272 • Macroeconomics

nature’s services are a huge infrastructure to the economy, and we are fail-
ing to maintain that infrastructure.
Why do our national accountants fail to subtract natural capital con-
sumption in calculating income? Neoclassical economics does not count
natural capital consumption as a cost because in its preanalytic vision of
the world, nature is not scarce. The reason natural funds and resource
flows are absent from the usual neoclassical production function is also
the reason there is no deduction for natural capital consumption in na-
tional income accounting.

GNP as Cost
Years ago, Kenneth Boulding suggested that GNP be relabeled GNC, for
gross national cost. While Boulding’s plea may have been tongue-in-
cheek, it bears close examination. GNP is a measure of the final goods and
services a society produces multiplied by the price at which they sell on
the market. But demand for the most important resources such as food,
energy, and life-saving medicines is inelastic. As you’ll recall from Chap-
ter 9, this means that large changes in price have little impact on how
much people want to consume, and conversely, that a small change in
quantity will lead to a large change in price. Imagine that one year the
food and oil industries decided to work less and reduced output by 20%
over previous years. Because people would not want to reduce their con-
sumption of food and energy, they would bid up the prices for these com-
modities dramatically. In fact, something like this really did happen, in
2008, when a small drop in grain supplies relative to annual consumption
led to a 200% increase in prices, and a drop in the rate of increase in oil
production led to a similar increase in oil prices. If we multiplied 80% of
2007’s output by 300% of 2007’s price, GNP would show a 140% increase
in economic activity in these sectors instead of a 20% decrease. Real GNP
would be lower, due to inflation, but the share of these commodities in
GNP would nonetheless soar.
Even when GNP reflects economic activity, it may not reflect well-
being. For example, compared to the other developed countries, the
United States ranks last on a wide variety of health care measures, rang-
ing from infant mortality to life expectancy. It also has by far the highest
percentage of uninsured individuals. By such measures, the U.S. health
care system provides fewer benefits than the systems in other developed
nations. However, in 2008 the United States spent 50% more per capita
on health care than any other nation,12 and these expenditures were ris-

12OECD Health Data 2009: Frequently Requested Data. Online: http://www.oecd.org/docu

ment/16/0,3343,en_2649_34631_2085200_1_1_1_1,00.html.
 Chapter 14 Macroeconomic Concepts: GNP and Welfare • 273

ing rapidly. Aside from those who reap income from health care, no one
claims this is a good thing. Yet if we measure well-being by the market
value of health care goods and services, the United States has by far the
best health care system in the world.
The fact is that one person’s income is another person’s expenditure, so
GNP is also an explicit measure of costs. As long as costs and benefits are
closely correlated, this does not matter, but we can’t take such a correla-
tion for granted. Striving to maximize expenditures on health care, food,
energy, or anything else would obviously be crazy.
What should be done about GNP? One approach would be to disag-
gregate GNP into two separate accounts: a national benefits account and
a national costs account (we'll explore the challenges to this below). As the
scale of the economy grows, both benefits and costs will increase. We
could compare those benefit and cost increases at the margin to find the
optimal scale (see Figure 14.2).13 It makes absolutely no sense to add
them together.
Another option is to move beyond consumption-based measures of
well-being altogether, as we discuss below. If the aim of economic activity
is to maximize human well-being, then health, nutrition, literacy, family,
friends, social networks, and so on are probably the most important indi-
cators, perhaps best measured by overall levels of happiness and satisfac-
tion with life (see Box 14.1).
Nonetheless, absent more rational measures of well-being, we can’t
help feeling a certain nostalgia for the good old days when newscasters re-
galed us with quarterly changes in the GNP. Now we are subjected to
hammer-banging, gong-clanging reports of hourly changes in the Dow
Jones and Nasdaq stock price indices—numbers that are an order of mag-
nitude further removed from either welfare or income than GNP is. For
example, in 2008, global stock markets lost trillions of dollars in value
with virtually no change in real productive assets. This is because stock
market values are forward-looking, based on expectations of future earn-
ings (even on speculators’ estimates of the expectations of others). By con-
trast, GNP is backward-looking, a historical record of what has already
happened. Since the past is better known than the future, GNP is inher-
ently a more trustworthy number than stock market values.

12For an effort in this direction for Australia, see P. A. Lawn, Toward Sustainable Development:

An Ecological Economics Approach, Boca Raton, FL: Lewis Publishers, 2001.

274 • Macroeconomics

Gross National Happiness and the

Box 14-1 Happy Planet Index

In the late 1980s, the country of Bhutan declared that it would strive
to increase Gross National Happiness (GNH) rather than GNP, in an ap-
proach that “stresses not material rewards, but individual development,
sanctity of life, compassion for others, respect for nature, social har-
mony and the importance of compromise.”a Rather than attempting to
measure happiness itself, Bhutan seeks to measure and improve the fac-
tors that contribute to happiness. The first global study on GNH included
multicriteria measures of economic, environmental, physical, mental, so-
cial, workplace, and political wellness.b While initially seen as a
quixotic goal, GNH is much less of a departure from economists’ histori-
cal conceptions of utility than is GNP, and the idea has taken off, along
with the study of happiness. A related measure is the Happy Planet
Index, which divides a country’s happy life years (life expectancy ad-
justed by subjective well-being) by its ecological footprint as an estimate
of ecological economic efficiency or sustainable happiness. By this
measure, Costa Rica is the world leader in sustainable development.c

aBhutan Planning Commsion, Bhutan 2020: A Vision of Peace, Prosperity, and

Happiness, Thimphu: Royal Government of Bhutan Planning Commission, 1999, p. 19.

bInternational Institute of Management, Gross National Happiness (GNH) Survey.

Online: http://www.iim-edu.org/polls/GrossNationalHappinessSurvey.htm.
chttp://www.happyplanetindex.org.

I Alternative Measures of Welfare: MEW, ISEW,

and GPI
In the early 1970s, there was considerable criticism of GNP growth as an
adequate national goal—so much so that economists felt obliged to reply.
The best reply came from William Nordhaus and James Tobin.14 They
questioned whether growth was obsolete as a measure of welfare and thus
as a proper guiding objective of policy. To answer their question, they de-
veloped a direct index of welfare, called Measured Economic Welfare
(MEW), and tested its correlation with GNP over the period 1929–1965.
They found that, for the period as a whole, GNP and MEW were indeed
positively correlated; for every six units of increase in GNP, there was, on
average, a four-unit increase in MEW. Economists breathed a sigh of relief,

14W. Hordhaus and J. Tobin, “Is Growth Obsolete?” In Economic Growth, National Bureau of

Economic Research, New York: Columbia University Press, 1972.

 Chapter 14 Macroeconomic Concepts: GNP and Welfare • 275

forgot about MEW, and concentrated again on GNP. Although GNP was
not designed as a measure of welfare, it was, and still is, thought to be
sufficiently well correlated with welfare to serve as a practical guide for
policy.
Some 20 years later, Daly and Cobb revisited the issue and began to de-
velop an Index of Sustainable Economic Welfare (ISEW) with a review of
the Nordhaus and Tobin MEW. They discovered that if one takes only the
latter half of the Nordhaus-Tobin time series (i.e., the 18 years from 1947
to 1965), the positive correlation between GNP and MEW falls dramati-
cally. In this most recent half of the total period—surely the more relevant
half for projections into the future—a six-unit increase in GNP yielded on
average only a one-unit increase in MEW. This suggests that GNP growth
at this stage in U.S. history may be quite an inefficient way of improving
economic welfare—certainly less efficient than in the past.
The ISEW was then developed to replace MEW, since the latter omit-
ted any correction for environmental costs, did not correct for distribu-
tional changes, and included leisure, which both dominated the MEW
and introduced many arbitrary valuations.15 The Genuine Progress Indi-
cator (GPI) is a widely used, updated version of the ISEW that does ac-
count for the loss of leisure time. The ISEW and GPI, like the MEW,
though less so, were positively correlated with GNP up to a point (around
1980), beyond which the correlation turned slightly negative.16 Figure
14.3 shows estimates of GNP and ISEW for seven different countries.
Measures of welfare are difficult and subject to many arbitrary judg-
ments, so sweeping conclusions should be resisted. However, it seems fair
to say that for the United States since 1947, the empirical evidence that
GNP growth has increased welfare is weak and since 1980 probably non-
existent (see also Figure 14.1 for further support of this claim). Conse-
quently, any impact on welfare via policies that increase GNP growth

15The concept of leisure is an important part of welfare, but the problems of valuing leisure

are difficult. Is the leisure chosen or unchosen? Should sleep time count as leisure? Is commuting
time leisure or “time cost of working”? Should we use the wage rate? The minimum wage? Should
the “leisure” of mom taking care of children be valued at her opportunity cost if she’s a doctor, or
at the cost of avoided daycare? Such difficult choices have a big effect on the index.
16Neither the MEW nor the ISEW considered the effect of individual country GNP growth on

the global environment, and consequently on welfare at geographic levels other than the nation.
Nor was there any deduction for legal harmful products, such as tobacco or alcohol, or illegal
harmful products, such as drugs. No deduction was made for overall diminishing marginal utility
of income resulting from GNP growth over time (although a distributional correction for lower
marginal utility of extra income to the rich was included). Such considerations would further
weaken the correlation between GNP and welfare. Also, GNP, MEW, GPI, and ISEW all begin with
personal consumption. Since all four measures have in common their largest single category, there
is a significant autocorrelation bias, which makes the poor correlations between GNP and the three
welfare measures all the more surprising.
276 • Macroeconomics

Figure 14.3 • Indices of GNP (solid) and ISEW (dashed) for seven countries. 1970
= 100 in all cases. (Source: R. Costanza, J. Farley, and P. Templet, “Quality of Life
and the Distribution of Wealth and Resources.” In R. Costanza and S. E. Jør-
gensen, eds., Understanding and Solving Environmental Problems in the 21st
Century: Toward a New, Integrated Hard Problem Science, Amsterdam: Elsevier,
2002.)

would also be weak or nonexistent. In other words, the “great benefit,” ha-
bitually used to justify sacrifices of the environment, community stan-
dards, and industrial peace, appears, on closer inspection, not even likely
to exist.17 Certainly if economic growth is to be the number-one goal of
nations and the central organizing principle of society, then citizens have
a right to expect that the index by which we measure growth, GNP, would
reflect general welfare more accurately than it does. Continued use of
GNP as a proxy for welfare reminds us of the quote often attributed to
Yogi Berra: “We may be lost, but we’re making great time.”
The objective, accurate scientific measurement of national costs and
national benefits is not a realistic goal. Both costs and benefits of eco-
nomic growth are spread out over time, and how we treat costs and ben-
efits that affect future generations is an ethical issue, not a scientific one.

17For further evidence from other countries, see M. Max-Neef, Economic Growth and Quality

of Life: A Threshold Hypothesis, Ecological Economics 15:115–118 (1995).

 Chapter 14 Macroeconomic Concepts: GNP and Welfare • 277

The use of a particular discount rate to address intertemporal distribu-

tion, for example, is clearly a value-laden decision. Ecosystem change
and evolution are not predictable, and how we treat the resulting un-
certainty is also an ethical issue. Even using monetary measures of
market goods is not objective; markets will yield different monetary val-
ues depending on the initial distribution of the wealth, and what con-
stitutes a desirable initial distribution is an ethical judgment. Monetary
values for a given resource also vary depending on the amount of the re-
source society is using; for example, the price of oil depends primarily
on current rates of extraction of oil. Oil is such an important input into
so many economic processes that all prices are affected by how much oil
we are using. Using prices determined by resource use in this period to
decide the appropriate amount of a resource to use is therefore a case of
circular reasoning; you can’t do it on a computer spreadsheet, and you
can’t do it in real life. Efforts to put monetary values on nonmarket
goods such as ecosystem services not only compound these ethical is-
sues with serious methodological problems but also imply that natural
capital and manmade capital are perfect substitutes, a position that most
ecological economists strongly reject.

