some sort of slope, steeper or atter depending on circumstances. The nal piece of the short-run model to discuss here is the Phillips curve. This is graphed with unemployment on the horizontal axis and ination on the vertical. A Phillips curve is anchored on a point dened by the natural rate of unemployment u and the expected level of ination e . Although it slopes down to the right, it is in eect an aggregate supply curve: a move to the right implies higher unemployment and thus lower output. (Figure 4 here) The Phillips curve can be combined with a curve showing the monetary policy reaction function (MPRF), and although it slopes up to the right, it is essentially an aggregate demand curve. It captures the idea that the monetary authority will react to higher ination by restricting the money supply, resulting in higher unemployment. A central bank that reacts strongly to hints of ination will produce a relatively at MPRF, while a more tolerant bank will produce a steep one. Figure 4 shows both an MPRF and a Phillips curve with its anchor points of expected ination and natural unemployment. 12

Since the Phillips curve has those two anchors, changes in either of them will move the curve. Prolonged experience of ination will raise expectations, as can policies thought likely to eventually generate higher ination (this second eect is more true the more one accepts the idea of rational expectations). Meanwhile, structural changes in the labor market may raise u . Increases in e and/or u are in eect negative supply shocks that will shift the curve up and/or to the right, creating a less favorable set of trade-os for the economy. The Phillips curve framework can also be used to represent dierent ways in which expectations are formed, with the curve moving instantaneously under rational expectations, slowly under adaptive expectations and (at least for a while) not at all under static expectations. All three of these short-run toolsIS-LM; AS-AD; PC-MPRFare centered around either potential output Y or natural unemployment u . Together, they provide a way of modeling deviations from those levels along with changes in the interest rate and the price level or ination.

Why resources are neglected

As discussed in section 2, there is extensive evidence that resources play a key role in the creation of wealth and thus in the economy. Yet the recognition of that role is a distinctly minority view. There are at least three types of reasons for the mainstream neglect of resources importance: A focus on land specically rather than resources in general. An excessively abstract view of technology and capital that mischaracterizes the relationship between them and resources. A confusion between the availability of resources with a country and the quantity of resources actually used by that countrys economy. All three are present in a representative textbook, worth quoting at some length [50, p. 380]: Other things equal, countries that are abundant in valuable natural resources, such as highly fertile land or rich mineral deposits, have higher real GDP per capita than less fortunate countries. . . . But other things are often not equal. In the modern world, 13

natural resources are a much less important determinant of productivity than human or physical capital for the great majority of countries. For example, some nations with very high real GDP per capita, such as Japan, have very few natural resources. Some resource-rich nations, such as Nigeria (which has sizable oil deposits), are very poor. Historically, natural resources played a much more prominent role in determining productivity. In the nineteenth century, the countries with the highest real GDP per capita were those abundant in rich farmland and mineral deposits: the United States, Canada, Argentina, and Australia. As a consequence, natural resources gured prominently in the development of economic thought. In a famous book published in 1798, An Essay on the Principle of Population, the English economist Thomas Malthus made the xed quantity of land in the world the basis of a pessimistic prediction about future productivity. As population grew, he pointed out, the amount of land per worker would decline. And this, other things equal, would cause productivity to fall. His view, in fact, was that improvements in technology or increases in physical capital would lead only to temporary improvements in productivity because they would always be oset by the pressure of rising population and more workers on the supply of land. In the long run, he concluded, the great majority of people were condemned to living on the edge of starvation. Only then would death rates be high enough and birth rates low enough to prevent rapid population growth from outstripping productivity growth. It hasnt turned out that way, although many historians believe that Malthuss prediction of falling or stagnant productivity was valid for much of human history. Population pressure probably did prevent large productivity increases until the eighteenth century. But in the time since Malthus wrote his book, any negative eects on productivity from population growth have been far outweighed by other, positive factorsadvances in technology, increases in human and physical capital, and the opening up of enormous amounts of cultivatable land in the New World. Note whats here in Krugman and Wells explanation of how we escaped from the Malthusian trap, and also whats missing. Resources are present, 14

but only in the form of enormous amounts of cultivable land in the New World. Of energy or fossil fuels, not a word. The focus on land rather than resources has deep roots, reaching down at least to the benchmark work on growth accounting by Denison. In [24, p. 52] there is interesting information about the poor match-up at the quarterly level between productivity downturns and the oil shocks of 1973 and 1979. But given the nature of how productivity is measured, long-run trends may be more reliable indicators than quarterly uctuations. Further on, [24, p. 54] relies on the small share of costs devoted to energy and focuses on energy per unit output, rather than energy per worker. But both of these pieces of evidence are merely arguments for not measuring the eect of resources. In his actual growth accounting he is using land to mean quite literally land, as can be seen from Tables 7-1 through 7-4 and 8-1 through 8-4 ( [24, p. 107-114]) where the input of land to the economy is unchanged over the period 1930-1982, a period during which use of petroleum went up by 413%, coal by 12%, and overall energy use by 209%. The same treatment of land is repeated in several other of Denisons works, i.e., [20], [21], [22], [23]. We can see the confusion between using resources and having them within your borders in Denison in [20, p. 185]. He extends land by considering dierent types, including what he refers to as mineral lands. Products measured were bituminous coal, lignite, anthracite, peat, natural gas, crude petroleum, iron ore, copper, uranium, zinc, lead, gold, silver, china clays, lime phosphate rock, salt, sulphur, pyrites, and potassium salts. But these are measured in value, not in volume, and more importantly, the data are marshalled for an approximate comparison of minerals production (emphasis added), not use. The same confusion is evident in Wood [74, p. 201-202], in more barbed language than Krugman and Wells employed: Whether countries or people are rich or poor does not usually depend fundamentally on natural resources. Economics is helpful in seeing through this illusion. . . . Some economists have taken a clear and correct line on this illusion, particularly in recent work on the role of institutions in development. But other economists have persuaded themselves by various sorts of theoretical and empirical analysis that countries are poor because they have too many natural resources and (though mercifully not usually in the same article) that people are poor because they have too few 15

natural resources. Woods pretended astonishment is easily cleared up if we apply the havevs.-use distinction. Having lots of resources may or may not be good for your economy, in part depending on the institutional factors that Wood rightly alludes to. As illustrated in the earlier passage from Krugman and Wells with the comparison of Japan and Nigeria, its easy to nd resource-rich countries that are poor, and resource-poor countries that are rich. But if dysfunctional institutions do keep you from turning resource abundance into economic prosperity, youll nd that it is, in a sense, because those bad institutions keep you from using the resources you have. Because whether you look at total energy from the International Energy Agency, or at ecological footprints from the Global Footprint Network, the relationship between resource use and GDP is exceptionally strong. Not only does a regression of GDP on resource use produce an astonishingly high adjusted r-squared. Its also true that there are no countries that are very poor yet use more-than-average quantities of resources, and there are no countries that are very rich and use less-than-average quantities of resources. The link between resource use and GDP is astonishing. Its only possible to miss it if youre looking at a countrys resource endowment or extraction and harvest rather than its own use. Turning to the nature of innovation, we see that Krugman and Wells list advances in technology (along with resources in the form of land) as one of the reasons for avoiding the Malthusian dynamic. Mokyr in [55, p. 324] puts it more pointedly, explicitly raising the technological side above the addition of resources: It is Europes intellectual development rather than its coal or its colonial ghost acreage that answers Pomeranzs query of why Chinese science and technologywhich did not stagnatedid not revolutionize the Chinese economy. The task, then, is to build resources into a macroeconomic model in a way that focuses on using rather than having, that looks at resources broadly rather than merely at land, and that gets right the relationships among innovation, investment, potential resources, and available resources.

Resources in the production function

This section is the core of the paper. I start by giving the key characteristics of resource supply that I want the model to capture. I then incorporate 16

that into the long-run model from section 3.1, then look at how technology paths can be characterized and how dierent paths interact with constrained resource supply. Finally, I look at the way the resource perspective changes the behavior and implications of the short-run model.

