“…the relationship between the economic process and the Entropy Law is only an aspect of a more general fact, namely, that this law is the basis of the economy of life at all levels.” Nicholas Georgescu-Roegen, The Entropy Law and the Economic Process, Harvard University Press, 1971.
“Economists are fond of arguing that since no model, whether in physics or economics, is accurate in an absolute sense we can only choose between a more and a less accurate model. …Such a position ignores an important detail, namely, that in physics a model must be accurate in relation to the sharpest measuring instrument existing at the time. If it is not, the model is discarded. Hence there is an objective sense in which we can say that a physical model is accurate… In social sciences, however, there is no such objective standard of accuracy.”
In the first two articles in this series, I introduced two elegantly simple models which we can bring to bear on the study of human economy in order to explain some general observations. The first, Pareto’s Yard Sale model , teaches us that migration of wealth from the middle class and the poor to the wealthy is the natural direction of flow in any human economy. The second, the gambler’s ruin problem of probability theory  teaches that this flow proceeds even as a result of pure chance or happenstance. It would seem that the rich get richer and the poor get poorer and that money does indeed attract money. Personal characteristics, such as hard work, intelligence, cleverness, athletic ability and dishonesty certainly improve the odds of one person over another acquiring riches but can only exacerbate the natural flow, the aggregation of wealth. We also learn that initial conditions matter and of course, how much money one inherits is also a matter of chance. The aggregation of wealth and resultant poverty and misery would appear to be the real eventual outcomes of Adam Smith’s invisible hand such as it were.
I posited that it was the discovery and exploitation of fossil fuel’s low entropy that enabled the rise of middle class fortunes and democracies during the last couple of centuries. Basically, the creation of wealth from the exploitation of fossil fuels exceeded the natural flow of wealth from the middle class and poor to the exceptionally well off. Coincidentally, Adam Smith first invoked the invisible hand of the market in the same year, 1776, that James Watt invented his steam engine, which enabled England to exploit its vast coal reserves and consequently become an empire.
This week, I introduce a third elegant model, which appears to be the bane of all neo-classical economic thought, Herman Daly’s ecosystem model of the economy . An accessible version of his theory was published in 2005 in Scientific American . Herman Daly is the founder of ecological economics. He is not the first to recognize the importance of the entropy law to human economy. That might be the Nobel Prize winning physical chemist Frederick Soddy, whom we’ve discussed previously . Daly makes the distinction between an empty world and a full world. He suggests that neo-classical economics works well in an empty world but fails in a full world. Figure 1 below shows the human economy embedded within an empty world. In this case the economy is only a very small part of the Earth ecosystem. As a consequence, the neo-classical economic assumption that the economy is a closed isolated system independent of any inputs and outputs, or that resources and sinks for waste are infinite, has some validity as an approximation when the human economy is far from physical limits.
Figure 1. “Since the ecosystem remains constant in scale as the economy grows, it is inevitable that the economy becomes larger relative to the containing ecosystem.” Herman Daly. This is Daly’s view of an Empty World. 
The salient observation from Figure 1 is that the economy runs entirely on the ability to transform low entropy into high entropy and in the process do useful work. I previously introduced the term entropy and the all important physical Entropy Law here . Suffice to say that this is the most important physical law and indeed the one law which defines time’s arrow. Your car sitting as it is out in the driveway is a hunk of metal and plastics which exists far from thermodynamic equilibrium. Eventually, your car will rust to pieces and end up crushed in some junk yard. The car can only go in one direction in time. The rust it will become cannot reconstruct the car. Physicists discovered that time flows in the direction of low entropy to high entropy. Time cannot flow in reverse. Meanwhile, if you want to use your car, you need gasoline which consists of hydro-carbon molecules which themselves are far from thermodynamic equilibrium, and your engine needs to combust these low entropy molecules with oxygen transforming the chemical energy into high entropy heat, motion and carbon dioxide pollution. You cannot reconstruct the gasoline from the scattered heat and carbon dioxide molecules.
I know it is confusing that physicist chose rather arbitrarily to label high quality energy and matter (your brand new car and all that wonderful gasoline) as “low entropy” and low quality energy and matter (your old rust bucket and the scattered molecules of carbon dioxide) as “high entropy”, but that turns out to be just a matter of convention that one simply has to get used to. Erwin Schrödinger introduced the term negentropy which may be more easily understood. In any event, the concept of entropy cannot be dismissed if one is to comprehend reality. In a discussion with a conservative Republican friend back in the 1990’s, he pointed out rather uncharitably but accurately that I didn’t know a damned thing about economics and advised me to take a class in economics 101. I advised my friend in turn to take a class in thermodynamics.
Economists only concern themselves with the little oval labeled “economy” in Figure 1 and generally ignore the more interesting and important ecosystem in with the human economy resides. Economists populate their models of the goings on in this oval with firms and households, unions and corporations, and governments and banks and so on and study the interactions between these groupings in great mathematical detail. Any ideology or economic opinion finds a home in one or another economist’s theory. The study of economics is really an aggregate of diverse and disparate and contradictory opinion or “schools”. In 2006, my daughter sold her home in Pensacola Florida and moved back up to Virginia. She wanted to take the proceeds of her house sale and purchase a home in the Washington D. C. area. Home prices had risen dramatically and there was some opinion that this was near the peak of the mother of all housing price bubbles. I found two academic economic articles on the subject. One written by Margaret Hwang Smith and Gary Smith  states:
“These data indicate that the current housing bubble is not, in fact, a bubble in most of these cities in that, under a variety of plausible assumptions, buying a house at current market prices still appears to be an attractive long-term investment. Our results also demonstrate the flaw in models that …”
It is amazing that they found the flaw in the models which turned out to be correct. The second written by Robert Shiller  compared then current housing prices with historic values. You can see a version of Shiller’s house price index here , but they are all over the internet in dozens of forms. Clearly from an historic perspective we were indeed experiencing an unprecedented housing bubble. Shiller wrote:
“The news is not good for homeowners. According to our data, homeowners face substantial risk of much lower prices that could stay low for a long time after.”