I Beyond Consumption-Based Indicators

of Welfare
Personal consumption is not an end in itself but merely one means toward
achieving the end of enhancing human welfare. GNP is inadequate as a
proxy for income, and income is only one element among many that pro-
vide human welfare. For example, the ecosystem services that increasing
GNP inevitably encroaches upon are at least as important as GNP in pro-
viding welfare.18

Human Needs and Welfare

Do other factors not yet discussed contribute to our welfare? It is reason-
able to assume that welfare is determined by the ability to satisfy one’s
needs and wants. What are our needs? Absolute needs are those required
for survival and are biologically determined. Some 1.4 billion individuals
globally and 26% of the population in the Third World currently live in
extreme poverty (less than $1.25 per day), and 2.6 billion earn less than

18See R. Costanza et al., The Value of the World’s Ecosystem Services and Natural Capital, Na-

ture 6630:253–260 (1997), in which the value of global ecosystem goods and services is found to
outweigh global GNP. While this article does put monetary values on natural capital for purposes
of comparison with manmade capital, it also explicitly discusses many of the problems with this
approach.
278 • Macroeconomics

$2.00 per day. These people have difficulty meeting even these absolute
needs.19 For this group, greater consumption is probably very closely cor-
related to greater welfare.
Once absolute needs have been met, as is the case for the remaining
three-fifths of the world’s population, then welfare is determined by the sat-
isfaction of a whole suite of primary human needs. Numerous researchers
have proposed a variety of human needs, typically claiming that they are
pursued in hierarchical order, with Maslow’s hierarchy (1954) (in which
consumption is the lowest rung on the needs ladder) being the most fa-
mous. The hierarchical ordering, though generally not seen as rigid by these
researchers, still leaves something to be desired. Even the 1.2 billion people
living in absolute poverty seek to fulfill needs other than mere subsistence.
Manfred Max-Neef20 has summarized and organized human needs into
nonhierarchical axiological21 and existential categories (Table 14.1). In
this matrix of human needs, needs are interrelated and interactive—
many needs are complementary, and different needs can be pursued si-
multaneously. This is a better reflection of reality than a strict hierarchy in
which we pursue higher needs only after lower ones have been fulfilled.
Also important in Max-Neef’s conception, needs are both few and finite.
This stands in stark contrast to the assumption of infinite wants, or the
nonsatiety axiom in standard economics.
If we are to evaluate the success of economic policies both now and in
the future (assuming that providing a high level of welfare for humans for
the indefinite future is our economic goal), then we must develop measur-
able indicators that serve as suitable proxies for needs fulfillment and
welfare.
To state the obvious, we cannot precisely measure welfare, which in the
present context is equivalent to quality of life (QOL). In the words of Clif-
ford Cobb,22
The most important fact to understand about QOL indicators is that all meas-
ures of quality are proxies—indirect measures of the true condition we are
seeking to judge. If quality could be quantified, it would cease to be quality.
Instead, it would be quantity. Quantitative measures should not be judged as
true or false, but only in terms of their adequacy in bringing us closer to an
unattainable goal. They can never directly ascertain quality. (p. 5)

19M. Ravallion and S. Chen, “The Developing World Is Poorer Than We Thought but No Less

Successful in the Fight Against Poverty.” Policy Research Working Paper Series 4211, The World
Bank. 2008.
20M. Max-Neef, “Development and Human Needs.” In P. Ekins and M. Max-Neef, Real-Life

Economics: Understanding Wealth Creation, London: Routledge, 1992, pp. 197–213.

21Axiology is the study of the nature of values and value judgments.
22C. W. Cobb, Measurement Tools and the Quality of Life: Redefining Progress, Oakland, CA. On-
line: http://www.rprogress.org/pubs/pdf/measure_qol.pdf.
I Table 14.1
MAX-NEEF’S MATRIX OF HUMAN NEEDS
Existential Categories
Axiological
Categories Being Having Doing Interacting
Subsistence Physical health, mental Food, shelter, work Feed, procreate, Living environment,
health, equilibrium, rest, work social setting
sense of humor,
adaptability

Protection Care, adaptability, Insurance systems, Cooperate, prevent, Living space, social
autonomy, equilibrium, savings, social security, plan take care of, environment, dwelling
solidarity health systems, rights, cure, help
family, work

Affection Self-esteem, solidarity, Friendships, family, Make love, caress, Privacy, intimacy,
respect, tolerance, partnerships express, emotions, home, space of
generosity, with nature share, take care of, togetherness
receptiveness, passion, cultivate, appreciate
determination,
sensuality,
sense of humor

Understanding Critical conscience, Literature, teachers, Investigate, study, Settings of formative

receptiveness, curiosity, method, educational experiment, educate, interaction, schools,
astonishment, discipline, policies, communication analyze, meditate universities,
intuition, rationality policies academies, groups,
communities, family

Participation Adaptability, Rights, responsibilities, Become affiliated, Setting of

receptiveness, solidarity, duties, privileges, work cooperate, propose, participative
willingness, share, dissent, obey, interaction, parties,
determination, interact, agree on, associations,
dedication, respect, express opinions churches,
passion, sense of humor communities,
neighborhoods, family

Idleness Curiosity, receptiveness, Games, spectacles, Daydream, brood, Privacy, intimacy,

imagination, recklessness, clubs, parties, dream, recall old space of closeness,
sense of humor, peace of mind times, give way to free time,
tranquility, sensuality fantasies, remember, surroundings,
relax, have fun, play landscapes

Creation Passion, determination, Abilities, skills, Work, invent, build, Productive and
intuition, imagination, method, work design, interpret feedback settings,
boldness, rationality, workshops, cultural
autonomy, inventiveness, groups, audiences,
curiosity spaces for
expressions, temporal
freedom

Continued
280 • Macroeconomics

I Table 14.1
MAX-NEEF’S MATRIX OF HUMAN NEEDS (CONTINUED)
Existential Categories
Axiological
Categories Being Having Doing Interacting
Identity Sense of belonging, Symbols, language, Commit oneself, Social rhythms,
consistency, religion, habits, integrate oneself, everyday settings,
differentiation, customs, reference confront, decide on, settings in which one
self-esteem, groups, sexuality, get to know oneself, belongs, maturation
assertiveness values, norms, recognize oneself, stages
historical memory, actualize oneself,
work grow

Freedom Autonomy, self-esteem, Equal rights Dissent, choose, be Ability to come in

determination, passion, different, run risks, contact with different
assertiveness, open- develop awareness, people at different
mindedness, boldness, commit oneself, times in different
rebelliousness, disobey places
tolerance

The column of Being registers attributes, personal or collective, that are expressed as nouns. The column of Having registers institu-
tions, norms, mechanisms, tools (not in material sense), laws, etc. that can be expressed in one or few words. The column of Doing
registers locations and milieus (as time and spaces). It stands for the Spanish estar or the German befinden, in the sense of time and
space. As there is no corresponding word in English, Interacting was chosen for lack of something better.
Source: M. Max-Neef, “Development and Human Needs.” In P. Ekins and M. Max-Neef, Real-Life Economics: Understanding Wealth
Creation. London: Routledge, 1992, pp. 197–213.

Objective Measures
Numerous efforts have been made to objectively measure welfare. The
problem is that these studies have found only weak relationships between
objective measures of welfare and the subjective assessments of the same
by the subjects concerned.23 However, both these studies and the various
types of national accounts seem to include a narrow range of objective in-
dicators, often placing what we consider to be an excessive emphasis on
consumption. Quite possibly the problem is that welfare is too rich a
gumbo for us to recapture its flavor with so few ingredients. An important
research agenda in economics is to develop a methodology for measuring
access to “satisfiers” (the means by which we satisfy a given need) for Max-
Neef’s axiological and existential categories of human needs as indicators
of welfare. With sufficient ingredients, we can produce something rea-
sonably close to the flavor of welfare.

23B. Haas, A Multidisciplinary Concept Analysis of Quality of Life, Western Journal of Nursing

Research 21(6):728–743 (1999).

 Chapter 14 Macroeconomic Concepts: GNP and Welfare • 281

Max-Neef’s human needs matrix as the basis of a welfare measure is a

dramatic departure from existing national accounts, as well as from most
of the proposed alternatives, differing even in its theoretical underpin-
nings. Neoclassical economics and GNP are explicitly utilitarian. Within
utilitarian philosophy, individual welfare is determined by the degree to
which individuals can satisfy their desires, and it is generally accepted that
the goal of society is to provide the maximum amount of utility for its cit-
izens. As utilitarian philosophy has been operationalized by NCE, citizens
are the best able to determine what provides utility. Because it is extremely
difficult to measure utility directly, economists have taken to using revealed
preferences as a proxy. Preferences are revealed by people’s objectively
measurable choices in the market. In the market economy, preferences are
revealed through market decisions, and market decisions can be made
only with money. Under this conception of utilitarianism, the philosophy
values only end-states and requires only “having” such things as posses-
sions and experiences. Sustainable income accounting and measurements
of economic welfare are basically just extensions of this philosophy, and
they similarly value only having.24
In Max-Neef’s framework, having things is important, but it is just one
of the elements required to meet our needs. Thus, a benevolent dictator
with the resources to provide us with all the physical things we need for
happiness would fail to meet our existential needs for being, doing, and
interacting, as well as our axiological needs for creation, participation, and
freedom. Also, within Max-Neef’s conception, people are not always best
able to determine what contributes to their quality of life; for example, ad-
vertising may falsely convince people that consumption satisfies their
need for affection, freedom, or participation.
This approach, which values human actions independently of their
outcomes, has been dubbed the “human development” approach to wel-
fare. Its main proponents include Nobel Prize–winning economist Amartya
Sen and philosopher Martha Nussbaum. In a similar tone to Max-Neef,
they argue that “capabilities” and “functionings” are critical to welfare.25
Roughly speaking, “functionings” correspond to human needs, while
“capabilities” include both states of being and opportunities for doing and
are therefore analogous to access to satisfiers for these needs in Max-Neef’s
matrix (see Table 14.1). In utilitarian theory, we might have several dif-
ferent options, of which we choose one. If all options but that one were

24C. W. Cobb, Measurement Tools and the Quality of Life (San Francisco, CA: Redefining

Progress, 2000). Online: http://www.rprogress.org/pubs/pdf/measure_qol.pdf.

25Ibid.; M. Nussbaum, “Aristotelian Social Democracy,” in R. B. Douglass, G. M. Mara, and H.

S. Richardson, eds., Liberalism and the Good, New York: Routledge, 1990, pp. 203–252; R. Sug-
den, “Welfare, Resources, and Capabilities: A Review of Inequality Reexamined by Amartya Sen,”
Journal of Economic Literature 31 (December, 1993): 1947–1962.
282 • Macroeconomics

eliminated, it would not affect our welfare. In the human development ap-
proach, losing options restricts our capabilities and would therefore affect
our welfare. The human development approach is less concerned with the
actual choices that people make than with the options they are free to
choose from, and the marketplace is only one of many spheres in which
choice is important.

Operationalizing Human Needs Assessment as a

Measure of Welfare
Measuring the extent to which human needs are satisfied is, of course, an
exceptionally difficult task and highly subjective. Following the lead of
Sen and Nussbaum, it would be most useful to measure capabilities, that
is, the extent to which individuals have access to satisfiers. However, as
noted by Max-Neef, specific satisfiers may vary by culture, and the differ-
ence in satisfiers required to meet a human need may indeed be one of the
key elements that defines a culture. This means that objective “welfare ac-
counts” must be very culture-specific. Second, some satisfiers might help
fulfill several human needs, while other needs require several satisfiers.
Further complicating matters, satisfiers may change through time. And
humans are social creatures who inhabit a complex environment; needs
are satisfied not only in regard to the individual but also in regard to the
social group and environment.26 Furthermore, while needs are different
and distinct, they are also interactive and may complement each other,
and therefore may not be additive. Abundant access to satisfiers for one
set of needs does not compensate for a lack of satisfiers for another set of
needs. This suggests that separate “accounts” should be kept for access to
satisfiers to different needs.
In developing welfare accounts based on human needs assessment
(HNA), it would be useful to test measurements of satisfiers empirically
in studies comparing these objective measures against subjective assess-
ments of welfare to determine their effectiveness. These empirical tests, as
well as efforts to operationalize HNA accounts, must involve people in di-
alogues to confirm or refute the validity of the needs Max-Neef specifies,
as well as the validity of the satisfiers we use to assess the degree to which
needs are met. Such dialogues would almost certainly elicit additions and
alternatives to the generic satisfiers, the entries in the columns of Table
14.1.27 While the average person may not always know exactly what sat-

26Max-Neef, op. cit., 1992.