5.1

Characterization of resource supply

As discussed earlier in the paper, there are numerous models that include resources in the production function in some fashion, but there are two key innovations in the present work: 1. Dening the role of resources in terms of a resource-intensity of labor that is, a quantity of resources that gets used along with a quantity of labor. 2. A theoretical structure for determining the quantity of resource use. Turning to the rst issue, let the resource intensity be ; then the quantity of resources used in the economy is R = N . If we denote the resource price as P R , and the eect of resource use on labor productivity as , then we can in principle write resource intensity as a function of resource price and eect on productivity: = (P R , ). This function can be dened so as to allow some short-term substitutability between labor and resources, but as Spencer et al. [69, p. 20] observe, In the short-term, [the elasticity of substitution between labour and energy] may be restricted by the lock-in of energy intensive capital stock; in the longer-term, as the capital stock evolves, the elasticity of substitution may increase. In the extreme, we can simplify by saying that, though the resource-intensity of labor can evolve over the long run, in the short-run it is xed, so that for a given economy it can be expressed as a function of time, = (t), with the understanding that it evolves slowly in response to changes in capital and technology.3 The second major change is to incorporate a resource supply curve Rs , analogous to the labor supply curve N s . Where the labor supply is determined by demographics and preferences, resource supply is shaped by investment and technology in combination with either biology or geology. Capital
Natal [57] uses an estimate of oil-labor substitutability of 0.33, but thats based on others estimates of oil price-elasicity. That doesnt necessarily justify a transfer to shortterm substitutability between labor and resources in general, since one way to respond to a higher oil price is to replace some of your oil with other resources, rather than with labor.
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can increase the harvest or capture of renewable resources, as when boats increase the amount of sh that can be caught in a year, forestry equipment increases the number of trees that can be cut in a year, and photovoltaic arrays and wind turbines increase the amount of solar or wind energy that can be captured in a year. A similar dynamic plays out with technology, where sh-nders, more powerful tree-harvesting machines, and better PV technology or wind-turbine blades can similarly increase harvest or capture, once those technologies are embodied in capital. The same thing happens with exhaustibles: all else being equal, more coal mines or oil wells will increase the amount of fossil fuel available in a given year, and new technologies for reaching deep under the ocean or releasing fuel from tight formations will similarly increase supplies. But with many renewables we have to account for biology, and with all exhaustible resources we have to take geology into consideration. More boats will increase our sh catch from a given stock of sh, but the increased harvest will also diminish next years stock. Analogously, more oil wells mean more available oil from a given stock of oil not yet extracted, but more extraction this year leaves less in place to be extracted in the future. Thus we can characterize resource supply in the following terms: 1. At a given time (in a given year), theres some maximum amount of a resource that can be made available to the economy, determined by the interaction of either geology or biology with the installed capital for extraction, capture, or harvest and the level of technology embodied in that capital. 2. Some of the resource will likely be available at relatively low cost, with prices rising ever faster as the quantity approaches the currently feasible maximum. This point and the previous one are summarized in gure 5. (Figure 5 here) 3. All else being equal, investment in capital for extraction, capture, or harvest will move the resource supply curve to the right. The same is true of technological innovations. 4. Harvest of a biological resource tends to move the supply curve to the left, with large harvests moving it strongly to the left. If the resource is left alone for a time, the resource supply should in principle recover and move back to the right. 18

5. Extraction of a nonrenewable resource moves the supply curve to the left. Being exhaustible and incapable of the regeneration that characterizes a biological resource, the supply curve of a nonrenewable resource will not move back to the right on its own, but only in response to new investment, technological innovation, or discovery. 6. At some point, the supply curve of a particular exhaustible resource (e.g., oil) must move left, regardless of any innovations or investments, or else it is not actually an exhaustible resource. 7. The supply of exhaustible resources can be moved rightward by innovations that reveal previously ignored materials to be valuable nonrenewable resources; this happened when petroleum was added to coal as a fossil fuel, and when uranium was added to fossil fuels as a source of energy. Yet we are on a nite planet, and so it seems reasonable that there will come a time when there simply are no new types of nonrenewable resources to discover. And perhaps well before that happens, we will reach a point where there are no new economically viable types of non-renewable resources to discover. Which suggests that at some point the aggregate exhaustible resource supply curve must also move leftward. The actual evolution of resource supply curves is thus a complicated interplay among capital, technology, and the history of harvest or extraction, summarized in gure 6. (Figure 6 here) To better understand the role of resources in the macroeconomy, it is important to note some stylized facts about the dierence between renewable and nonrenewable sources. While renewable resources are, by denition, unlimited over time, their rate of ow is constrained. The quantity of solar energy hitting the Earth in a year dwarfs the quantity of energy used by humans, so it might seem that, in principle, this ow constraint shouldnt be a big deal. But harvesting or capturing solar-derived energy requires physical capital, and various pieces of evidence suggest that the combination of capital costs and ow constraints has historically made renewable resource supply curves more dicult to move to the right than has been the case with exhaustible resources during the Industrial Revolution. Pomeranz ( [60, p.19] observes that prices of wood and fodder generally rose throughout the early modern period. In contrast, petroleum prices exhibited a strong downward 19

trend from 1864 to 1970 (see [7]) and Barnett and Morse [3] document a similar trend for a broader range of resources. And as Figure 7 illustrates, theres a strong tendency for wealthier countries to have a larger share of their ecological footprint be from nonrenewable resources. (A weighted-leastsquares regression of renewable share on log GDP per capita and capacity of biologically productive land area per capita produces an adjusted r-squared of 0.607 and the coecient on log(GDP) is -0.144 with a t-statistic of -15.0.4 ) These observations suggest that nonrenewable energy sources tend to have lower capital costs per unit of energy made available, and that expanding the ow of fossil sources is easier than expanding the ow of renewableswhile supplies last . . . . (Figure 7 here) This vision of resource supply is unusual, even in macroeconomic models that do incorporate resources. For example, Natal [57] describes oil prices as subject to shocks in an AR(1) process with 0 = 0.95, but the shocks themselves appear to be strictly exogenous. There is no co-evolution of supply and demand shaping prices over time, with plausibly exogenous shocks such as the 1973 oil embargo laid on top of that structure. Aghion et al. [1] implicitly assume, but do not address, the realism of having clean (i.e., non-fossil) resources replace fossil resources at the scale at which we currently use fossil fuels. In fact, it does not appear that provision of the clean resource is subject to any sort of environmental constraint: The two inputs, Yc and Yd [the clean and dirty inputs to production, respectively], are produced using labor and a continuum of sector-specic machines (intermediates), and the production of Yd may also use a natural exhaustible resource. [1, p. 5] And the extraction cost of the nonrenewable resource is specied as a non-increasing function of the remaining stock, thus omitting any role for discovery, investment, and innovation as described here. Lastly, their user cost is in some cases determined by an application of the Hotelling rule, whereas the model in this paper leaves the Hotelling rule aside; it is an important insight and an elegant construct, but when looking at the economy as a whole it seems to be of limited applicability.
The footprint data are from [28] and the GDP data are from the UNDPs World Development Report.
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5.2

Revised long run

Were now ready to revise the production function, incorporating the resource supply curve and the role of resources in production. Resources can be included in the production function in an obvious way, as an additional item in the Cobb-Douglas production function (note that the technology parameter A has been changed to A, for reasons that will be explained further on): Y = K (AN ) R . But since R = N , we can rewrite equation 4 as Y = K (AN ) (N ) . (5) (4)