In my view, the Schiller conclusion was consistent with the Entropy Law and the conclusion of Smith and Smith was in contradiction. The challenge for the latter two would have been to discover why the economy of 2006 was behaving radically different than at any time before if we were not in fact experiencing a housing price bubble. Why was it different this time? This of course was not their hypothesis at all. The point of my exercise was to discover how to advise my daughter. The lesson for me is that you can find learned economic papers which thoroughly contradict each other. Based on Shiller’s well presented data, I advised her that we were experiencing the mother of all housing price bubbles and that she should not purchase a home at that time.
The collection and analysis of economic data, what Shiller did, is comparable to what physicists do and is entirely rational and relevant. As Georgescu-Roegen points out, physics hypotheses that don’t explain the data don’t survive. In economics, they appear to thrive. The Smiths published their paper in March, 2006, just months before the collapse of the housing bubble in December of that year. How could such learned economists get it so very wrong? By the way, Shiller gets no free pass either. He also wrote:
“Luckily, though, derivatives products, notably a futures market, are being developed that they [homeowners] will soon be able to use to insure against this risk.”
Personally, I don’t know a single homeowner who was spared foreclosure by the purchase of lucky derivatives and I wasn’t about to advise my daughter to compound the purchase of a home at the top of the market by purchasing derivatives. We’ve all since learned more than we would have ever wanted to know about derivatives and their contribution to the recession.
Another thing which the study of neo-classical economics has going against it, is that those economic schools which favor the extremely well heeled (and the continuation of economic growth) will receive the most funding and will tend to proliferate, quite independent of their relevance to any concept of reality or their ability to make actionable forecasts about possible future events such as the rather obvious ones which are only nine months away. This may explain why Mankiw’s economics text book , which we briefly cited last week, became popular. Without any economic training and without having ever ventured into an economics class room, I saw the housing bust coming at us like a freight train as early as 2003. In this regard, I will unhesitatingly recommend the importance of good economic data such as presented by Shiller. But I would study that data with the eye of an engineer.
Figure 2, by contrast, shows the economic model in a full world where the limits of low entropy matter and energy within the ecosystem impose themselves rather forcefully onto the economy. Also in this figure, the economy runs smack into its own high entropy pollution. Figure 2 shows precisely the situation which exists today. This is what the authors of the sapient book Limits to Growth saw coming.
Figure 2. “The evolution of the human economy has passed from an era in which man-made capital was the limiting factor in economic development to an era in which remaining natural capital is the limiting factor.” This is Herman Daly’s view of a Full World. 
From an examination of figure 2, solutions to our entropy problem are evident. First, we need to reduce our consumption of low entropy converting as quickly as possible to reliance on solar energy inputs or we need to quickly discover another source of low entropy. I want to emphasis that conservation is not the same thing as increasing efficiency. Increasing efficiency is an important strategy for reducing our consumption but it can also lead to an increase in consumption. This effect is called Jevon’s Paradox and we will discuss it in a future article because it is quite interesting. Second, we need to reduce our emissions of high entropy or waste. We need to make stuff which lasts longer for example. We also need to recycle waste as much as possible back into the input hopper.
Third, and most important, we need to reallocate the transformation of entropy to more productive pursuits. The latter suggests some rather obvious immediate actions. Military and defense spending is purely waste when not used and is the best way to destroy wealth when it is used. The most important action we Americans can do is cut our defense spending by 95%. This is not proposed here as an option. The argument that it is politically impossible is only an argument that the destruction of our nation is inevitable. When I discuss this with people they argue that surely we need to cut defense spending somewhat but it is impractical to cut it by 95% because we need a strong national defense. So I ask why we need to spend more than say Canadians and the response is that nobody hates the Canadians but there are lots of people in the world who hate us. But why I ask do most people in the world hate America but not Canada? Please keep in mind that whatever you’ve been taught by the American Media regards why we invaded Iraq, the rest of the world is convinced we invaded the country to steal its oil and if you look at the evidence with an unbiased eye, you will have to admit that it is hard to escape that view. I’ll leave that for you to ponder and we will return to it in future articles. Unfortunately, the Entropy Law demands that we stop misallocating low entropy on military misadventures. Otherwise, we are screwed.
If you need motivation, consider that eventually, all our sophisticated military apparatus may be used against us, citizens who protest too much.
I recommend the study of ecological economics and its more recent child biophysical economics.
 Herman Daly, Beyond Growth, Beacon Press, 1996.
 Daly, Herman E., “Economics in a Full World”, Scientific American, September 2005, Vol. 293, Issue 3
 Margaret Hwang Smith and Gary Smith, “Bubble, Bubble, Where’s the Housing Bubble?” Preliminary draft prepared for the Brookings Panel on Economic Activity, March 30-31, 2006.
 Robert J. Shiller, “Long-Term Perspectives on the Current Boom in Home Prices,” Economists’ Voice www.bepress.com/ev March, 2006.
 Mankiw, Principles of Economics, Fourth Edition, South-Western Cengage Learning, 2007.