27E.g., food and shelter are specific dimensions of “having” that are satisfiers of the need for
“subsistence.” How we actually meet our needs for food and shelter are culture-specific. A tradi-
tional Inuit might be satisfied with walrus blubber and an igloo, while a New Yorker would re-
quire hamburgers and a high-rise apartment.
 Chapter 14 Macroeconomic Concepts: GNP and Welfare • 283

isfiers will best meet their needs, interactive discussion with people is
nonetheless essential to select and test appropriate indicators. We would
also need to develop group-based methodologies to determine the effec-
tiveness of our indicators in a social setting.
It is clear that Max-Neef’s approach is very difficult to operationalize,
even if his concept is theoretically more compelling than GNP or even
ISEW. The debate over which approach to take to national accounting—
theoretically sound measures or ease of accounting—is old. As Irving Fisher
argued back in 1906, the appropriate measure, even of income, is one that
captures the psychic flux of service (i.e., satisfaction of needs and wants)
and not simply the final costs of goods and services.28 And at the time
Fisher wrote, the absence of suitable data for calculating either psychic flux
of service or final costs no doubt led many to ignore the debate as entirely
academic. The widespread use of GNP indicates that in practice, Fisher lost
this earlier debate. However, measures such as the ISEW suggest that the
GNP is becoming increasingly incapable of measuring economic welfare,
much less general human welfare. Even if we can never quantify access to
satisfiers as precisely as we currently quantify GNP, as Sen suggests, perhaps
it is better to be vaguely right than precisely wrong.29
Accepting Max-Neef’s human needs matrix as a framework for the spe-
cific elements of human welfare, and access to satisfiers as potentially the
best objective indicator of welfare, has profound implications with respect
to scale, distribution, and allocation. First, most of the possible indicators
suggested by Max-Neef require few, if any, material resources beyond
those needed to sustain human life and hence are less subject to physical
exhaustion. Thus, for most elements of human welfare, increases for one
person or one generation do not leave less for others. Second, explicitly
accepting that there is a limit to material needs implies that we can limit
consumption greatly with little, if any, sacrifice of welfare. This result is
critical, because the laws of thermodynamics make it impossible to un-
couple physical consumption from resource use and waste production.
Abundant evidence suggests that current levels of consumption could not
be sustainably met with renewable resources alone, and we must therefore
limit consumption or else threaten the welfare of future generations.
The difficulty of operationalizing Max-Neef’s framework may actually
be a point in its favor. Why do we want to measure welfare in the first
place? It’s not just to track its rise or fall but to help us create policies to

28H. Daly and J. Cobb, For the Common Good: Redirecting the Economy Toward Community, the

Environment, and a Sustainable Future, Boston: Beacon Press, 1989.

29D. Crocker, “Functioning and Capability: The Foundations of Sen’s and Nussbaum’s Devel-

opment Ethic, Part 2.” In M. Nussbaum and J. Glober, eds., Women, Culture, and Development: A
Study in Human Capabilities, Oxford, England: Oxford University Press, 1995.
284 • Macroeconomics

improve it. Simply providing statistical data on welfare doesn’t help us

achieve this end. However, applying Max-Neef’s framework would require
extensive surveys asking people to think deeply about what their needs
really are and how they can satisfy them. Ultimately, improving welfare
falls to decisions by political, cultural, and religious groups about what
they want and how they want to achieve their goals, and making the cor-
rect decisions will require people to think deeply about what it is they ul-
timately desire.

BIG IDEAS to remember

I Fallacy of composition I Defensive expenditures or

I General equilibrium model “anti-bads”
versus aggregate I Natural capital consumption
I Sustainable income
macroeconomics
I MEW and ISEW
I Optimal scale of
I Gross national cost
macroeconomy
I Relative wealth and welfare
I Gross national (or domestic) I Human needs and welfare
I
product Matrix of human needs
I Total welfare = economic (Max-Neef)
welfare + noneconomic I Human needs assessment
welfare (HNA)
 CHAPTER

15
Money
M oney ranks with the wheel and fire as ancient inventions without
which the modern world could not function. Probably more people
today are run over and burned by out-of-control money than by out-of-
control wheels and fires. Money is mysterious. Unlike matter and energy,
it can be created and destroyed, evading the laws of thermodynamics. Pri-
vate citizens (counterfeiters) are sent to jail for making even small
amounts of it, yet private commercial banks make almost all of it, and we
pay them for it! Sometimes money is a costly commodity (gold) and some-
times a costless token (paper notes). It is easily transferable into real assets
by individuals, but the community as a whole cannot exchange its money
into real assets at all, since someone in the community ends up holding
the money. Some economists think the money supply should be deter-
mined by fixed rules, others think it should be manipulated by public au-
thorities. And some people think the love of money is the root of all evil!
Anyone who is not confused by money probably hasn’t thought about it
very much.
Money functions as a medium of exchange, a unit of account, and a
store of value. The functions are interrelated but worth considering sepa-
rately. To measure exchange value, we need a unit—call it a dollar, a peso,
a franc, or a yen. If the unit is stable over time (no inflation or deflation),
then money automatically serves as a store of exchange value. To function
as a medium of exchange and let us escape the inconvenience of barter,
money must hold its value at least long enough to effect both sides of the
transaction, which in barter, of course, are simultaneous. A moment’s re-
flection shows how tremendously inefficient barter is and consequently
how efficient money is. In barter there must be a coincidence of wants. It
is not enough that I want what you have to trade; you also have to want
whatever it is that I have to trade, and we have to find each other. Money

285
286 • Macroeconomics

provides a common denominator that everyone wants simply because

everyone else is willing to accept it. It is a standard, well-defined com-
modity (or later a token) that breaks the two sides of a difficult barter
arrangement into two separate and easy transactions.
Karl Marx analyzed transactions as follows. First we have simple barter,
which he denoted as
C—C*
Commodity C is exchanged for commodity C*. You have C and prefer
C*; I have C* and prefer C. We are both better off after the transaction.
We both increase the use value of what we own. Exchange value is not
separated from use value. No money is needed, but we were lucky to have
found each other.
Next for Marx comes simple commodity production:
C—M—C*
Now we have money functioning as a medium of exchange. Exchange
value, the sum of money, M, is entirely instrumental to bringing about an
increase in use values by facilitating the exchange. The process begins and
ends with commodity use values. The goal is to increase use value, not ex-
change value.
For Marx the critical change comes in the historical shift from simple
commodity production to capitalist circulation, which he symbolized as
M—C—M*
The capitalist starts with a sum of money capital, M, uses it to make com-
modity C, and then sells C for the amount M*, presumably greater than
M. Thus:
M*—M = ∆M
∆M is profit, or surplus value in Marxist terms. For us the important thing
is not Marx’s notion of surplus value, which is tied up with his very prob-
lematic labor theory of value, but the simple observation that in moving
from C—M—C* to M—C—M* the driving motive has shifted from in-
creasing use value to increasing exchange value.
Use value arises from the actual use of commodities; it is concrete and
physically embodied. Exchange value is abstract and inheres in money. It
has no necessary physical embodiment.1 Real wealth—commodities—
obeys the laws of thermodynamics. Money, a mere symbolic unit of ac-
count, can be created out of nothing and destroyed into nothing. There is
a physical limit to the accumulation of use values. There is no obvious

1Though, of course, exchange value is real only if something exists for which money can ac-

tually be exchanged.
 Chapter 15 Money • 287

limit to the accumulation of exchange value. Fifty hammers are not much
better than two (one and a spare) as far as use values are concerned. But
in terms of exchange value, fifty hammers are much better than two, and
better yet in the form of fifty hammers’ worth of fungible money that can
be spent on anything, anywhere, and at any time.

Box 15-1 Diamonds-Water Paradox

The distinction between use value and exchange value goes back to Aris-
totle and was used to “resolve” the diamonds-water paradox—the para-
dox that although water is a necessity it has a low price, while diamonds
are practically useless but have a high price. Economists dealt with this
conundrum by declaring that there are two basic kinds of value, use
value and exchange value, and one has nothing to do with the other. In
the late 1800s the marginalist revolution in economic thinking resolved
the paradox as follows: Exchange value is determined by marginal utility,
and use value is determined by total utility; that is, exchange value
equals marginal use value. Water has enormous total utility, but it is so
plentiful that at the margin we use it for trivial satisfactions. This mar-
ginal utility determines exchange value. How do we know that? If you
want to buy a gallon of water from me, what determines how much you
will have to give me in exchange? If I give you a gallon of water, I won’t
stop drinking and go thirsty, nor will I stop bathing and be dirty. I’ll prob-
ably water my petunias less often. The petunias are my least important
use value, my marginal utility of water, my opportunity cost for a gallon
of water. Since the marginal utility of water is what I will sacrifice by
trading away a gallon, that’s what determines the exchange value of
water. Exchange value is determined by the least important use value,
the value sacrificed. Water is abundant, so its marginal utility is very
small; diamonds are scarce, so their marginal utility is still high.

A hoard of hammers takes up space and is subject to rust, termites,

fire, and theft. Fifty hammers’ worth of money is not subject to rust, rot,
and entropy, and far from costing a storage fee will earn interest from
whoever gains the privilege of “storing” it for you. Production for use value
is self-limiting. Production for the sake of exchange value is not self-lim-
iting. Since there is no limit to the accumulation of abstract exchange
value, and since abstract exchange value is convertible into concrete use
value, we seem to have concluded that there must not be any limit to con-
crete use values either. This has perhaps led to the notion that exponen-
tial growth, the law of money growing in the bank at compound interest,
is also the law of growth of the real, or material, economy.
288 • Macroeconomics

I Virtual Wealth
Frederick Soddy summarized all this by carefully distinguishing wealth
from debt.2 He noted that “a weight, although it is measured by what it will
pull up, is nevertheless a pull down. The whole idea of balancing one thing
against another in order to measure its quantity involves equating the quan-
tity measured against an equal and opposite quantity. Wealth is the positive
quantity to be measured and money as the claim to wealth is a debt” (p.
103).3 Monetary debt, the measure of wealth, is negative wealth, say minus
two pigs. It obeys the laws of mathematics but not of physics. Wealth, on
the other hand, plus two pigs, obeys the laws of thermodynamics as well as
mathematics. Positive pigs die, have to be fed, and cannot reproduce faster
than their gestation period allows. Negative pigs are hyper-fecund and can
multiply mathematically without limit. As Soddy put it, “You cannot per-
manently pit an absurd human convention, such as the spontaneous incre-
ment of debt (compound interest), against the natural law of the
spontaneous decrement of wealth (entropy)” (p. 30).
The holding of token money by the public to avoid the inconvenience
of barter gives rise to the curious phenomenon that Soddy called virtual
wealth, which he defined as the aggregate value of the real assets that the
community voluntarily abstains from holding in order to hold money in-
stead. Individuals can always convert their money holdings into real as-
sets, but they choose not to in order to avoid the inconvenience of barter.
This raises the question of whether money should be counted as a part of
the real wealth of the community. Yes, if money is a commodity like gold
that circulates at its commodity value. No, if it is token money like a dol-
lar bill whose commodity value is nil but whose exchange value is signifi-
cant. Even though each person can at an instant convert his money into
real assets, it is impossible for the community as a whole to do this, as we
have previously noted.
Money, therefore, represents not real wealth but, in Soddy’s term, vir-
tual wealth. More exactly, it is the magnitude of virtual wealth that deter-
mines the value of money. What happens if the government puts into
circulation more money than people currently want to hold? People will
exchange money for real assets and drive up the price of real assets. As the
price of real assets rises, the real value of money falls until it again coin-
cides with the virtual wealth of the community. If there is too little money,
people will exchange real assets for money, thereby driving down the price

2F. Soddy, Wealth, Virtual Wealth, and Debt, London: George Allen & Unwin, 1926.
3When banks create money by providing someone with a loan (see below), they actually cre-
ate a debt as the first step. On the asset side of the accounting books, the banker enters a debt for
the amount of money borrowed (to be paid off with interest). This borrowed money is then placed
in a bank account, which is listed in the bank’s books as a liability.
 Chapter 15 Money • 289

of real assets. As the prices of real assets fall, the value of money increases
until it again equals the virtual wealth of the community. The value of a
dollar, then, is the virtual wealth of the community divided by however
many dollars are in circulation. It follows that the value of a unit of token
money is determined not by the total wealth of a community, nor by its
annual GNP, but by its virtual wealth relative to the money supply.

Box 15-2 Virtual Wealth and Fiduciary Issue

Nobel laureate economist James Tobin comes very close to Soddy’s con-
cept of virtual wealth in his explanation of the “fiduciary issue”:
The community’s wealth now has two components: the real goods accumu-
lated through past real investment and fiduciary or paper “goods” manufac-
tured by the government from thin air. Of course, the nonhuman wealth of
such a nation “really” consists only of its tangible capital. But as viewed by
the inhabitants of the nation individually, wealth exceeds the tangible capital
stock by the size of what we might term the fiduciary issue. This is an illusion,
but only one of the many fallacies of composition which are basic to any econ-
omy or society. The illusion can be maintained unimpaired as long as society
does not actually try to convert all its paper wealth into goods.” a

aJ. Tobin, “Money and Economic Growth,” Econometrica (October 1965), p. 676.

I Seigniorage
Who owns the virtual wealth? Since it does not really exist, we might say
that no one owns it. It is a collective illusion. Yet individuals voluntarily
hold money instead of real assets, and they behave as if money were a real
part of their individual wealth, even if they understand that collectively it
is only “virtual” or illusory. Every member of the community who holds
money had to give up a real asset to get it—except for the issuer of
money. The one who creates the money and is the first to spend it gets a
real asset in exchange for a paper token. The difference between the mon-
etary value and the negligible commodity value of the token, the profit to
the issuer of money, is called seigniorage, in recognition of the lordly na-
ture of this privilege. Who is this fortunate person? Historically it was the
feudal lord, or the king, the sovereign, who issued money within his do-
main. One might expect that this privilege would have been passed on to
the sovereign’s legitimate heir, the democratic state. To some extent this
is the case, because only governments can issue currency or legal tender.
However, over 90% of our money supply today is not currency but de-
mand deposits created by the private commercial banking system.4 They

4Demand deposits are ordinary checking accounts from which money is payable on demand

to the bearer of your check.