As in the conventional model, labor demand N d is derived from the marginal product of labor, but output is no longer a function of K and A, but is instead a function of K, A, and , so labor demand is a function of those same arguments. As before, increased K or A both lead to higher marginal product of labor, but now an increase in has the same eect technology and capital that allow a single worker to control a greater ow of resources have the eect of making that worker more productive. This change from (A) to (A and ) reects the historical reality of technological change, because while some innovation has been in the form of an abstract, almost Platonic, learning how to do things better, a large portion has been learning how to make use of more resources than before. From the harnessing of re and the domestication of animals through the development of nuclear power, much of our getting cleverer has been getting cleverer specically at applying more exosomatic energy, so as to make the most of our tightly limited supplies of endosomatic energy. (See the discussion in Hall and Klitgaard [35].) Equilibrium is no longer a matter merely of labor demand and labor supply, since hiring a unit of labor now also means buying the resources that labor must have it its disposal in order to realize the productivity promised by the labor demand curve. This cost depends on which, by assumption, is xed in the short run, but also on P R , which depends on the quantity actually bought. Fortunately, we have the resource supply curve Rs , and so any given quantity of labor Ni can be converted into a quantity of resources

21

Ri = Ni , and the resource curve will then turn that resource quantity Ri into a resource price PiR . Now a quantity of labor Ni combines with the labor supply curve to tell us a wage wi that has to be paid in order to obtain Ni . And that same Ni combines with and the resource supply curve to tell us the quantity of resources that must be bought per worker () and the price at which those resources can be bought (PiR ). In other words, we know the marginal wage cost of employing another unit of labor (wi ), and the marginal resource cost of buying the resources needed to make that labor productive (PiR ). We can add this new information about resource costs into the laborsupply diagram. The labor supply curve N s translates any quantity of labor Ni into wi , the marginal wage implied by Ni . And if you go above that point by the amount PiR , you have the full marginal cost of employing another unit of labor. If you choose many dierent values of Ni , this series of points wi + PiR traces out a second curve, lying above the original N s , separated by the space PiR . We can think of this curve as the resource-augmented labor supply curve, denoted (N + R)s . As we move to the right, to higher levels of N and thus higher levels of R, the resource price should increase, causing the space between N s and (N + R)s to increase, though if resources are abundant, P R will stay low and the space between the two curves might not change appreciably. We can now determine equilibrium in this modied long-run model. As in the conventional model, the labor demand curve reects the marginal product of labor, but the new resource-augmented labor supply curve reects the full marginal cost of employing another unit of labor, including the cost of the accompanying resources. So equilibrium is determined by the intersection of labor demand with resource-augmented labor supply (N + R)s , rather than with the simple labor supply N s . This intersection determines both N and w + (PR ) , and the height of N s at N determines w . This is illustrated in Figure 8.5 (Figure 8 here)
This approach is reminiscent of Natals statement that Changes in oil prices act as a distortionary tax on labor income and amplify the monetary policy trade-o, [57, p. 4] except that the comparison to a distortionary tax is unfortunate. Energy costs arent a distortion of an otherwise natural economic outcome. Theyre real costs, just as real as labor, and economic agents develop and choose capital that commits them to those costs because they expect the benets to justify the decision.
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5.3

Technology paths

In the standard model, technology is captured by the single variable A, while in the resource-inclusive model, technology has been split into two components, A and . The term is the resource-intensity of labor, but that intensity is shaped by the technology embodied in the capital being used. Increases in A and both increase what labor can accomplish, but with very dierent implications for resources. The factor does its job specically by increasing the amount of resources used, whereas A has its eect without directly increasing the use of any other factor of production. In other words, A is the eciency with which all inputs are turned into output, something like total factor productivity. In the conventional model growth in output per worker comes from increased capital and improved technology. In the resource-inclusive model, increased labor productivity arises from a more complicated interaction among A, , and resource supply. In general, technological change will involve simultaneous changes in A and . Any combination of changes that increases A will increase labor productivity and thus move labor demand to the right. But changes in A have no eect on the resource-augmented labor supply curve(N + R)s whereas changes in do have such eects. For a given resource supply curve, a change in also changes P R , the space between simple labor supply N s and resource-augmented labor supply (N + R)s . Obviously the direct eect of an increase in is to increase P R . But in addition, a higher means that each labor quantity Ni corresponds to a larger resource quantity Ri = Ni , and thus to a higher resource price PiR . So this indirect eect further opens up the space between N s and (N + R)s A decrease in has the opposite direct and indirect eects. Figure 9 illustrates two dierent technological paths, one involving an increase in A alone, from A0 to A1a , the other entailing a smaller increase from A0 to A1b along with an increase in from 0 to 1 , such that 0 A1a = 1 A1b . This equality implies that both technological paths involve the same d d shift in labor demand, from N0 to N1 . But the resulting equilibria are not the same. d We start with labor demand N0 and resource-augmented labor supply (N + R)s , and have employment N0 , wage w0 , and full marginal cost of 0 R employment w0 + 0 P0 . In the case of a large increase in A with no increase 6 s in , (N + R) will remain at (N + R)s , with the resulting wage wA , full 0
6

And assuming for simplicity no change in resource supply Rs

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R marginal cost of employment wA + 0 PA , and employment level NA . When does increase from 0 to 1 , the resource-augmented labor supply curve will instead move to (N + R)s , with lower wage w , higher full marginal cost of R employment w + 1 P , and lower employment level N . (Figure 9 here) This has implications for useful growth strategies. If Rs is xed, then increased labor productivity from higher values of must eventually become self-defeating. Since the resource supply curve asymptotically approaches a nite value, continual increases in must eventually bring about a situation with an extremely high P R ; the equilibrium employment level will then be constrained by the limited availability of the resources required by the high . As gure 9 suggests, when resources are not abundant, it may well be possible in principle for a resource-intensive increase in labor productivity (i.e., an increase in ) to result in a decrease in wages and employment rather than an increase. Of course, it seems unlikely that even semi-rational agents would pursue such a path in that type of situation. On the other hand, if Rs moves continually to the right along with the overall growth of the economy, then higher labor productivity through higher is not self-defeating. The required quantity of R continually increases, but the increased supply of it allows the price to stay low or even fall. The (N + R)s curve stays close to the N s curve, and the resource situation has no pronounced eect on production. Still, growth through increased has this potential roadblock, and even if resources are cheap, theyre not free. Given those realities, why would an economy pursue a high- strategy rather than a path of high A? Before oering a speculative answer to that question, lets consider what has actually happened. Early in the Industrial Revolution, energy use grew faster than the economy (see [60, p. 17]), but more recent behavior has been dierent. Energy use in the U.S. increased from 0.96 quadrillion Btus in 1825 to 75.68 quadrillion Btus in 1973. Meanwhile, from 1820 to 1973 population grew from 9.6 million to 211.9 million, and real GDP grew from an estimated 12.5 billion dolalrs to a level of 3,536.6 million.7 The share of the population

GDP gures are from Angus Maddison, Contours of the World Economy, 12030 AD, via http://en.wikipedia.org/wiki/List of regions by past GDP (PPP), and are in 1990 international dollars. Energy use is from Tables E.1 and 1.3 from Annual energy review, October 2011, produced by the Energy Information Administration of the U.S. Department of Energy. Population before 1900 is from p. 25 of Historical statistics of the United States 1789-1945: a supplement to the Statistical Abstract of the United States, pub-

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in the labor force wasnt constant over that period, but it didnt go up by enough to alter the conclusion that energy use has risen faster than not only population but also than the labor forcein other words, has increased over that span. At the same time, the increase in energy use per capita was less than the increase in GDP per capita, which means that A must also have increased. Looking at the period since 1949 when the data are more reliable (see gure 10), we can see a relatively smooth trend of increasing through 1973, decreasing from there until 1986, then relatively stable resource intensity of labor through this last decade. The rst period, when was rising, corresponded with a period of 3.2% annualized growth growth in labor productivity; during the second period, when fell, productivity growth averaged 1.5%; and the nal period has seen a productivity growth rate of 2.0%. While there are obviously other factors at work in productivity growth, the data are consistent with a relatively constant growth of A, with the diering rates of productivity growth being driven by the changing behavior of . (Figure 10 here) So the U.S. experience suggests that technological progress has generally been characterized by increases in both A and . There was a dramatic reversal in , corresponding to a period of historically high energy pricesat the time, the highest that had been seen in a century. Even this tempering of the growth of hasnt undone the vast majority of the increase over the course of the Industrial Revolution. An examination of CO2 emissions data for various countries suggests similar experience in them as well. So it seems broadly true that economies grow by increasing both A and , rather than the seemingly ecient path of increasing A alone, or even decreasing and compensating with a still larger increase of A. This raises the question of why economies seem to follow this path. The simplest explanation is that increases in A are harder to come by than increases in . It would follow that, during times when its relatively easy to increase resource supplies, innovations that increase will tend to have an edge over those that focus only on increasing A.
lished by the Census Bureau, available at http://www2.census.gov/prod2/statcomp/ documents/HistoricalStatisticsoftheUnitedStates1789-1945.pdf. Population from 1900 to 1973 is from Historical National Population Estimates: July 1, 1900 to July 1, 1999, http://www.census.gov/popest/data/national/totals/pre-1980/ tables/popclockest.txt. Population for 2003 is from Vintage 2009: National tables at http://www.census.gov/popest/data/historical/2000s/vintage 2009/index.html.