290 • Macroeconomics

are created out of nothing and loaned into existence by the private com-
mercial banks under rules set up by the government. Who gets the seignior-
age? Seigniorage from currency goes to the government. Seigniorage from
demand deposits goes to the private sector, initially to commercial banks.
To the extent there is competition between banks for savings, they will re-
distribute some of the seigniorage to depositors. Sectors of society too
poor to save will receive nothing.
What does money consist of in our economy? A further mystery of
money is that it has several definitions. The most restrictive is “currency
plus demand deposits in the hands of the nonbank public.” More expan-
sive definitions include savings deposits and even credit card debt. Most
of our money supply bears interest as a condition of its existence. Who-
ever borrowed it into existence must pay back what he borrowed plus in-
terest. Thus, a requirement for growth (or else inflation) is built into the
very existence of our money supply. Moreover, the money supply, ceteris
paribus, expands during boom times when everyone wants to borrow and
invest, and contracts during recessions when loans are foreclosed, thereby
aggravating cyclical instabilities.
On learning for the first time that private banks create money out of
nothing and lend it at interest, many people find it hard to believe. In-
deed, according to Joseph Schumpeter, as late as the 1920s, 99 out of 100
economists believed that banks could no more create money than cloak-
rooms could create coats. Yet now every economics textbook explains
how banks create money. We will explain how it works in a minute, but
first we’ll let the strangeness of it sink in. Of course, this is not the only
way to create money. Nonetheless, most economists today accept this sit-
uation as normal. But the leading economists of the early twentieth cen-
tury, Irving Fisher and Frank Knight, thought it was an abomination. And
so did Frederick Soddy.

Local Currencies and Local Exchange

Box 15-3 Trading Systems
Currencies are not created exclusively by governments. A variety of non-
government legal currencies exist in countries throughout the world, and a
closer look at local currencies can provide important insights into money.
There are three ways to design a currency system. Most national curren-
cies are created by fiat. There is nothing to back up fiat money but faith
that someone else will accept it in exchange for goods (“In God We
Trust,” or as the Ithaca HOUR says, “In Ithaca We Trust”). Second, a cur-
rency can be valued in terms of a commodity and may or may not be re-
 Chapter 15 Money • 291

deemable in terms of that commodity. For example, the Constant, one of

the earliest alternative currencies and a forerunner of today’s local cur-
rencies, was introduced in the 1970s on an experimental basis in Exeter,
New Hampshire. The Constant was designed to maintain a constant
value against a basket of 30 different commodities. Finally, a currency
can be backed by a commodity, which means it can freely be exchanged
for that commodity. Such was the case for U.S. currency in the nine-
teenth century, when money holders could theoretically exchange gold-
backed dollars for gold at any time, and the necessary gold reserves
were physically available to do this.a
The city of Ithaca, New York, has one of the best-developed local cur-
rency systems in the world. The currency is known as Ithaca HOURs. An
individual can participate in the HOURs system simply by agreeing to ac-
cept HOURs in exchange for the goods or services she produces. New
money must be issued to chase this greater supply of goods and serv-
ices. Where does this new money come from?
Published backers of the HOUR directory, which is considered a serv-
ice provided to Ithaca HOURs, are paid 2 HOURs (the equivalent of ap-
proximately $20 US) on first participation and again when they renew
their commitment. Technically speaking, the participant is being paid for
publicly backing HOURs, but one could also say that in the HOURs sys-
tem, the person who agrees to generate new goods and services earns
the right to seigniorage. While at first glance it may seem strange that
one would be entitled to money for simply agreeing to accept money,
new money must clearly come from somewhere, and it’s reasonable for
part of it to go to the person responsible for creating the new wealth.
Theoretically, the amount of new money created times the velocity
with which the money circulates should equal the amount of new goods
and services being offered. So far it seems that new participants have on
average offered more than enough goods and services to use up their 2
new HOURs. Several mechanisms are used to increase the money supply
and prevent deflation. Residents of Ithaca may request interest-free
loans of HOURs, organizations may request grants of HOURs, employees
of member businesses can accept HOURs as a regular part of their pay,
and people may purchase HOURs into circulation with dollars, from the
HOUR bank. Additional money is created to finance administrative costs
of the system. The circulation committee of Ithaca HOURs is responsible
for deciding how many HOURs to create. So far, Ithaca HOURs are hold-
ing their own against the U.S. dollar, and they continue to trade at a
ratio of 1 HOUR to 10 U.S. dollars.b
aR. Swann and S. Witt, Local Currencies: Catalysts for Sustainable Regional Economies.

Revised 1988 Schumacher lecture, 1995/2001. Online: http://www.schumachersociety.

org/currencypiece.html (E. F. Schumacher Society).
bSee also http://www.ithacahours.com. Paul Glover, the founder of Ithaca HOURs, was

also very helpful in providing information.

292 • Macroeconomics

I The Fractional Reserve System

What allows banks to create money is our fractional reserve system. If
banks had to keep 100% reserves against the demand deposits they cre-
ate, then there would be no creation of money. Therefore, the reform
called for by Soddy, Fisher, Knight, and others was for a 100% reserve re-
quirement on demand deposits. Banks would still provide the conven-
ience of checks and safekeeping, and they would charge for these services.
They could still lend other people’s money for them and make a profit, but
those people would have access to that money only after it was repaid.
Banks could not create money any longer.
Exactly how does the fractional reserve system enable banks to create
money? Suppose the law required banks to keep 10% reserves against
their demand deposits (actually, it is much less). Reserves are either cash
or deposits with the Federal Reserve Bank owned by the commercial
bank. The bank needs reserves only to settle the difference between daily
deposits and withdrawals, which nearly always balance to within a few
percent. Therefore, the bank feels that keeping 100% reserves is exces-
sively cautious. It can keep only 10% reserves and meet all imbalances
that are statistically likely to ever happen. The “excess reserves” can be
loaned at interest, thereby increasing the bank’s profits. The government
has concurred in this practice and made it legal; it is known as fractional
reserve banking. It works as long as all depositors do not demand their
money at once, as happens in a bank panic (when depositors doubt the
solvency of the bank and all rush to get their money out at the same time).
To avoid panics, the government set up the Federal Deposit Insurance
Corporation (FDIC). If depositors are insured against loss when a bank
fails, then they will be less likely to panic and cause the very failure they
feared. (They will also be less likely to demand prudence from their bank,
but that’s another story we leave for later.)
How do banks actually create money? Let’s first consider a monopoly
commercial bank. Because it is the only bank, it knows that any check
drawn against it in one branch will be deposited with it in another branch.
When it clears its own check, there is no transfer of money, of reserves, to
another bank. Therefore, if it has a new cash deposit of $100 that counts
as reserves, and the reserve requirement is 10%, it can lend out in newly
created demand deposits an amount of $900. People and businesses bor-
row only what they intend to spend, so it is certain that this $900 will be
spent. Its total additional demand deposits are $100 in exchange for the
new cash deposit, plus $900 in new loans, giving $1000 in new demand
deposits backed by $100 in new reserves, thus satisfying the 10% reserve
requirement. Net addition to the money supply is $900 worth of demand
deposits.
 Chapter 15 Money • 293

Now let’s consider a competitive banking system rather than a single

monopoly bank. Suppose Bank A receives a new cash deposit of $100.
Unlike the monopoly bank, Bank A cannot lend out $900 because nearly
all of the checks written on that amount of new demand deposits will be
deposited in other banks, not Bank A. Clearing will necessitate a transfer
of reserves to other banks. If it had lent out $900, it would surely soon
have to transfer almost that amount to other banks. But it only has $100
in new reserves and thus will not be able to meet its legal reserve require-
ment of 10%.
So how much can Bank A lend as a result of a new cash deposit of
$100? If it safely assumes that all checks drawn on its loans will be de-
posited in other banks, it can only lend out $90. Therefore, it still creates
money—$90 in new demand deposits above the $100 demand deposit in
exchange for the $100 cash. But the process does not stop here. The $90
of excess reserves safely lent by Bank A end up being transferred to Bank
B, which can now safely lend 90% of that, or 0.9 ($90) = $81. So now the
money supply has gone up by $90 + $81 = $171. But then the new $81
excess reserves of Bank B get transferred to Bank C, which can create new
deposits of 0.9 ($81) = $72.90. And the process continues in an infinite
series, the sum of which turns out to be—can you guess it? Exactly $900
of new money, as with the monopoly bank, or $1000 of new demand de-
posits, remembering the exchange of $100 cash for a $100 demand de-
posit that started the whole process.5 The whole process works in reverse
when someone withdraws cash (reserves) from the bank.
Just as money is created when banks loan it into existence, money is
destroyed when it is paid back. Interest-bearing loans require that more
be paid back than was initially borrowed, however, demanding a constant
increase in the money supply. The net result of simultaneous processes of
money creation and destruction determines the net growth of the money
supply.

I Money as a Public Good

Money is a collective phenomenon, not a privately owned resource. In a
peculiar but very real way, money is a true public good. You might think
that if you own money, you can exclude others from using it, but if you
did so completely, your money would have no value whatsoever. Money
has value only if everyone can use it. And money is certainly nonrival, in
that my spending a dollar in no way decreases the value of that dollar for

5If r is the required reserve ratio, then the demand deposit multiplier is this infinite series:

1 + (l – r) + (1 – r)2 + (l – r)3 + . . . + (l – r)n = l/r

294 • Macroeconomics

the next person. Since money is a public good, one would expect seignior-
age to be public revenue, not private. The virtual wealth of the commu-
nity could be treated as a publicly owned resource, like the atmosphere or
electromagnetic spectrum. But that is not the case. The money supply is
privately loaned into existence at interest. The fact that most of our money
was loaned into existence and must be paid back at interest imparts a
strong growth bias, as well as cyclical instability,6 to our economy. There
is no economic reason why the monetary system must be linked with the
private commercial activity of lending and borrowing.
What are the alternatives? Soddy offered three reforms. His first pro-
posal was to gradually raise the reserve requirement to 100%. That would
put the private banks out of the money creation business and back into
the business of borrowing and lending other people’s real money, provid-
ing checking services, and so on. Control of the money supply would then
belong to the government. How, then, would the government regulate the
money supply? Soddy’s second policy suggested an automatic rule, based
on a price level index. If the price level index is falling, the government
should finance its own activities by simply printing new money and
spending it into existence. If the price level is rising, the government
should cease printing money and tax more than it spends, that is, run a
surplus. This would suffice for a closed economy, but for an open econ-
omy, one that engages in international trade, the domestic money supply
can be increased or decreased by international payments balances. Soddy’s
third proposal (back in 1926, under the gold standard) was freely fluctu-
ating exchange rates. Currencies would trade freely and directly against
each other; an equilibrium exchange rate would eliminate any surplus or
shortage (deficit) in the balance of payments and consequently any inter-
national effect on the domestic money supply. Remember our discussion
of surplus and shortage in Chapter 9.
Of course, this is not what we have now.
The gold standard has been abandoned, and fixed exchange rate
regimes have given way to flexible exchange rates, but not to freely float-
ing exchange rates, which are thought (rightly or wrongly) to be too
volatile and disruptive of international trade. (We return to the topic of
exchange rates in Chapter 20.) The money supply is determined largely
by the commercial banking system, subject to some manipulation, but not
control, by the Federal Reserve (the Fed). The Federal Reserve System

6We will explain this instability in more detail in Chapter 17. In the meantime, it is enough

to understand that banks are eager to loan new money into existence during economic booms, in-
creasing the money supply and favoring more economic growth. During recessions, banks prefer
to collect more in old loans than they loan out in new ones, reducing the money supply and ag-
gravating the recession.
 Chapter 15 Money • 295

is a coordinated system of district central banks in the U.S. that influences

interest rates and money supply.
The Federal Reserve has three tools for manipulating the money sup-
ply. First, the Fed can set the reserve requirements, within limits pre-
scribed by law, and thus reduce or expand the supply of money created
by banks, as explained above. This tool is used infrequently, because it has
large impacts on the financial sector. Second, the Fed can change the in-
terest rate it charges to lend reserves to the commercial banks (known as
the discount rate), thus making it more or less profitable for the commer-
cial banks to lend to their customers, and in doing so expand (or limit the
expansion of) the money supply. Third, the Fed can conduct open market
operations, directly increasing or decreasing the money supply by buying
and selling government securities in the open market. When the Fed buys
government securities, it does so by crediting the bank account (at Re-
serve Banks) of securities dealers. This directly increases the available sup-
ply of money by the amount of the purchase. The deposit also increases
the bank’s reserves, allowing the bank to make more loans and create even
more money. When the Fed sells government securities, the money sup-
ply contracts.

I Money and Thermodynamics

Frederick Soddy was a Nobel Prize winner in chemistry and a great be-
liever that science should be used to benefit humankind. He doubted that
this would happen, however, and even predicted back in 1926 the devel-
opment of the atomic bomb. Why are the fruits of science often badly
used? Because, thought Soddy, we have a flawed and irrational economic
system. Unless we reform that system, scientific progress will only help us
destroy the world faster. Soddy spent the second half of his 80-year life
studying the economic system. He understood thermodynamics and en-
tropy and the biophysical basis of economics, and he forcefully called at-
tention to this interdependence. But he focused his attention mainly on
money. Why? Because money was the one thing that did not obey the laws
of thermodynamics; it could be created and destroyed. And yet this undis-
ciplined, imaginary magnitude was used as a symbol and counter for real
wealth, which has an irreducible physical dimension and cannot be cre-
ated or annihilated. Money is the problem precisely because it leads us to
think that wealth behaves like its symbol, money; that because it is possi-
ble for a few people to live on interest, it is possible for all to do so; and
that because money can be used to buy land and land can yield a perma-
nent revenue, money can yield a permanent revenue.
Because of this fallacy, M. King Hubbert recently had to remind us that
exponential growth—growth at a constant percentage rate—is a tran-
296 • Macroeconomics

sient phase in human history.7 The classic example of the power of expo-
nential growth is the story about putting a grain of wheat on the first
square of a chessboard, two grains on the second, four on the third, and
so on. At the next-to-last, or 63rd, square the board contains 263 grains of
wheat, far more than the world’s whole wheat crop, and the last, or 64th,
square will by itself contain that much again. Hubbert’s conclusion was
that the world cannot sustain 64 doublings of even a grain of wheat. In
our world, many populations are simultaneously doubling—populations
of people, livestock, cars, houses—things much bigger than a grain of
wheat. How many times can each of these populations double? How
many times can they all double together? A few tens at most, was Hub-
bert’s answer. Our financial conventions, on the other hand, assume that
this doubling will go on forever.
This expectation gets played out in reverse when we discount future
values to an equivalent present value. We simply run the exponential cal-
culation backward, asking: How much would we have to deposit in the
bank today at today’s interest (discount) rate in order to have the given fu-
ture amount at a given future date? This discounting procedure is, as we
have seen, at the heart of the financial model of present value maximiza-
tion, which has displaced the more traditional economic model of profit
maximization. The error that bothered Soddy is deeply ingrained in pres-
ent economic thinking. We have already encountered it in our discussion
of why renewable resources are driven to extinction.
It is convenient to dismiss Soddy as a “monetary crank” and to remark
what a pity it was that such a brilliant chemist wasted so much of his time
on a topic that he was unqualified to think about. This is exactly the treat-
ment that Soddy was given. It was harder to dismiss Irving Fisher and
Frank Knight, who also called for 100% reserve requirements, because
they were the leading economists of their generation. But their ideas on
money were simply classed separately from the rest of their economics,
treated as a peccadillo, and were ignored.
Our previous statement—that money does not obey the laws of
thermodynamics—needs some qualification. Exchange value is hardly a
value if there is nothing for which it can be exchanged. If money is issued
without real wealth to back it up, spending that money simply drives up
the prices of goods and services, causing inflation and bringing “real
money” back closer into line with real wealth (more on inflation later).
What about virtual wealth? Are there limits to the amount of real
wealth people are willing to forgo in order to hold money? If not, then the
amount of real money in circulation can continue to grow independently

7M. King Hubbert, “Exponential Growth as a Transient Phenomenon in Human History.” In

H. Daly and K. Townsend, eds., Valuing the Earth, Cambridge, MA: MIT Press, 1993.
 Chapter 15 Money • 297

of the production of real goods and services. Financial assets are neither
money nor real wealth, but they are bought and sold in the market, and
people will hold more money to be able to meet their demand for trans-
actions in these assets. In addition, people trade in money itself, using one
national currency to buy another, and this similarly increases the demand
for money. Both currency speculation and growth in financial assets have
increased dramatically in recent years.
The M—C—M* equation previously showed how money has become
less a means for facilitating exchange, more an end in itself. In reality, the
M—C—M* equation has itself been dwarfed by pure currency specula-
tion and trading in financial paper. John Maynard Keynes warned back in
the 1930s, “Speculators may do no harm as bubbles on a steady stream of
enterprise. But the position is serious when enterprise becomes the bub-
ble on a whirlpool of speculation. When the capital development of a
country becomes a by-product of the activities of a casino, the job is likely
to be ill-done.”8 While global production of marketed goods and services
is roughly on the order of $30 trillion per year,9 the trade in paper pur-
chasing paper (or, more accurately these days, electrons purchasing elec-
trons) with no intervening commodity is almost $2 trillion per day.10 This
means that the buying and selling of paper assets and currencies, M—M*,
is more than 20 times greater than exchanges in the real economy! Real
enterprise has indeed become a bubble on the whirlpool of speculation.
As no productive activity intervenes in these speculative purchases, the
sole result seems to be a magical growth in money. But is such growth ac-
tually possible indefinitely?
Growth in money is meaningless unless there is a corresponding in-
crease in real wealth, so now we must ask: Does financial speculation lead
to growth in real wealth? Some paper-paper purchases are purchases of
new stock offerings that do provide financial capital, which can mobilize
physical factors of production, but this is only an estimated 4% of stock
purchases. Speculation in currency, in which millions of dollars are traded
back and forth for very small margins over short time scales, clearly pro-
duce nothing. Indeed, such transactions almost certainly contributed to
the crises in several Southeast Asian economies in 1997–1998 as specula-
tors sold off regional currencies, and these crises meant dramatic decreases
in production from those economies. Yet such speculation would not be

8J. M. Keynes, The General Theory of Employment, Interest and Money, Orlando, FL: Harcourt

Brace, 1991, p. 159.

9Official estimates based on purchasing power parity (PPP) are on the order of $40 trillion per

year; the numbers for speculation are in nominal dollars, not PPP.
10D. Korten, The Post-Corporate World: Life After Capitalism, San Francisco: Berrett-Koehler,
1998.
298 • Macroeconomics

undertaken unless some profits were being made somewhere. For exam-
ple, George Soros, who participated in the financial speculation in South-
east Asia, is reported to have earned 1 billion pounds speculating on
England’s currency in 1995.11 The only possible explanation is that if
those who produce nothing are earning, through speculation, more
money that entitles them to more real wealth, then those who actually do
produce something must be becoming entitled to increasingly less wealth.
In summary, it appears that the illusion that money can grow without
physical limits results from three things. First, as long as the production
of real goods and services increases, more money is needed to pursue
them, so growth in money is justified. But such growth cannot, of course,
continue forever on a finite planet. Second, as the number or price of fi-
nancial assets grows, such as through speculative bubbles, demand for
money grows as well, and supply can increase to meet this demand. The
fact is, however, that financial bubbles inevitably burst. Third, holders of
financial capital see their capital grow because speculation can transfer re-
sources from those who produce to those who merely speculate. Such
transfer of wealth has limits, though the limits are obscured by continued
economic growth. Thus, the appearance that money is exempt from the
laws of thermodynamics is an illusion that can be maintained only while
scale is increasing, or the financial sector is expanding relative to the real
sector. It remains impossible for real money to grow without limit.
THINK ABOUT IT!
What do you think would happen if a national government tried the
same approach to seigniorage as Ithaca HOURs? For example, the gov-
ernment could impose 100% reserve requirements to prevent banks
from creating money, award every new entrant to the economy some
lump sum of money (perhaps by providing 18-year-olds sufficient
money to pay for a college education or start a business), and lend
money into existence at 0% interest for socially desirable projects.

11W. Greider, One World, Ready or Not: The Manic Logic of Global Capitalism, New York: Simon

& Schuster, 1997.

 Chapter 15 Money • 299

BIG IDEAS to remember

I Money as medium of I Seigniorage

exchange, unit of account, I Fractional reserve banking
store of value I Money creation
I Barter; simply commodity I Money as public good
production; capitalist I Federal Reserve System
circulation I Money and laws of
I Exchange value vs. use value thermodynamics
I Virtual wealth I Local currencies
 CHAPTER

16
Distribution
W e have emphasized that ecological economics is concerned with
three issues: the allocation of resources, their distribution, and the
scale of the economy. We have seen how the ecological sustainability of
the Earth is related to the size or scale of the macroeconomy. We have also
explored the economist’s meaning of efficient allocation in our discussion
of microeconomics and the basic market equation. We then looked at the
macroeconomic allocation problem in Chapter 14. But the second issue,
distribution and the fairness thereof, has remained largely in the back-
ground.

I Pareto Optimality
In dealing with allocation, we saw that economics defines efficiency as the
Pareto optimal allocation of resources by the market. This definition as-
sumes a given distribution of wealth and income. More specifically, an ef-
ficient allocation is one that best satisfies individual wants weighted by the
individual’s ability to pay—that is, by her income and wealth. Change the
distribution of income and wealth, and we get a different set of efficient
prices (since different people want different things), which define a differ-
ent Pareto optimum. Because different Pareto optima are based on different
distributions of income and wealth, economists are reluctant to compare
them; one optimum is as good as another. We saw that a major reason for
scale expansion—economic growth—has been to avoid the issue of dis-
tributive equality. As long as everyone is getting more from aggregate
growth, the distributive issue is less pressing, at least as a cure for poverty.
Besides, the efficiency of the allocation of aggregate growth loses its well-
defined meaning (Pareto optimality) once we accept the legitimacy of
changing distribution in the interest of fairness. Consequently, economics

301
302 • Macroeconomics

has tended to address distribution out of logical necessity but quickly sets
it aside in the interests of political convenience.

Does a Pareto Optimal Allocation

Assume a Given Scale as well as a
Box 16-1 Given Distribution?
If we take the concept of scale literally, as in the scale model of a house,
to involve only a proportional change in all linear (scalar) dimensions,
then we might say that a scale change is simply an increase or decrease
in which all proportions remain constant. All relative prices, measuring
unchanged relative scarcities, would also remain constant, defining an
unchanging Pareto optimal allocation in terms of proportions. This
seems to be what standard economists often have in mind. But is it pos-
sible to have everything grow in proportion? No, for two reasons. First, if
something is fixed, it obviously cannot grow proportionally to everything
else. What is fixed from the ecological economist’s perspective is the
size of the total ecosystem. As the economic subsystem grows, albeit
proportionally in terms of its internal dimensions, the ecosystem itself
does not grow. The economy becomes larger as a proportion of the total
system—what we have called an increase in its scale, meaning size rela-
tive to the ecosystem. Natural capital becomes more scarce relative to
manmade capital.
Of course, if the economy were to expand to encompass Earth’s entire
ecosystem (the model of “economic imperialism” in Chapter 3), the scale
issue would disappear. In this sense the neoclassical economist’s claim
that if only all externalities were perfectly internalized then prices would
automatically solve the scale problem (in the process of allocating every-
thing in creation) makes sense. But it’s a rather utopian point, like
Archimedes’ boast that he could move the Earth, if only he had a fulcrum
and a long enough lever.
The second difficulty, long noticed by biologists and some econo-
mists, is that if you scale up anything (increase all linear dimensions by
a fixed factor), you will inevitably change the relative magnitudes of non-
linear dimensions. Doubling length, width, and height will not double
area; it will increase area by a factor of four and volume by a factor of
eight. Biologists have long noted the importance of being the right size.
If a grasshopper were scaled up to the size of an elephant, it could not
jump over a house. It would not even be able to move, because its
weight (proportional to volume) would have increased eightfold, while
its strength (proportional to a cross-sectional area of muscle and bone)
would have increased only fourfold.
Returning to our example of a house, doubling the scale will increase
surfaces and materials fourfold and volumes to be heated or cooled eight-
fold. Relative scarcities and relative prices cannot remain the same. The
 Chapter 16 Distribution • 303

answer to our question, does the notion of Pareto optimal allocation as-
sume a given scale as well as a given distribution, appears to be yes. Size
cannot increase proportionally because (1) there is a fixed factor, namely
the size of the ecosystem, and (2) it is mathematically impossible even for
all relevant internal dimensions of the subsystem to increase in the same
proportion. In sum, it seems quite true that an optimal allocation assumes
a given scale, just as it assumes a given distribution.