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In the terms of this model, the more a technological path reduces , the greener it is. And the more it combines that with an overcompensating increase in A, the more it can be described as a path of green growth. Its an unresolved empirical matter whether a green growth path can exist on a widespread scale and over an extended period of time. However, in light of the strong historical relationship between economic growth and increased energy use, such as is documented by [8], there is cause for skepticism about the prospects for long-term continued dematerialization of the global economy. Note the dierence from the treatment of technology by Aghion et al. [1]. Instead of dividing technology into something like total factor productivity and resource intensity of labor, that model distinguishes between Ac,t and Ad,t , the ecacy with which the economy uses labor and capital (and, in the case of the dirty input, exhaustible resources) to produce the two inputs to production. The fundamental limit, then, on producing the clean input is merely past innovative eort directed at such production. The authors are condent that sucient eort of this type going forward will allow us to continue our past growth experience with no more than a transitional period of slower growthand they argue that the transition will be shorter and shallower the sooner we shift our eort to clean technology.

5.4

Response to resource constraints

Weve discussed what happens over the course of historically normal growth, with A, , and Rs all increasing, but the resource-inclusive model really comes into its own when you consider a contraction of the resource supply, a situation where the resource constraint on the economy becomes signicantly more binding. For any given quantity of N and value of , this means that P R will be greater than when resources are abundant; the resource supply curve may even have its asymptote within the range to which N could possibly drive it. If we denote the original resource-augmented labor supply curve as (N +R)s , 1 this implies that the new curve (N + R)s must lie above (N + R)s and may 2 1 well approach its asymptote well to the left of where (N + R)s does so. As 1 illustrated in Figure 11, this should have the eect, all else being equal, of driving down the level of employment and the real wage, while increasing the resource-inclusive cost of employing people. Remember from section 3.2 that long-run equilibrium in the labor market indicates full employment, which in turn points to potential output. So if 26

full employment has been reduced by a leftward shift of resource supply, then a tightened resource constraint leads to a lower level of potential output, a lower real wage, and a higher natural rate of unemployment. These eects are at the core of the implications that the resource-inclusive approach has for understanding the short-run behavior of the economy. (Note the comment in [63, p. 550]: The observed eects of oil shocks are even more puzzling when the eects on real wages are considered as well. In standard growth models, the predicted contraction of the supply of output is greater the less real wages fall in response to the shock, and is greatest if real wages actually increase (perhaps because the product wage rises relative to the consumption wage). The emphasis on the eciency wage in [9] suggests a similar story. In other words, the output decline in these models is coming in large part from a avor of sticky wages, or even perverse wages, that go up in the face of adversity. In contrast, with the model in this paper, resource supply constraints lead directly both to lower output and to lower wages.) (Figure 11 here)

5.5

The short run in the resource-inclusive model

The short-run tools discussed in section 3.2 are all anchored around either potential output or the natural rate of unemployment and the level of expected ination. Since declining resource availability reduces potential output and increases the natural rate of unemployment (as explained in section 5.4, it will also have eects in the short run, with implications both for how policy should be carried and for the ecacy of any policy responses that are actually adopted. In the IS-LM framework, the goal of good policy in the mainstream conception is to keep actual output close to potential output. If the output gap is negative (actual output below potential), policy makers in principle want to move either the IS curve or the LM curve to the right, unless they judge that autonomous forces in the economy are about to do one of those things on their own. But the usual calculations of potential output dont take into account resource availability and so are unaected by resource shortages. In the aftermath of the recent (current) energy price spike, the U.S. economy has experienced continued elevated unemployment, and the Bureau of Economic Analysis has revised downwards its estimate of Y including a small retroactive revision. The Congressional Budget Oce now says that Y in 2008:Q3 27

was 13,461.6, whereas in 2008 it was telling us that potential GDP for that same quarter was 13,568.4, so it has carried out a retroactive revision of 0.8%. But much larger revisions have been carried out following the nancial meltdown. In 2007, CBO projected that potential GDP in 2012:Q1 would be 15,100.6, but when we got to 2012:Q1, it said that potential output for that period was only 14,270.3, a revision of -5.5%8 . But the reason given for this is hysterisis, the phenomenon by which extended absence from the workplace makes someone less likely to get a new job for a long time, an eect that wouldnt kick in until around 2009. In contrast, the implication of the resource-inclusive model would be that Y had been falling (and u had been rising) already in the mid-2000s, and was particularly high in 2007 and 2008 ahead of the bursting of the bubble. This downward revision of potential output would solve something of a puzzle that otherwise exists. The growth of the mid-2000s and the collapse of 2008 had all the signs of a credit bubble expanding and then bursting (see, e.g., [32]). The essence of a credit bubble is that loans are made that cannot be justied based on a realistic assessment of overall (future) ability to produce output. Translating this into terms of potential output, a credit bubble should be marked by actual output rising signicantly above potential during the bubble expansion, then falling back to potential, or below it if credit or autonomous expenditure has overreacted to the bursting of the bubble. But thats not what we see based on current methods of estimating potential GDP. Using the CBOs estimates from 2007, the output gap before the current recession peaked in 2006:Q1 at 0.6% of potential GDP, and even with the most recent revisions, from the beginning of 2012, the peak of the output gap was only 1.6%. By way of comparison, the far less damaging tech bubble of the late 1990s raised the output gap to 4.1% according to the 2007 estimate of potential GDP, or 3.5% based on the 2012 estimate. Figure 12 illustrates these changes, with the estimates of potential GDP made in 2007:Q1, 2008:Q3, and 2012:Q1. (Figure 12 here) The implication for policy in the IS-LM framework is that, if you overestimate potential GDP, youll be aiming at the wrong target. This is illustrated in gure 13a, where YC is potential output as estimated in a conventional model, while YR is the potential output as calculated in the resource-inclusive
Vintage potential GDP estimates are downloaded from http://alfred.stlouisfed. org/series?seid=GDPPOT&cid=106
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model. Under these circumstances, actual output YA looks just about right compared to YC , but if we think potential output is better represented by YR , were getting a signal that the economy is probably, in standard terminology, overheating. Its harder to say whether the revisions have adequately accounted for the return of oil prices to levels that, while not matching the highs of 2008, are nonetheless four to ve times the average for the 100 years from 1873 to 1973. (Figure 13a here) This problem is recognized by Kozicki [48] and Gavin [26] but, as can be seen in gure 12, the revisions to potential output have been most pronounced in the aftermath of the nancial crisis, as a result of continued observations of low output and high unemployment, rather than preceding the crisis and incorporating a recognition of the role of resources in economic output. While gure 13a shows how a bubble can be perceived as perfect macroeconomic management, gure 13b illustrates a post-bubble situation, where again resource constraints are binding. Potential output level YC1 shows po tential output as originally estimated, while YC2 is the conventional estimate, now revised down because of an observed pattern of low output and high unemployment. YR is potential output according to the resource-inclusive model, which could in principle be higher or lower than YC2 , depending on how serious the resource constraint was and how large had been the revision in the conventional approach; as shown here, YR < YC2 . Of course, the IS and LM curves will be aected by the bursting of the bubble. Diminished expectations may push down autonomous consumption and investment, shifting the IS curve to the left; the same factors may increase demand for liquidity, pushing the LM curve to the left as well. So the economy may very well be in the general area of potential output, but if policy-makers are working with the wrong conception of potential output, they would think it was seriously under-performing.9 In the AS-AD model, the resource constraint shifts the AS curve to the left from ASC to ASR and causes it to bend upward sooner (see gure 14; the high resource prices may also shift AD leftward from AD1 to AD2 , through some combination of damage to the nancial system and reduced willingness to spend on non-resource purchases). Eorts to move the AD curve to the
There is some similarity here to Natals criticism of welfare-based optimal policies on the grounds that they rely on unobservables such as the ecient level of output or various shadow prices. [57, p. 5, emphasis added]
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right and thus increase expenditure will have a harder time than before actually eliciting output, for a combination of reasons: the resources needed for increased output are harder to come by, and to the extent that economic agents are aware of and spooked by the resource constraint, they will be reluctant to take the risk of ramping up. If policymakers have an overestimate of Y , they will be tempted to adopt stimulative policies,10 and then will be surprised at how little of the stimulus was converted into increased output and how much of it ended up as higher ination. (Figure 14 here) The Phillips curve mainly extends our understanding in terms of expectations. The tightened resource constraint reected in Figure 11 will, in itself, increase the natural rate of unemployment u , and thus shift the Phillips curve to the right, in the direction of less desirable ination-unemployment tradeos. But there is also the possibility that people will react to the higher resource prices by stepping up their expectations of ination, thus shifting the Phillips curve up as well, further into undesirable territory. Figure 15 shows this, with the natural rate of unemployment rising from u to u and C R e e expected ination rising from C to R . The Phillips curve thus moves from PCC to PCR , and even without a drop in demand (that is, a rightward shift in the MPRF), unemployment will rise from u1 to u2 . (Ination will rise as well, but these levels are omitted in gure 15 so as to avoid clutter.) This outcome is reminiscent of the eect identied by [31], who includes changes in oil prices as being among the supply shocks that can move the Phillips curve toward either more or less favorable employment-ination tradeos, with the dierence that he doesnt tie this to a role of resources in production. Rather, the supply-shock eect is explained through the combination of many markets having sticky prices while oil is traded in auction markets that clear with exible prices. (Figure 15 here)