Economics prides itself on being a “positive science.” Allocative effi-

ciency is thought to be a positive, or empirically measurable, issue, even
though, as we just saw, it presupposes a given distribution. Whether or
not the scale of the economy is sustainable is also considered to be a pos-
itive issue involving biophysical constraints, although normative ques-
tions of conservation for the future and other species are not far below the
surface. Distributive equity, on the other hand, is a normative issue. This
is the main question addressed to distribution: Is it fair? Not, is it efficient?
or Is it ecologically sustainable? The question “Is it fair?” is directly and
unavoidably normative, and for that reason alone it is given minimal at-
tention by the positivist tradition of economics.
But like other sciences, economics assumes certain cultural values.
First, the very criterion of objective efficiency, Pareto optimality, embod-
ies an implicit normative judgment, namely that malevolence or invidious
satisfactions are not acceptable. If everyone but you becomes better off
and you remain no worse off, the Pareto criterion tells us that is an objec-
tive increase in social welfare. But if everyone else is better off except you,
and you are an envious person, then you will be less happy than before,
even though your absolute situation is no worse. Economists must make
either the (false) positive judgment that people are in fact not invidious
and jealous or the (true) normative judgment that envy at another’s good
fortune is a moral failing rather than a welfare loss.
There is a second reason that economics is less positive than some
think. Redistribution can be efficient in the sense of increasing total social
utility, yet economists make the value judgment that this kind of efficiency
should not count. For example, redistributing a dollar from the low mar-
ginal utility use of the rich to the high marginal utility use of the poor will
increase total utility to society and is in that sense efficient. The Pareto cri-
terion forbids such interpersonal comparisons and summations of utility.
Some argue that the major function of the Pareto criterion was precisely
to sterilize the egalitarian implications of the law of diminishing marginal
utility,1 a law that economics cannot afford to give up, as we saw in our
discussion of demand curves (see Chapter 9).
1J. Robinson, Economic Philosophy, Middlesex, England: Penguin, 1962.
304 • Macroeconomics

If we admit interpersonal comparisons of utility, then distribution has

efficiency implications as well as fairness implications. The extreme indi-
vidualism of economics insists that people are so qualitatively different in
their hermetical isolation from one another that it makes no sense to say
that a leg amputation hurts Smith more than a pin prick hurts Jones. If we
are all isolated individuals, we can rule out such obviously realistic human
characteristics as envy and benevolence. Man as atomistic individual is the
Homo economicus of neoclassical economics. Ecological economics’ con-
cept of the nature of man is “person-in-community,” not isolated atom.
Community here means community both with other humans and with the
rest of the biosphere.

I The Distribution of Income and Wealth

Ecological economics distinguishes between the distribution of income
and the distribution of wealth and between the functional and the per-
sonal distribution of income.
Wealth is a stock of assets, measured at a point in time, that is, cash
in the bank, plus the market value of bonds, corporate shares, land, real
estate, and consumer durables as of a given date. Income is the flow of
earnings from these assets, plus the earnings of your own labor power
(or human capital), between two dates, that is, over a period of time,
usually a year. Labor power is not usually counted as capital because
one cannot sell it all at once to another person (short of slavery) but can
only rent it for certain durations. Income and wealth are thus two
different magnitudes, measured in different units and distributed differ-
ently over the population.2 Wealth is usually more concentrated than in-
come. And financial wealth is even more concentrated than wealth in
general. In 1989, the top 1% owned 48% of financial wealth, while the
bottom 40% had negative net worth. Virtually all of the growth in
wealth between 1983 and 1989 in the U.S. went to the top 20%. The
bottom 80% was excluded from this growth (Table 16.1), and the bot-
tom 40% saw their wealth decline in real terms. Inequality of wealth de-
clined somewhat from 1989 through 1998. However, from 2001 to
2004, median incomes fell by nearly 7%, while mean incomes increased
by 10%. In that period, median net worth fell by 0.7% in spite of sky-
rocketing home prices, and median financial wealth fell by an astonish-
ing 26.5% while mean financial wealth increased. All are indicators of

2Wealth is measured in dollars (for example) and income in dollars/time. These magnitudes

are as different as miles (distance) and miles per hour (speed).

 Chapter 16 Distribution • 305

I Table 16.1
U.S. PERCENTAGE SHARE OF WEALTH AND INCOME BY PERCENTILE GROUP
Percentile Shares
Year Top 1% Next 19% Bottom 80% Gini Coefficient
Net Worth (Wealth)
1983 33.8 47.6 18.7 0.799
1989 37.4 45.3 16.2 0.832
1992 37.2 46.6 16.3 0.823
1995 38.5 45.8 16.1 0.828
1998 38.1 45.3 16.6 0.822
2001 33.4 51.3 16.6 0.826
2004 34.3 50.4 16.3 0.829

Income
1983 12.8 39.0 48.1 0.480
1989 16.4 39.0 44.5 0.521
1992 15.7 40.7 43.7 0.528
1995 14.4 40.8 44.9 0.518
1998 16.6 39.6 43.8 0.531
2000 20.0 38.6 41.4 0.562
2003 17.0 40.9 42.1 0.540

Source: E. N. Wolff, Top Heavy, The Twentieth Century Fund Report, New York: New Press, 1995, p. 67 (years 1983–1992); E. N. Wolff,
Recent Trends in Wealth Ownership, 1983–1998, Working Paper No. 300, Table 2, Jerome Levy Economics Institute, April 2000 and E.
B. Wolff, Recent Trends in Household Wealth in the United States: Rising Debt and the Middle-Class Squeeze, SSRN eLibrary.

dramatic increases in inequality.3 By 2006, after-tax income inequality

was the highest ever recorded.4
Economics has a theory that explains income, as discussed next, and
one that explains the prices of assets (though not entirely, as the “price” of
entrepreneurship is a residual) but no theory at all to explain the distri-
bution of wealth among individuals. It is the historical result of whose an-
cestors got there first, of marriage, of inheritance, plus individual ability
and effort, and just plain luck.

I The Functional and Personal Distribution

of Income
Income distributed among people, regardless of its source, is called the
personal distribution. Income is also distributed according to how much
of total income goes to wages, interest, rent, and profit—the functional

3See E. Wolff, Recent Trends in Household Wealth in the United States: Rising Debt and the Middle-

Class Squeeze, SSRN eLibrary, 2007.

4A. Sherman, Income Gaps Hit Record Levels in 2006, New Data Show: Rich–Poor Gap Tripled Be-

tween 1979 and 2006, Washington, DC: Center on Budget and Policy Prioirities, 2009.
306 • Macroeconomics

Figure 16.1 • The Lorenz curve. Because the Lorenz curve is in percentages, its
shape does not depend on units of measure. It is therefore useful for making
comparisons across countries and over time.

distribution. The idea behind the functional distribution is that income is

not first created, then distributed. Rather, it is distributed as it is created
among the factors combining to create it.
Remember from the circular flow diagram (see Figure 2.4) that sup-
ply and demand in the factors market determine the prices of factors—
wages, interest, rent, with profit as a residual. Factor prices times the
total amount of each factor used yields the functional distribution, usu-
ally expressed as percentage of total income going to landowners (rent),
laborers (wages), capitalists (interest), and entrepreneurs (profit). Prices
of each factor times the amount of the factor owned by each individual
yields the personal distribution of income. The amount of each factor
owned by each person, including labor power, is the personal distribu-
tion of wealth. Therefore, the personal distribution of wealth times the
rental price of each type of wealth asset determines the personal distri-
bution of income.
 Chapter 16 Distribution • 307

Figure 16.2 • The frequency distribution of income.

I Measuring Distribution
Although economists have no good theory by which to explain the distri-
bution of wealth and income, they do have useful ways of measuring and
describing it statistically.5 One useful representation is the Lorenz curve,
shown in Figure 16.1. The x-axis shows the number of income recipients
in terms of cumulative percentages, from lowest to highest income. The y-
axis shows the percentage of total income. The lengths of the axes are
equal, so that when closed in, they make a square.
The Lorenz curve plots the percentage of total income going to each
percentage of income recipient. We know that 0% of income recipients
will get 0% of the income, and that 100% of income recipients will get
100% of the income, so we already know the two extreme points on any
Lorenz curve. If each percentage of the population received the same per-
centage of the income (i.e., the bottom 20% got 20% of total income, the
bottom 70% got 70% of income), we would have perfect equality. The
Lorenz curve would be the 45-degree line connecting (0, 0) with (100,
100). But suppose the bottom 80% of recipients get 44% of the income.
That gives us another point, one that lies well below the 45-degree line. If
we fill in many points between the extremes, we get a curve shaped like
the one in Figure 16.1. The closer the curve to the 45-degree line, the
more equal the distribution; the farther away, the less equal. The shaded

5For a clear and insightful exposition, see J. Pen, Income Distribution, New York: Praeger, 1971.
308 • Macroeconomics

area defined by the curve and the 45-degree line measures inequality. In
the limit, if one person got 100% of income and everyone else got 0%, the
Lorenz curve would coincide with the axes and look like a backwards L.
The ratio of the shaded area (between the curve and the 45-degree line)
to the total triangular area under the 45-degree line is called the Gini co-
efficient. For perfect equality the shaded area is zero, and consequently
The Gini coefficient is used to the Gini coefficient is 0; for perfect inequality the shaded area takes up the
measure the inequality of the whole area under the 45-degree line, and consequently the Gini coeffi-
distribution of wealth or in-
cient is 1. Values of the Gini coefficient for U.S. wealth and income dis-
come across a population. A
tribution are given in Table 16.1.
Gini coefficient of 1 implies per-
fect inequality (one person A more familiar statistical description is the common frequency distri-
owns everything), and a coeffi- bution, shown in Figure 16.2. The x-axis shows income category, and the
cient of zero indicates a per- y-axis shows number of members in each income category (frequency).
fectly equal distribution. Income distribution does not follow a normal distribution, as does height
or many other personal characteristics. Rather, it is highly skewed, with
the mode well below the mean and a very, very long tail to the right
needed to reach the top income.
If we wanted to show the maximum income on Figure 16.2, we would
need a fold-out extending the horizontal axis by the length of a football
field. Graphical representations generally do not capture the extreme
inequality at the upper income range. Income categories are frequently
truncated at a maximum category of “$100,000 and over,” where “over”
means four orders of magnitude over.
Another interesting way to look at income distribution is to consider a
football field, where the zero yard line represents the poorest person, the
the 50 yard line the person with median income, and 100 yard line the
richest person in the U.S. Incomes are depicted as the height of a stack of
$100 bills. At the 50 yard line the median personal income (in 2005) of
$25,149 is represented by a one-inch stack of bills. Around the 99 yard
line, we see a stack of bills about a foot high—$300 million. Nearing the
100 yard line, the top hedge fund manager in 2008, a recession year,
earned $2.5 billion, a stack of bills 1.7 miles high. Bill Gates once earned
a stack nearly 30 miles high!6
Moreover, these data are just for the United States. The distribution of
wealth and income between countries is far greater than that found within
countries.
What is the proper range of inequality in the distribution of income?
Surely it is impossible to have one person owning everything and everyone
else owning nothing. Maybe we could have everyone else getting a subsis-

6L. Story, Top Hedge Fund Managers Do Well in a Down Year, New York Times, March 24,

2009. See also http://www.lcurve.org.

 Chapter 16 Distribution • 309

tence wage, and the fortunate one person enjoying the entire social surplus
above subsistence. But most people would not consider that fair, even
though possible. At the other extreme, few people think a perfectly equal
distribution—a Gini coefficient equal to zero—would be fair either. After
all, some people work harder than others, and some jobs are more difficult
than others. Fairness in a larger sense would require some income differ-
ences. There is a legitimate case to be made that differences in distribution
provide a socially useful incentive for industriousness and innovation.
Is there a legitimate range of inequality, beyond which further inequal-
ity becomes either unfair or dysfunctional? What might such a range be?
Plato thought that the richest citizen should be four times wealthier than
the poorest. Ben Cohen and Jerry Greenfield, of Ben and Jerry’s ice cream
fame, at one time reportedly pledged that the highest-paid executive
would receive no more than five times the salary of the lowest-paid em-
ployee. Maybe Plato, Ben, and Jerry were wrong, though, and maybe a fac-
tor of 10 would be better. Or 20 or 50. Currently the acceptable ratio is
not defined, and in 1999 in the United States, the typical CEO earned 475
times the typical worker.7 Ecological economics does not accept the cur-
rent notion that real total output can grow forever. If the total is limited,
then the maximum for one person is implicitly limited. The issue of a
proper range of inequality in distribution is therefore critical for ecologi-
cal economics, even though it has not yet received due attention. The
standard economist’s effort to keep distribution at bay forever by eternal
growth is not a satisfactory solution.
Finally a word on the functional distribution of income. For industrial
countries, the division varies around the following: wages = 70%, profits
= 20%, interest = 8%, and land rent = 2%. For ecological economics, what
is striking is that essentially none of the value of the total product is
attributed to natural resources or services. Even land rent is mainly a lo-
cational premium, not a payment for resources in situ or natural serv-
ices—one more piece of evidence that the flow of low entropy from nature
is treated as a free good. If we think of two social classes struggling to di-
vide the pie, we have laborers getting 70% and capitalists, business own-
ers, and landowners together getting about 30%. This division represents
a kind of balance of power in the social struggle. Neither side wants to in-
clude nature as a participant in production, which would require that na-
ture’s services be paid according to their scarcity and productivity.
Even if one wanted to pay for nature’s contribution, who would collect
on nature’s behalf? There is no social class analogous to labor or capital