Policy continuity and divergence

In some respects, the resource-inclusive macro model proposed in this paper provide signicantly dierent policy guidance than does the conventional neoclassical synthesis. But if you consider the matter from a slightly more
10

Or not, depending on the political environment . . .

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abstract perspective, the guidance is actually quite similar, while the details of that guidance have changed. Regarding the long run, the standard model says growth comes from better technology and increased (physical and human) capitalin other words, larger values of K and A. The resource-inclusive model says that growth comes from increases in K, A, and , together with increases in resource supply Rs , and that when Rs cant be expanded, it count be counter-productive to increase . These dierences are unintentionally highlighted by Solow in [68], who cautions against equating conservation with sustainability. He makes the common assumptions that capital can substitute for resources and that conservation implies diminished output in the present. It then follows that if conservation means less consumption in the present, there might be some point to it, but if the reduced output means less investment, then it is counterproductive, by leading to less capital in the future, when in fact more will be needed if our descendants are to live at least as well as us, even with limited resources. Further, Solow expects the future to be signicantly richer than the present, just as our wealth dwarfs that of our grandparents, so that diminishing present consumption for the supposed benet of future generations becomes a questionable choice. All of this follows in a straightforward manner from the standard model where Y = K (AN ) and resources are included only on an ad hoc basis. But in the revised model, dierent investments can have very dierent eects, and the only allow growth with shrinking resources if they lead to declining values of combined with signicant increases in A. As discussed in section 5.3, a path with those characteristics may not actually exist, and if thats true, then future prosperity will be far more dependent on resource supplies than would be suggested by standard models. In that case, the best thing we can do for the future is conservation, in order to bequeath a larger Rs than otherwise, as well as encouraging investment and innovation aimed at reducing as much as is reasonably possible. So on the surface, the resource-inclusive model points in a very dierent direction from the conventional one. Yet if we take a slightly more abstract look, the lesson of both models is that, in the long run, demand-side management is irrelevantgood policy aims at encouraging favorable conditions of future production. All that changes in going from the conventional model to one with resources is what constitutes favorable conditions for future production. 31

With the short-term tools theres a clear dierence between the models in that the resource-inclusive one tells you to be more cautious about stimulative policy, because potential output may be lower (natural unemployment may be higher) than you estimate based on the conventional model. So there can be cases where a conventional analysis would tell you to adopt stimulative policies while the resource model says no. But again, at a more abstract level, the advice is the same: try to keep the economy close to potential output. The only dierence is in where potential output is thought to be. As mentioned in section 5.3, Aghion et al. [1] prescribe a policy of moving the economy away from dirty inputs toward clean ones and argue that, after a period of slower growth than usual, the economy will return to the growth path to which weve grown accustomed. If we combine the observations of sections 5.4 and 5.5 and the possibility that conservation is meaningful, despite Solows warning above, we get similar advice in one regard. That is, the model suggests that when we face binding resource constraints, we should accept lower GDP in the near term than would be possible, in order to improve our future prospects. But the model here provides a way of understanding why improved future prospects might mean less loss of GDP than otherwise, rather than, GDP growth as rapid as were used to.

Resources and economic history

One of the basic issues in economic history is how and why the Industrial Revolution came about, and why it happened rst in Europe, leading to the global dominance of Europe and the neo-Europes populated largely by selfgoverning European settlers. As discussed briey in section 2, one position emphasizes the role of resources, e.g., [61], who portrays a pre-modern world in which China is ahead of Europe, with Europe able to catch up and then far surpass China because of the resource windfall represented by its colonial control of the transatlantic world. Several reviewers dispute the importance that Pomeranz attributes to resources, for example Deng [19], who points out that China came into a serious resource windfall with the acquisition of Manchuria, but that it didnt do as good a job exploiting resources as Europe did. At the same time, Deng undercuts his argument by citing an earlier researcher who recognized the importance of the unprecedented endowment gains from the New World. [19, p. F492] If Europes endowment gains were unprecedented, couldnt that uniqueness have contributed to the dierence 32

in outcomes between Europe and China? Joness response to Pomeranz (see [45]) is more adamant in his downplaying of the role of resources, for instance: In this account both cores were coming under ecological stress because preindustrial techniques of land use were damaging and incapable of much further intensication. Then, suddenly, Europe happened upon fresh resources. Pomeranz admits that Europe had not actually banged up against limits, but endlessly implies that Europeans would have been unable to transcend them once they were reached. This tends to disarm anyone who dissents from his pessimism about European land-use practices. [45, p. 856] Overall, Jones in [45] makes an excellent case that resource availability was not a sucient condition for growth, but hes much less convincing in his dismissal of their role as a necessary condition. He writes, Once new energy and raw-material windfalls could be exploited, Europeans would have been foolish to forego them. But this does not mean that they had reached the end of their own ecological road. [45, p. 857]. True, it doesnt mean that in 1800 they were already faced with tightly binding resource constraints. But could they have gotten to where they were by 1900 without those outside supplies? Its plausible that they never reached the end of their own ecological road because they found for themselves a turn-o before reaching that end. Jones continues: And supposing Europe had depended on external resources for which there were no substitutes, its advantage lay in building cumulative means for exploiting them. How anomalous that Europeans, portrayed as too uncreative to tackle resource scarcities, so quickly found the technology and organization to work deep coalmines and suck food, ber and timber out of the New World. [45, p. 858]. But note how they tackled resource scarcities: not by developing on the small resource base available to them, but by guring out how to obtain more resources, whether from the ground beneath their feet or the conquered and settled lands across the ocean. Its not exactly a demonstration of how resources were not crucial to European development. The growth in European energy use from coal during the 19th century was stupendous, leading to levels that dwarfed what had been used previously from other sources, and far outstripping what was available from water power. 33