7J. Reingold and F. Jesperson, Executive Pay: It Continues to Explode—and Options Alone Are

Creating Paper Billionaires, Business Week, April 17, 2000. Online: http://www.businessweek.com/
careers/content/jan1990/b3677014.htm.
310 • Macroeconomics

Box 16-2 Distribution and Taxation

Income distribution has changed markedly over the years in the United
States. Paul Krugman refers to the period up to the Great Depression as
"the Gilded Age," when both wealth and income were highly concen-
trated in the hands of the few. Beginning just prior to World War II up
through 1943, there was an impressive reduction in income inequality
known as the great compression (which Krugman attributes largely to
President Franklin Roosevelt’s New Deal), followed by about 40 years of
"Middle-Class America." Beginning the 1980s, about the time of Ronald
Reagan’s election, income inequality began to increase steadily in "the
Great Divergence."a A graph on Paul Krugman’s blog (see footnote) de-
picting the income share of the top 10% of U.S. society shows these
trends very clearly.
A slightly different graph in Figure 16.3 shows the income share of
the top 0.1% of U.S. society, along with the highest marginal tax
bracket. It’s pretty evident that the highest marginal tax bracket is in-
versely correlated with pre-tax income, suggesting that the more income
the wealthy are allowed to take home, the more capital they accumulate,
and the greater their income in future years. Middle-Class America was
associated with top marginal tax brackets of 70% and higher. Currently,
the top tax rate is less than half that amount. Hedge fund managers are
taxed at the capital gains rate of 15% per year, but due to a tax loophole,
they are able to delay paying taxes on their income for as long as 10
years.b

aP. Krugman, The Conscience of a Liberal blog. Online: http://krugman.blogs.nytimes

.com/2007/09/18/introducing-this-blog/.
bJ. Anderson, Managers Use Hedge Funds as Big I.R.A.’s, New York Times, April 17, 2007.

that has an interest in seeing to it that nature’s services are properly ac-
counted and paid for. Historically the landlord class may to some extent
have played the role of defender of nature’s services, but that class hardly
exists anymore, and few lament its demise. The government is the biggest
landholder in the U.S., and it has followed a policy of cheap resources in
order to benefit and ease the tensions between labor and capital. The ex-
isting classes, labor and capital, see it in their mutual interest not to share
with a third party. Since in reality there is no third party, all that would be
necessary is to pay into a fund a scarcity rent for natural resources and
services, and then redistribute the fund back to labor and capital, perhaps
on the same 70–30 division. This would get the cost accounting and
prices right and improve the efficiency of allocation, without necessarily
affecting the distribution. Alternatively, since many of the goods and serv-
ices provided by natural capital are nonmarket goods, the scarcity rent
 Chapter 16 Distribution • 311

4%

income share (%), top 0.1%

3%

2%

1%

0%
1925
1928
1931
1934

1937

1940

1943
1946
1949

1952
1955

1958
1961

1964

1967
1970

1973
1976

1979

1982
1985

1988

1991
1994

1997
2000
Highest tax bracket Income share, top 0.1%

Figure 16.3 • The income share of the top 0.1% of U.S. society (left axis), and the
highest marginal U.S. Tax break (right bracket) between 1913 and 2002.

could go toward supplying other nonmarket goods. The government

could do this directly or could subsidize the private production of such
goods. The rent could also be redistributed progressively by financing the
abolition of regressive taxes.

I Consequences of Distribution for

Community and Health
The existing distribution of wealth is not only a precondition for efficient
allocation; it is also a fundamental dimension of justice in society. As such,
it affects us more directly than we might at first think. Evidence indicates
that inequality of income distribution (independently of absolute poverty)
has a substantial effect on rates of morbidity and mortality.8 The relatively
poor have higher incidences of death and sickness than the relatively rich,
regardless of the absolute level of income of the relatively poor. The main
reason investigators suggest is the extra stress associated with being
relatively poor, being at the bottom of a dominance hierarchy. This extra
stress is caused by less control over the circumstances of one’s life, greater
risks of job loss, a lower level of social standing and respect, and more

8See. G. Wilkinson, Mind the Gap, New Haven, CT: Yale University Press, 2001.
312 • Macroeconomics

frequent experiences of disrespect and shame, with consequent anger and

violence. Life at the bottom is more threatening, and the threat often
comes from stressful relations with people higher up, including bosses,
landlords, and government officials. Stress, of course, has well-known
negative direct physiological effects on health.
In addition to these direct effects, inequality has indirect social effects
on health. It is more difficult to form friendships across wider income
gaps, as well as more difficult to form civic associations when wealth lev-
els and economic interests are very disparate. Lack of friends and civic co-
hesion is also correlated with ill health. Treating people as atomistic,
isolated individuals, unaffected by social relationships, literally makes
them sick. As seen from our discussion of Max-Neef’s human needs ma-
trix (see Table 14.1), we are persons-in-community, related to each other
internally—that is, our personal identity is constituted largely by our re-
lation to others in the community. We are not independently defined en-
tities held together only by external relations of the cash nexus. When
these identity-constituting social connections become strained and cor-
rupted by excessive inequality, we get sick more often and we die younger.
We are also less happy.

I Intertemporal Distribution of Wealth

Every bit as important as the distribution of wealth and income within a
generation is the distribution of resources between generations. However,
while people have pondered the distribution of resources within a gener-
ation for millennia, the concern for distribution between generations is
more recent. For the vast majority of human history, natural resources ap-
peared limitless and technological advance was slow. People had approx-
imately the same resource endowment as their great-grandparents had
enjoyed, and they expected their great-grandchildren to inherit the same
endowment as well. As the pace of technological change and fossil energy
use accelerated with the Industrial Revolution, change became noticeable
from one generation to the next, and people began to expect a better life
for their children than they themselves had enjoyed. The “Protestant work
ethic” asked people to work hard and invest for their children. At least up
through the 1960s, the question most economists asked was: How much
consumption should this generation sacrifice for the ever-growing well-
being of the next?9

9E.g., J. Robinson, Essays in the Theory of Economic Growth, London: Macmillan, 1968; E.

Phelps, Second Essay on the Golden Rule of Accumulation, American Economic Review 55(4):
793–814 (1965).
 Chapter 16 Distribution • 313

However, the onset of the atomic age made it apparent that technolog-
ical advance had the capacity to bring harm as well as good. Growth in
population and per-capita consumption raised the specter of resource de-
pletion. Worsening pollution caused alarm, and ecologists began to worry
that many systems were nearing irreversible, catastrophic thresholds. The
relevant question was no longer: How much should we sacrifice to make
the future even better off? Now it was: How much should we sacrifice to
keep the future from being worse off than the present? Paradoxically, at
least in the United States, a culture change was occurring at about the
same time. The work ethic was no longer “work hard, live frugally, and in-
vest in the future” but rather “work hard, borrow heavily, and consume as
much as possible now.” As a result, personal savings rates in the U.S.
plunged to historic lows and rapidly approached zero early in the twenty-
first century, while federal deficits reached historic highs.
Should people strive to make the future better off than the present? Do
we have at least an obligation to make sure it is not worse off than the
present? There are no easy answers to the “appropriate” distribution of
wealth between generations. Even a brief survey of philosophies is beyond
the scope of this text. We will quickly examine two alternative approaches:
the ecological economics approach, based on ethical judgments concern-
ing obligations to future generations (intergenerational justice), and the
more mainstream approach in economics that argues for an “objective”
decision-making rule (intergenerational allocation).

The Normative Approach of Ecological Economics

Ecological economists generally take the position that intergenerational
resource distribution is an ethical issue. The generation into which some-
one is born is based entirely on chance. There is therefore no moral justi-
fication for claiming that one generation has any more right to natural
resources, the building blocks of the economy, than any other. At the very
least, future generations have an inalienable right to sufficient resources to
provide a satisfactory quality of life. The current generation thus has a cor-
responding duty to preserve an adequate amount of resources. What is
adequate depends on both technological and ecological change, both of
which are characterized by pure uncertainty (ignorance). How we choose
to deal with uncertainty is also an ethical decision.
What does this mean in practical terms?
Renewable and nonrenewable resources are fundamentally different
and must be treated separately. An equal distribution of finite nonrenew-
able resources among a virtually infinite number of future generations
would imply no resource use by any single generation. But there is no
point in leaving resources in the ground forever, never to do anyone any
good, so an upper limit to exhaustible resources for any one generation
314 • Macroeconomics

might be determined by the waste absorption capacity of the environ-

ment. As long as the use of the resource generates waste no faster than the
ecosystem can absorb it, the use of exhaustible resources by one genera-
tion will not reduce renewable natural capital. Keeping fossil fuel use
within such limits would automatically limit our ability to extract other
mineral resources.
Even with a limited ability to extract nonrenewable but recyclable re-
sources, each generation would have a further obligation to efficiently re-
cycle such resources or at least minimize the generation and dispersion of
“garbo-junk” as much as possible to make such resources as intergenera-
tionally nonrival as possible. If existing technologies make our well-being
dependent on nonrenewable resources—as is currently the case—then we
are simply obliged to develop substitutes for these resources. One option
would be to capture marginal user costs, the unearned income from non-
renewable resources, and invest them toward developing such substi-
tutes.10
Renewable resources as fund-services provide essential life-support
functions, and these functions clearly must be maintained. Renewable re-
sources as stock-flows must also be harvested at sustainable levels. No one
created renewable resources, and therefore no single generation has the
right to reduce the amount of the resource a future generation can sus-
tainably consume, suggesting resource stocks must be at least as large as
that which provides the maximum sustainable yield. As we saw in Chap-
ter 12, sustainable management of renewable resources in a manner that
“optimizes” both stock-flow and fund-service benefits will in general
maintain these resources far from any catastrophic ecological thresholds.
It is worth bearing in mind that as nonrenewable resources are finite, the
exhaustion of these resources is a finite loss to future generations. Renew-
able resources, as both stock-flows and fund-services, produce a finite
flow over an immeasurable number of future generations, and their irre-
versible loss therefore imposes a perpetual cost to the future.

The “Positive” Approach of Neoclassical Economics

Conventional economists, in contrast, favor an objective decision rule to
determine the intergenerational allocation of resources. The problem thus
becomes simply a technical one of comparing future benefits and costs
with those that occur in the present. From this point of view, the market
can tell us the value of things in the future relative to things today, and
therefore the market can solve the problem of intergenerational allocation.

10For practical guidelines on investing scarcity rents, see S. El Serafy, “The Proper Calculation

of Income from Depletable Natural Resources.” In Y. J. Ahmad, S. El Serafy, and E. Lutz, eds., En-
vironmental Accounting for Sustainable Development, Washington, DC: World Bank, 1989.
 Chapter 16 Distribution • 315

Intertemporal Discounting. How does the market reveal future values?