This undercuts another claim Jones makes: We do not know, by the way, what might have been possible on the basis of water power; there is room for a Fogelian counter-factual exercise here. [45, p. 858] But consider the example of Japan. If Joness counterfactual were plausible, then we might expect Japan of all places to have followed it. Its endowment in the resources of the industrial age is almost zero, and so if anyone were to have an incentive to develop through technology alone, they would be it. Yet they instead followed in Europes footsteps, developing on the basis of resources it didnt have at home. Why did it invest so much in military control of resources and ultimately roll the dice on a military strategy built on an irreconcilable internal contradiction? Did it do that out of an uncreative following of Europe and Americas lead? Or did it take that path because those resources, in per capita quantities that Europe couldnt have mustered at home, are necessary to what we think of as development? The nature of a Fogelian counter-factual is that youre comparing the actual economy to what you imagine might have happened in the absence of some development of interest. So in some sense anything goes. But if someone wants to claim that a many-fold increase in energy use was of no particular economic importance, the burden of proof should really be on them. While Jones in [45] seems determined to minimize the role of resources in Europes takeo, elsewhere (in [44], speaking of the Discoveries and the process of bringing most of the rest of the world under Europes control) he oers evidence for their importance, and in fact provides the key for thinking about their role. An unparalleled share of the earths biological resources was acquired for this one culture, on a scale that was unprecedented and is unrepeatable. . . . The Discoveries were the rst positive economic shock, or stimulant in Leibensteins (1957) terminology, of a magnitude capable of promoting system-wide growth. The general advantages which, considered as a great country, Europe has derived, to use Adam Smiths (1884:243) conceptualization, were staggering. The average area of land available per capita in western Europe in 1500 had been 24 acres, and the Discoveries raised this to 148 acres per capita a six-fold gain. Full 34

utilization of the resource potential was deferred, partly by the seductions of precious metal. But even in the preindustrial period the fall-out of raw materials and the capital investment and technology generated to exploit them was a boost to the development impulses already being released by the growth of trade within Europes borders. Commodities came in that could never have been produced at home at anything less than an innite cost. A range of climates was eectively coupled to Europes own. [44, p. 82] This perspective helps explain the data presented by deLong ( [17]), who marvels at the change in growth rates, from 0.01% per year from 8000 B.C.E. to the beginning of the common era; 0.02% annual growth from then until 1500 C.E., 0.09% from 1500 to 1800, 0.89% during the 19th century, and 2% from 1900 to 2007. His description of the escape from the Malthusian Era (before 1500) is that it was: selective at rst; involved a demographic transition; and resulted from invention and innovation. Similarly at [16] he shows a Malthusian relationship between English population and wages from the 1250s to the 1640s, with population and wages transiting up and down a negatively sloped line of inverse relationship; after the 1640s, the data points move o that line, rst with higher wages unaccompanied by lower population, then with increasing population without falling wages, and nally during the 19th century wages and population rising together. DeLong observes, Something happened to change the pace of innovation; Something happened to change the dynamics of population growth. Not all of his commenters overlook the possibility that the observed relationships might have something to do with stagnant energy and resource use in the earlier period, turning to rapidly growing resource use in the latter. Particularly in the case of the acceleration of global growth, the periodization with resources is remarkably tight. The early modern period (1500-1800) coincides with when the Discoveries put the resources of much of the world at the disposal of one particular segment of the worlds population, enabling it to invent and invest in the technologies that would allow it to grow, and eventually to spread those to other parts of the world. The 19th century aligns with the age of oil and a bigger increase in the use of resources, while the 20th century is the age of oil, bringing a still bigger increase in resource use. This is all consistent with Joness statement cited above, that The Discoveries were the rst positive economic shock, or stimulant . . . of a magnitude 35

capable of promoting system-wide growth. This passage also helps in the reinterpretation of the focus on technology found in Mokyr [55], for whom resource play something of an also ran role: Intellectual factors never operate alone; institutional change was equally necessary. The importance of property rights, incentives, factor markets, natural resources, law and order, market integration, and many other economic elements is not in question. But without an understanding of the changes in attitudes and beliefs of the key players in the growth of useful knowledge, the technological elements will remain inside a black box. [55, p. 327]. Resource availability can oer a potential answer to an issue that Mokyr leaves vague: Pre-1750 economic growth created the economic surpluses that made it possible for a considerable number of people to move to urban areas and nonagricultural occupations, including by becoming full-time intellectuals. Yet despite the stimuli of the Great Discoveries and the technical advances of the fteenth century, Renaissance Europe did not generate anything like modern growth. Many highly commercial societies of the past, for one reason or another, failed to switch from trade-based growth to technology-based growth. Even the great Dutch prosperity of the seventeenth century dissipated and petered out in the end. [55, p. 339] (emphasis added) Growth episodes before the Industrial Revolution of the 18th century were largely based on renewable resources.11 Even the windfall described by [44] above was not as powerful as the coal that would come to dominate in the 19th century. And note that the Dutch prosperity of the seventeenth century also petered out as they lost control of their most readily accessible resource-rich colony in New Amsterdam.
De Decker in [15] makes this statement more precise: while stating that a story of a progression from renewables to fossil fuel is basically correct, he also observes that Our romantic image of the Middle Ages and Renaissance as a paradise of renewable technologies results largely because of our failure to distinguish between thermal and kinetic energy. The breakthrough of the steam engine was needed for fossil fuel to be a source of kinetic energy, but it was already important as a source of heat. Almost all of the leading economies in Western Europe during the last millenium relied on a large-scale use of fossil fuels such as peat and coal.
11

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Mokyr has his candidate for that one reason or another that the growth wave of the Industrial Revolution didnt peter out like the earlier ones: The short answer as to why the West is so much richer today than it was two centuries ago is that collectively, these societies know more. This does not necessarily mean that each individual on average knows more than his or her great-great grandparent (although that is almost certainly the case given the increased investment in human capital), but that the social knowledge, dened as the union of all pieces of individual knowledge, has expanded. [55, p. 287] Theres nothing wrong with this in itself, but its worth reiterating that a large piece of what we know is how to use resources, and a large portion of innovation has been the development of new ways to use resources, i.e., the of this papers model, as opposed to its A. So while the resources would be of little avail without the innovation, the innovation and knowledge themselves wouldnt get us very far without the resources. Thus it is hard to agree with Mokyrs next statement: The eective deployment of that knowledge, scientic or otherwise, in the service of production is the primaryif not the onlycause for the rapid growth of Western economies in the past centuries. [55, p. 287] This risks degenerating into a semantic argument. If the knowledge is about how to access and utilize resources, then is it the resources or the knowledge which is the cause of growth? Perhaps its best to look at knowledge and natural resources as two necessary conditions, rather than looking at either one as a sucient condition. But they are not merely two necessary conditions, for innovation, investment, and potential resource availability are tightly intertwined. If you think about the motive for investment and innovation, the model in this paper suggests a possible resolution of the dispute in economic history between the proponents of resource-based explanations and those who point to innovation, investment, institutions, or other more social factors. Its true that resources on their own make nobody rich. The vast coal and oil reserves of North America were here for 10,000 years without providing any benet to the Native Americans, and that uselessness continued for a few centuries more, although now it was the European settlers to whom they were of no use. These resources only became useful once innovations occurred that 37

showed people how to apply them, and investments were made in the capital that allowed people to actually extract and use them. Even the agricultural wealth of the prairies waited on innovation and investment. The grasslands did support vast herds of bualo, which the natives turned to good use. But the much more protable exploitation of the fabulously rich soil beneath the grass was only possible with the inventionand mass manufactureof the steel plow to break the sod, and this commercial exploitation was greatly abetted by the extension of the railroadsmore innovation and investment out across the land. So investment and innovation have certainly been crucial to development and growththe North American example can easily be replicated. But these social factors do not act independently of potential resources. The plough and the railroad made the soil protable, but these investments themselves would not have been nearly as protable without the rich soil being there in the rst place. A parable can help illuminate the eect of an abundant stock of resources on innovation and investment. A small stream will never repay the investment in a large waterwheel. Innovation might allow the neighbors to make better use of the little ow there is, but only to a point. Even if the stream is utilized to the theoretical maximum of its potential, it still wont provide very much power. In contrast, a large river richly rewards even a small investment in a run-of-river water wheel. And if you make the same innovation that might have allowed you to squeeze a few hundred watts of extra power out of the small stream and apply it instead on the large river, the result is thousands and thousands of watts of additional power. The same comparison holds for the investments which implement the innovation. And while one may argue that people dependent on such meagre resources have all the more motivation to innovate and invest so as to make the very best use of what they have, its also true that innovations and (particularly) investments have real costs, and that if those costs are not justied by the results, the innovation and investment are less likely to occur. In the extreme, unwise investment is self-limiting, even without a competitive market, as the unrecouped costs are a continuing burden to those who incurred them. So it is reasonable to suppose that abundant potential resources encourage progress by rewarding it handsomely, whereas a situation that makes it difcult to convert investment into, say, useful power will tend to elicit less investment and innovation rather than more. A as power goes, so go other pieces in the chain of development. The 38

essence of the automation at the core of the Industrial Revolution was a change in the role of human labor. Before, people provided both the control of the process and the motive power to make it work, running spinning wheels with their feet, running looms with their feet and their arms. After automation, humans retained their role in control of the machinery (though at a higher and higher level as automation progressed), but the movement of the machinery and of the material through the machinery was driven by outside power sources, rst water wheels, then steam engines. So without access to powerboth the underlying resource of falling water or available coal, and the innovation and investment to make it a currently available source of powerthere would be little economic benet to automation and thus little incentive to innovate and invest in that direction. Prairie soils, forests, rivers, coal, oil: Everywhere we turn, we nd another variation on the same tune. Innovation and investment are needed to make resources more economically useful, but that same innovation and investmenton the scale that is the mark of the modern world, and particularly of the Industrial Revolutionhappen because the potential resources are there. Take away those potentially available resources, and Europes scientic revolution would simply not have produced modern economic growth.12

Extensions and implications

1. Complementarity between labor and resource use, dened by technology and capitalevolving over time so that, in eect, new capital can

There are three core ideas presented in this work:

It may be worth distinguishing one very small set of innovations from the rest, with the small set consisting of those that made us aware that a particular thing was a resource, while the larger set is made up of advances that improved a type of use or made it feasible under new circumstances. Coals potential as a source of thermal energy had long been known (though its dirty qualities had also limited its demand), but it wasnt an energy resource for the ferrous metals industry until a series of innovations in 18th century England (see Harris [40]). Subsequent innovations made it a better resource, but didnt unlock a new resource. On the other hand, even as coal was becoming established in the iron industry, it still wasnt a source of kinetic energy until the invention of the steam engine. Once that breakthrough was made, further innovations brought increased eciency that made steam engines aordable in more uses, and they brought reductions in weight together with increases in power that made them practical rst for ships and then for railroad locomotives (see Smil [66]). But these innovations were new applications of a known resource (coal for kinetic energy), not innovations that made coal into a resource.

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lead to long-run substitution between labor and resources, but with only limited substitution possible in the short run. 2. Supply curves of resources currently available, which shift right with investment, innovation, and discovery or conquest, but shift left with extraction or high levels of harvest. 3. Economic outcomes determined by the interaction among resource supply, labor supply, and labor productivity, with that productivity being determined in part by the ability of labor to apply resources. These have been attached here to the models at the core of the neoclassical synthesis, in part to maximize the compatibility with the approach most commonly found in textbooks, but they can be incorporated into other perspectives as well. The school of Modern Monetary Theory (e.g., Wray [75]) presents an interesting alternative to the standard textbook understanding of what money is and how monetary policy works to shape aggregate demand. Likewise Keen [46] (cited in section 1) argues for a rejection of the entire IS-LM framework in favor of a model built around the role of money creation and debt It would be useful to explore ways of connecting these perspectives with a resource-based view of how value is created to pay o credit and how both the reality of and expectations about that process are aected by changes in resource supply and the technology of resource use in the economy. In Keens terms [46, p. 157], debt nances the expansion of economic activity via innovation and investment, but it can also cause asset bubbles and eventually, an economic crisis if too much of this debt is directed to Ponzi Finance. The model in this paper has implications for readily debt actually can lead to economic expansion, and increased diculty in achieving that expansion may thus mean that a greater share of debt it, by default, getting funneled into Ponzi Finance. In a dierent direction, more can be done with the dierences between the behavior of renewable and non-renewable resources described in section 5.1. Aggregate resource R can be divided into exhaustible resources E and renewable resources B.13 Then in addition to A and , a stock of capital and
The choice of B reects that many renewable resources, such as sh or biofuels, are based in biological systems, and this inuences their behavior. Obviously things such as hydroelectricity and wind power dont t that description, and would could in principle
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the technology embedded in it can be said to also determine , the share of resources that comes from exhaustible resources. Then N = R = E + B = N + (1 )N. (6)

We can now add a detail to the description of the Industrial Revolution, which is that increased from near zero to about 0.9. For reasons discussed in section 5.1, it is often easier to expand the supply of non-renewables than of renewables, so that a shift to a greater will enable an economy to grow faster by allowing it to use a type of resource with a more quickly increasing supply. Adaptation to dwindling fossil-fuel stocks, or policy to reduce climate impacts from fossil-fuel consumption, also have an additional dimension, not only an eort to reduce , but the possibility of reducing as well, so long as the resulting demand for renewables doesnt cause unacceptable damage to ecosystems. Changing direction again, section 5.5 lays out the logic by which this model cautions against stimulative monetary or scal policies when resource constraints are binding. On a supercial level, this sounds like the structural arguments promoted by freshwater economists, saying that macroeconomic policy is useless in our current recession, but there are two fundamental dierences. First, as expounded by, e.g., Lucas [53], the freshwater position is a rejection of the mechanisms of Keynesian economics: new spending by the government cannot logically lead to more economic activity, because the $100,000 spent by the government on a bridge had to be taxed or borrowed away from someone, and that other person would have spent the same $100,000 on some other purpose. The model in this paper makes no such claim. It is fully compatible with views on the role of money and spending in Modern Monetary Theory, the debt-based approach of Steve Keen, other post-Keynesian models, or the work of Keynes himself. Second, while there is a structural aspect to this model, its a very different one from what we nd in the freshwater canon. Freshwater economists are likely to point to high taxes, excessive regulation, and technology shocks as the causes of our current stagnation, and the policy prescription is therefore to reduce taxes (and government expenditure), reduce regulation, get government out of the way, and wait for the market to reallocate factors of production and return to equilibrium, where we will once again witness a
create a third category for non-biological renewable resources, but for now Ill limit the discussion to only two categories.