Where adequate financial markets exist, people can borrow money today
at interest, which requires them to pay back more money in the future.
The fact that people engage in this activity reveals that people prefer
things now rather than in the future, and economics must respect people’s
preferences.
There are three basic reasons why people might prefer things now to
things in the future. First, people may simply be impatient. Anyone who
goes into interest-bearing debt to purchase something is willing to sacri-
fice a greater quantity in the future for a smaller quantity now. Some of
this impatience may come from uncertainty—no one knows for sure if he
or she will be alive tomorrow, so why not eat, drink, and be merry today?
This rationale for discounting is known as the pure time rate of prefer-
ence (PTRP).
Second, for things that reproduce, it makes sense that a given quantity
in the future would be worth less than a given quantity now. For exam-
ple, a handful of seed corn now can become a bushel of marketable corn
a few months from now, so if growing corn was risk-free and required no
resources or effort, then a handful now would be at least as valuable as a
bushel in a few months. Of course, growing corn is risky and requires
land, labor, and resources. However, market goods (in this case, seed
corn) can be sold for money. Investing the money earned from the sale of
the seed corn in an insured bank is not very risky and for the individual
investor basically requires no further resources or labor. As we explained
in Chapter 10, this rationale for discounting is known as opportunity
cost, the lost opportunity to invest. If money is a substitute for any other
resource, then we should give more weight to any resource today over the
same resource tomorrow.
Third, the economy has grown fairly steadily for hundreds of years.
People therefore expect that they will be richer in the future than they are
today. Just as an extra $1000 provides less utility to Bill Gates than to a
pauper, the law of diminishing marginal utility means that money in the
future will be worth less than the same amount of money today. This is
sometimes referred to as the “richer future” argument.
In general, this process of valuing the future less than the present is
known as intertemporal discounting, introduced in Chapter 10. Busi-
nesspeople explicitly discount the future when making investment deci-
sions, and mainstream economists argue that people automatically apply
this concept to all of their purchase decisions. As a result, they conclude,
the market efficiently allocates goods between the present and future.
What’s more, if intertemporal discounting leads to allocative efficiency
in the market, then it should also be applied to nonmarket investments.
For example, one of the biggest nonmarket decisions we face today is how
316 • Macroeconomics

to deal with global climate change. Virtually all economic analyses of cli-
mate change place a lower weight on future costs and benefits than on
present ones. These analyses look at different policy scenarios and for
each sum up the present costs and benefits with discounted future costs
and benefits to arrive at a net present value (NPV). NPV basically tells
us what present and future costs and benefits are worth to us today (not
to the future tomorrow), which implies that future generations have no
particular right to any resources, and we have no obligation to preserve
any. Under this type of benefit-cost analysis, the higher the NPV relative
to required investments, the better the project.
Such analyses can carry a great deal of weight as society decides how
to address some of the most pressing problems we now confront. The cen-
tral importance of the discount rate in determining the outcome of such
analyses means the topic deserves our attention.

Intertemporal Discounting and

Box 16-3 Global Climate Change

Policy makers seeking an objective decision-making tool for resolving

the problems of global climate change have turned to economists. Econ-
omists typically respond to the problem by creating complex models of
future costs and benefits of climate change and compare these to the
costs of mitigation measures in a cost-benefit analysis designed to cal-
culate net present value. Not surprisingly, analyses using a fairly high
discount rate find that future damages from global warming do not jus-
tify efforts today to reduce greenhouse gases. The 6% discount rate
used in one study would have us believe that we should not invest $300
million today to prevent $30 trillion (a rough estimate of today’s global
GNP) in damages in 200 years.a A similar study using a 2% discount rate,
in contrast, finds that we should make substantial investments now to
reduce the impacts of global warming in the future. Similarly, what we
decide to do with an old-growth forest that supplies a small but steady
flow of benefits forever if left intact or a large, one-time return if it is
clear-cut will depend on the discount rate we choose.
A frequently asked question is: Does a higher or lower discount rate
favor the environment? For a given fishery or mine, as we have seen,
higher discount rates increase the intensity and rate of exploitation and
therefore are bad for the environment. But a higher interest rate (dis-
count rate) slows down aggregate growth in GNP and throughput, thus
easing pressure on the environment. In terms of evaluating a given proj-
ect, a high discount rate favors projects whose costs are mainly in the fu-
ture and whose benefits are in the present, rather than those whose
costs are in the present with benefits in the future. Most issues in eco-
nomics are not simple, and that certainly holds for discounting.
 Chapter 16 Distribution • 317

In many such models, the choice of a discount rate may be the single
most important factor, yet respected economists addressing the same
problem use dramatically different rates and arrive at dramatically differ-
ent results. Are such models actually objective decision-making tools?
a30 trillion is a number that’s hard to wrap your mind around. Putting it into perspec-

tive, 30 trillion seconds is slightly less than a million years (951,294 years, to be
precise).

Discounting Reconsidered
We have already explained why intertemporal discounting can make
sense for the individual and for market goods. We must now examine
whether it also makes sense for society and for nonmarket goods.
We saw why individuals might have a pure time rate of preference:
People are impatient; they don’t live forever; possessions can be lost, de-
stroyed, or stolen, and opportunities disappear. A reasonable individual
may discount the future for any one of these reasons—why should I pay
money now to reduce damages from global warming that will occur only
after I am dead?—but the same logic does not apply to society. Relative to
the individuals of which they are composed, societies are immortal, and
uncertainties are averaged out. For this reason, there is, in fact, fairly wide
consensus within the economics profession that social discount rates
should indeed be lower than individual discount rates. The social dis-
count rate is a rate of conversion of future value to present value that re-
flects society’s collective ethical judgment, as opposed to an individualistic
judgment, such as the market rate of interest.
When it comes to the opportunity cost of capital, however, the con-
sensus changes. Financial capital does function as a productive asset, and
if we have it now instead of in the future, we have the opportunity to in-
vest it in productive activities that will increase the quantity of market
goods in the future. There are a number of important issues we must bear
in mind, however.
First, the real value of money can grow only if the production of goods
and services that money can acquire also grows, and we know that the
production of goods and services cannot grow forever on a finite planet.
While there may always be some areas that are growing, justifying a dis-
count rate for the individual, the economy as a whole cannot grow in-
definitely, in which case a social discount rate into the indefinite future
may be inappropriate.
Second, we must recognize that many investments are “profitable” be-
cause we ignore many of the costs of production. We know that all human
productive activities use up natural resources and return waste to the en-
vironment, and these costs of production are often ignored. Many of these
318 • Macroeconomics

costs, such as contributions to global warming, have greater impacts on

future generations. Thus, ignoring costs to future generations allows us to
earn higher returns on investments. We then use these higher returns to
justify the fact that we ignore costs imposed on future generations. Even
in the short run, then, it seems that market-determined interest rates are
not suitable discount rates.
Related to the opportunity cost of capital is the argument that the fu-
ture will be richer than the present because of investments we make now.
Of course, if the economy does not continue to grow, the future will not
be richer, and if we deplete our natural resource stock, there is every
chance the future will be poorer. In fact, measures such as the ISEW sug-
gest that society is already growing poorer, not richer, if we take into ac-
count external costs. Also, if we believe that natural capital must be
treated separately from manmade capital (because they are complements
rather than substitutes and natural capital has become the limiting factor),
then the decline in natural capital, coupled with the law of diminishing
marginal utility, suggests we should apply a negative discount rate to nat-
ural capital. At the very least, we might consider applying a positive dis-
count rate only to goods and services that are actually highly fungible with
money—that is, that can be converted into money and back again with
little effort. Basically, this would mean that we should discount only mar-
ket goods and services.
Third, there are only finite opportunities for productive investment in an
economy; investments, like other things, show diminishing marginal re-
turns. For example, someone borrows money to explore for oil, and some-
one else borrows money to build a car factory. The next person to borrow
money to explore for oil will have fewer places to explore and therefore will
expect lower returns. The next person to borrow to build a car factory will
face a more saturated market and therefore expect to sell fewer cars. As more
and more people borrow to invest and opportunities are used up, the re-
turns on investments can be expected to decrease, ultimately falling to zero.
More likely, if interest rates are determined in the market by the supply and
demand of money for borrowing and returns on investments, a balance will
be reached in which investors cannot afford to pay high enough interest
rates for consumers to be interested in deferring consumption. Theoreti-
cally, then, in a perfect market situation, the opportunity cost of capital at
the margin will just equal the PTRP of the existing generation. (Obviously,
future generations cannot take part in financial markets any more than they
can in any other market.) However, a high PTRP means consumption will
be high and investment and growth low,11 and a low PTRP implies the op-

11Returns on investments will be high, but the total amount invested will be low, and there-

fore growth will be low.

 Chapter 16 Distribution • 319

posite. Thus, if we allow the market interest rate to determine the discount
rate, there would theoretically be an inverse correlation between discount
rate and economic growth, the exact opposite of what would justify the
“richer future” rationale for discounting.

Box 16-4 Discounting, Psychology, and Economics

Economists argue that economics is the science of human preferences,
so human preferences must be respected. If people value the present
more than the future, we must respect that. The question is: Do people
exponentially discount the future? While it is true you may prefer to have
something now rather than the same thing in 5 years, how do you value
something that happens 100 years in the future compared to 105 years?
If you heard that global warming was going to result in the deaths of 50
million Bangladeshis in 125 years, would that make you feel only half as
bad as finding out it would actually kill those 50 million Bangladeshis in
100 years? If you are like most people, you would feel equally bad in ei-
ther case, yet influential economic models of the impacts of global
warming really do assume we would care only half as much about those
deaths if they occurred 25 years later.
Empirical studies show that people do discount the future but do not
do so exponentially. We might give more weight to what happens now
than to what happens in the near future, but we are nearly indifferent be-
tween the same outcome occurring at different times in the more distant
future. One approach to modeling this type of behavior mathematically is
known as hyperbolic discounting. While this precise formulation of in-
tertemporal discounting may not be perfect, evidence suggests it is far
more representative of human preferences than exponential discounting.
While the approach was first introduced over 30 years ago and has
gained increasing attention in the last few years, it is still fairly rare to
see it in use.
An increasing number of studies in the area of Behavioral Economics
are finding that the traditional economic assumptions of human behavior
are often seriously flawed. If economics is serious about becoming the
science of human preferences, it would do well to pay more attention to
how humans really behave.a
aFor a good introduction to the field of Behavioral Economics, see R. Thaler and C. Sun-

stein. Nudge: improving decisions about health, wealth, and happiness. Yale Univer-
sity Press, New Haven. 2008.

Finally, many economists argue that technology is the driving force for
economic growth. Not only does technology ensure we won’t run out of
resources and the economy won’t stop growing, but it offers yet another
reason to discount the value of resources in the future. Technology is
likely to develop substitutes for natural resources. When these substitutes
320 • Macroeconomics

become available, the resources they replace will lose value. Therefore,
they will be worth less in the future than they are today. After all, hasn’t
oil largely replaced coal, and haven’t fiber optics replaced copper in many
uses? However, technology ultimately complements resources and can
never completely replace them. Some 150 years ago, oil had little value.
Today, it is an integral part of an overwhelming number of industrial
processes and products. As we saw in Chapter 5, we are actually develop-
ing new uses for oil and other raw materials faster than we are developing
replacements, again suggesting that the value of raw materials will in-
crease in the future, not shrink.
What can we say about discount rates in the end? They do make sense
for individuals in the short run. For some small-scale, short-term social
projects, they may also make sense. However, justifications for discount-
ing the future on a large scale and over long time horizons are question-
able at best.12 Intertemporal allocation is the apportionment of resources
across different stages in the lifetimes of basically the same set of people
(the same generation). Discounting can make sense for someone effi-
ciently allocating resources intertemporally. But as we lengthen the time
period we are more and more talking about different people (different
generations) and less and less about the same people at different stages in
their lives. Intertemporal distribution is the apportioning of resources
across different generations, across different people. Distribution is fun-
damentally different from allocation, and, consequently, justice replaces
efficiency as the relevant criterion for policy when time periods become
intergenerational.

BIG IDEAS to remember

I Pareto optimality I Gini coefficient
I Role of scale and distribution I Inequality and health
in defining Pareto optimal I Intertemporal distribution vs.
allocation intertemporal allocation
I Income distribution vs. I Discounting and net present
wealth distribution value
I Functional vs. personal I Pure time rate of preference
distribution (PTRP)
I Social limits to range of I Individual vs. social discount
inequality rates
I Lorenz curve

12See A. Voinov and J. Farley, Reconciling Sustainability, Systems Theory and Discounting,

Ecological Economics 63:104–113 (2007) for a more detailed discussion.

 CHAPTER

17
The IS-LM Model
W e have now explored three of the major issues with which macro-
economics is concerned: gross national product (GNP), money,
and distribution. We questioned the appropriateness of GNP as the desir-
able end for economic policy and emphasized the importance of a just dis-
tribution as a desirable end but said little about policies for attaining
whichever ends we choose to pursue. In this chapter, we examine the pol-
icy tools at the macroeconomist’s disposal that can help us attain an econ-
omy with sustainable scale, just distribution, and efficient allocation.
Of course, to know how policies work, we have to know how the
macroeconomy works. One way of doing this might be to build on mi-
croeconomic principles to construct a model in which supply and demand
of all goods and services balances simultaneously. This approach would
extend the basic market equation presented in Chapter 8—MUxn*MPPax
= MUyn*MPPay—into a general equilibrium model encompassing all
goods (x, y, z . . .), all commodities (a, b, c . . .), and all consumers (n, m,
o . . .). Such a model can easily become overwhelming. A thousand si-
multaneous equations with a thousand unknowns is hard to come into
mental contact with. It does show that everything depends on everything
else, which is interesting and usefully humbling, but it is also crippling
from a policy perspective to have to face the implication that in order to
predict anything, you have first to know everything. But a smaller system
of two or three or five especially important aggregate sectors interacting
through two or three or five simultaneous equations that reflect key be-
havior can aid the understanding and give basic policy insights. This is the
kind of model that most macroeconomists have sought. They still look at
the whole economy, but they divide it into fewer but larger aggregate

321