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comfortable growth rate of around 3% per year and a normal unemployment rate around 5%. The model proposed here sees a dierent structural problem. Its not taxes, or regulation, or some generalized technology shock. Rather, its that a mismatch has developed between the technology embedded in our capital and the resources available to make that capital protable. Until thats dealt with, standard Keynesian or post-Keynesian prescriptions may well fall short of expectations, but not for freshwater reasons. In this model, the structural problem could be dealt with by increasing resource supplies, but that has two complications. One is that it may not be possible, for reasons reviewed in section 5.1. The other is that even this model only indirectly takes into account environmental damage, to the extent that it limits resource supplies (primarily biologically based renewable resources). Environmental damage is of course costly in its own right, and so if increased resource supply requires large increases in environmental damage, or enables the economy to extend its negative environmental impact, an increase in resource supplies may not be desirable even if it is possible. The other way to resolve the structural problem of resource constraints is to reduce , the resource intensity of labor. Since this is determined by evolved technology and capital, it is not a quick x. It may well require direct investment by government, or taxation of the use of scarce resources or other regulatory measures designed to accelerate the move away from their use. There is one point of commonality with the New Classical perspective, which is that wages may have to fall. In the long run, the productivity of labor represents an upper bound on wages, since people cannot in aggregate be paid more than they produce. If resource costs rise, then the productivity of labor has been eectively reduced and higher employment does, as the freshwater economists would have it, require lower wages. Even in the long run, wages may not be sustainable at current levels. When is reduced, a suciently large increase in A will sustain labor productivity, but as discussed toward the end of section 5.3, such a tradeo may not actually exist. With a suciently constrained resource, we may be better of with a low value of than with a high one, even if A doesnt fully compensate, but that doesnt alter the implication that future productivityand thus future wageswill be lower than current wages. An economy facing resource constraints may be simply unable to match the level of wealth that was common when resources were available more cheaply. The question is how respond to that. 42

In thinking about this, it is important to consider whether an economy has a purpose, and if so, what that purpose is. If we analogize an economy to an ecosystem, then perhaps the one, just like the other, simply is. But as human inhabitants of an economy, we are entitled to views about what an economy should do. A useful construct in this context is the idea of the core economy as described in Goodwin et al. [29], the part of the economy that directly addresses human wants and needs. If resource supplies cannot or should not be greatly expanded, and if there isnt a technologically feasible path to continue increasing labor productivity while reducing resource use, then the standard macroeconomic goal of continual GDP growth may very well be out of reach. However, that does not mean that improvements in the functioning of the core economy are impossible. We have left such improvement to happen as an assumed automatic byproduct of increasing GDP per capita. Above a basic level of economic wealth, this connection has long been suspect, suggesting more explicit attention to the core. If GDP growth is now ramping down, such explicit attention becomes all the more important, so that the social response to economic degrowth doesnt devastate the core.

Conclusion

In 2009, when the security of the global nancial system was still a daily worry, Blanchard [5, p. 210] wrote that, The state of macro is good. Three years later we have U.S. headline unemployment that has been above 8% for three-and-a-half years, long-term unemployment unmatched since the Great Depression, the UK in a double-dip recession, parts of the Eurozone in depression, and the euro itself in danger of disintegrating even as it contributes to the distress in some of the Eurozone countries. Against that background, Blanchards pronouncement looks ever more questionable. One could counter that macroeconomics is in good shape, that the problem is with the politicians who are failing to implement the useful policies that economists know will work. If an epidemic were spreading and biologists recommended a combination of quarantines and medication, you wouldnt blame the biologists for the continued spread of the disease if politicians hadnt followed their advice. But the phrase biologists recommended implies a kind of consensus in that discipline that is lacking in macro. Saltwater economists advocate increased government spending and looser 43

monetary policy, and President Obama partly heeds them. Prominent freshwater economists worry that our decit is too large and that the Federal Reserves actions are already too much, and the Congressional Republicans, along with many Democrats, follow their lead. A statement that economists recommend x runs the risk of being incoherent if x is to represent the full range of respectable opinion in the eld. So on its own terms, macroeconomics is arguably in crisisor should be. And thats without considering the environmental situation. From global warming to habitat destruction and accelerated rates of extinction, were facing a host of serious environmental problems, issues in which our economic activity is implicated, one way or another. And yet the economic models we bring to these questions are usually specialized tools meant for considering relatively narrow environmental concerns. It seems clear to some (the present author included), that there is a fundamental, two-way relationship between the economy on the one hand, and resources and the environment on the other. The awareness of that relationship has yet to make its way to the heart of the discipline and day-to-day macroeconomic analyses and decisions are made without a coherent view of how resources shape our real options and how our economic actions aect the environment. The project of mending macroeconomics may need to include something like a Post-Keynesian approach in order to better handle asset-market turbulence such as weve witnessed over the last several years. But the resourceinclusive approach, even in the version presented here installed underneath a conventional 1978-era framework, already provides some improved insight into the recent turmoil and recession. And it oers a way in which diverse models, from New Classical to Post-Keynesian, can more meaningfully reect the real, physical world in which we live. This may not be a complete model in the sense implied by Pollitt et al. [59], but hopefully it is a signicant step forward.

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Figure 1: Labor market in conventional model

52

r IS LM

r IS LM

r1

11

Y1 12 (a)

13

1012 $

90%

Y1 100% (b)

110% % of Y

Figure 2: (a) IS-LM framework with potential GDP of 12 trillion and actual GDP of 11.64 trillion; (b) IS-LM framework relative to potential GDP, with output gap of -3%

53

 AS AD

90%

Y1

100%

110% % of Y

Figure 3: Standard AS-AD diagram, relative to potential output

8% Phillips Curve MPRF 4% e 1

3%

u u1

9%

Figure 4: Standard Phillips Curve diagram

54

PR RS

Rmax R Figure 5: Resource supply curve

55

PR
S R1 S R3

Innovation, investment, discovery

S R2

Depletion, over-harvest

R Figure 6: Resource supply curves over time

56

0.9

0.8
Renewables share of total footprint

0.7

0.6

0.5

0.4

0.3

0.2

0.1 5.2 6.2 7.2 8.2 log (GDP per capita) 9.2 10.2 11.2

Figure 7: Relationship between renewables share in footprint and GDP per capita. Dashed line shows relationship from OLS; solid line is from WLS, using population as weights. Both regressions include biocapacity per capita; both t lines use sample average biocapacity to produce a straight line.

57

w, w + P R (N + R)s Ns

w + (P R ) w N

Nd N

Figure 8: Labor market with resource costs

58

w, w + P R (N + R)s (N + R)s 0 Ns

R w + 1 P R wA + 0 P A R w0 + 0 P0 w0 d N1

wA w N N0 NA

d N0

Figure 9: Dierent technology paths interacting with moderately scarce resources

59

950

900

850

Million Btu per worker

800

750

700

650

600

550 1949 1951 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Figure 10: Energy per worker, United States, 1949-2010, million Btu per worker. Employment data from Bureau of Labor Statistics, series LNS12000000; Energy data from Annual Energy Review, Energy Information Administration, U.S. Department of Energy, Table 1.1 Primary Energy Overview, total consumption

60

w, w + P R (N + R)s 2 (N + R)s 1 Ns

R w2 + P2

w2 N2 N1

Nd N

Figure 11: Labor market with abundant and scarce resources

61

6.0%

4.0% Output gap (actual minus potential) in % of potential

2.0%

0.0% 2011 2012

2007 2008 -4.0% 2012 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-2.0%

-6.0%

-8.0%

-10.0%

-12.0%

Figure 12: Output gap, based on three dierent vintages of potential GDP. Potential GDP data downloaded from http://alfred.stlouisfed.org/ series/downloaddata?seid=GDPPOT&cid=106, June 30, 2012.

62

r IS LM

r IS

LM

YA
11 YR YC

YB 13 1012 $ 11
YR YC2 YC1

13

1012 $

(a)

(b)

Figure 13: (a) Economy with undiagnosed overheating due to overestimate of potential GDP; (b) Post-bubble economy with overestimated ability to recover, due to overestimate of potential GDP

63

YR

YC

ASR AD2

ASC

AD1 11 Y2 Y1 12 13 1012 $

Figure 14: Aggregate supply curve shifted left and steepened by worsening supply constraint

64

 PCR PCC
e R e C

MPRF

u u1 u C R

u2

Figure 15: Phillips curve shifted up by higher expected ination and rightward by higher natural unemployment, both resulting from worsening supply constraint

65