#12 Innovation as magic wand economics
While everyone knows from real life that it is impossible to solve every problem
Hi all,
You may have had your fill of my sports analogies; apologies for their abundance, but I have another one. There have been times when I enthusiastically pursued sport climbing and mountaineering. I even embarked on an expedition (although it didn't go quite as planned, to say the least). No matter how hard I trained, I never quite reached the top of the climbing world, far from that. I was terrible at climbing.
I enjoyed the mountains, the planning, the camaraderie, and the travel, but climbing didn't click for me. In theory, I understood what was required, but as we all know, practice is a different story. I always found my hands becoming sweaty too quickly (making gripping a challenge), and, to be honest, I was also fearful. Partly due to a severe accident, but mainly because that's just who I am: not a climbing hero. And that didn't help matters.
Despite taking courses, investing in new gear, and experimenting with all the latest innovations, I only seemed to make a little progress. After around ten years (or more precisely, after the disastrous expedition), I called it quits and never looked back.
I learned that sometimes we must humble ourselves and acknowledge that certain things are beyond our reach, no matter how hard we try.
I was thinking about this when reading that ‘we must redefine and reorient our growth patterns toward sustainability.’ There's a pervasive belief that every problem has a solution—innovation is seen as a cure-all for our woes. We have immense problems caused by markets, but fixing how markets work will bring solutions.
Yet, no scientific evidence guarantees that humanity will be able to solve all problems; this is more akin to faith. The prevailing notion is that, under the right conditions, private firms and markets can provide those solutions.
But is this realistic? Is it plausible that the mechanism that led us into this ecological crisis can also extricate us from it? And what are the necessary conditions for you to achieve this? Economists often speak of incentives and markets, but is that sufficient? What about transitions, complexity, and failures? These are the questions I aim to explore in this newsletter.
In summary (for those who prefer brevity), I doubt placing blind faith in innovation and markets. It is magic wand economics: just a flick of the economist magic wand, and we have sustainable markets. Following the economists' blueprint may yield the most profitable solutions, but there's no guarantee they will address the most pressing issues. What's certain is that human ingenuity within private markets is primarily driven by profit maximization. We must look beyond standard economics' confines to tackle sustainability problems and the ecosystem crisis.
This realisation is crucial. This means the answer to our sustainability problems can not be ‘just growth and innovation’. Other economic theories, other roles for governments, non-market interactions, and transition processes lead to different ideas about what to do next.
I hope you enjoy the read.
Magic wand economics
There is a broad consensus that innovation is what brings us progress. There are even a lot of agreements that markets, driven by profit-seeking behaviour, have led to the most efficient solutions for some problems. But not for all. Because it often derails: why do we need twenty flavours of toothpaste, ultra-fast fashion, or what problem are handerpants a solution for? Markets overproduce and plan obsolescence and are not interested in solving any problem. They are driven by another thing: profit. And, as long as making the highest profit is aligned with societal interests, there is no problem.
However, market outcomes need to be aligned with (longer-term) societal interests. Planetary boundaries are transgressed on a massive scale, and there is only one dominant reason for that overshoot: economic activity. On top of that, market outcomes are only helping some. There is (still) a lot of inequality, people without access to education or housing, and poverty. This is the distributional outcome of a system that produces enough for everyone on an aggregate level.
The evidence has piled up that violations of the primary conditions that need to be in place for markets to work correctly are exacerbated by globalisation, financialization, and technology—the so-called GFT-nexus (Globalisation, Financialization, Technology).
The standard answer of economists for this problem is quite simple. The story is about ‘correcting market failures’, and then the party can continue! These primary conditions can be called invisible hand conditions:(1) perfect competition, (2) symmetric and perfect information, (3) diminishing marginal returns to scale and scope, (4) no externalities, (5) private property rights, and (6) infinite substitutability between different forms of capital and (7) static efficiency.
This sets forth a policy agenda emphasizing the need for competition, transparency, and clearly defined property rights, with efficiency as the yardstick for evaluating policies. Correcting externalities emerges as the shining beacon of policy advice, where pricing the negative impacts of economic activities (such as pollution, emissions, biodiversity loss, and mispriced inexhaustible resources) or, when not feasible, establishing norms, offers a viable solution—a concept with broad applicability.
Economists advocate for a blend of available instruments when addressing societal issues like climate change. Pricing mechanisms are favoured for their efficiency, supplemented by public investments in general knowledge (because private actors will underinvest because of free-riding), which profit-driven enterprises can later leverage to scale and enhance cost-effectiveness. This approach promises to yield the most efficient solutions to our challenges and drive innovation.
However, within the confines of conventional economics, transitioning remains a mystery. It often feels like waving a magic wand: implementing an 'optimal' policy aligned with theoretical conditions and considering the job done—mere comparative statistics shifting from one equilibrium to another.
It's as though we're wielding a magic wand to conjure the invisible hand conditions that guide innovation, expecting them to miraculously and efficiently deliver solutions to our era's most pressing challenges, all driven by profit-seeking private actors.
Frankly, I've heard better fairytales.
It is all about transitions and failure
Of course, economists increasingly understand that magic wand economics does not exist. However, no uniformly accepted alternative theory describes a different story and guarantees that an economy will adjust in the right way, at the right speed.
A few different routes are being travelled to understand better how more economists think about it (this is a partial overview!). It is all about the various assumptions economists make. First, a group that studies non-market interactions; Second, people that focus on various assumptions listed above; and finally, some that say that sustainability transitions are different animals.
If you believe that only markets can lead to innovation, this is a limited version of reality. Nobel Laureate Elinor Ostrom champions non-market interactions or polycentric governance of common property resource management. She showed in her research that self-governed resource management could be better than markets to prevent ecological collapse. So, not markets, but common interests in preservation as a guiding principle.
Others (like Mazuccato) argue that the government can be equally effective in innovation and help determine its direction. Moreover, the government ensures innovation is directed at the most pressing societal issues. Mission-driven innovation is the buzzword here. The idea is that:
Mission-oriented innovation policy responds to these ‘grand challenges’ by identifying and articulating concrete problems that can galvanise production, distribution, and consumption patterns across various sectors. In doing so it recognises that:
• economic growth has not only a rate but also a direction,
• innovation requires investments and risk taking by both private and public actors,
• the state has a role in not only fixing markets but also in cocreating and shaping them,
• successful innovation policy combines the need to set directions from above with the ability to enable bottom up experimentation and learning,
• missions may require consensus building in civil society
This makes sense. But it also makes it more challenging. Apart from fixing markets, building markets is difficult or maybe even impossible given politics, information asymmetries and imperfect foresight. And what about making the right choices about where and how to invest?
A second strand of literature goes into the different assumptions underlying magic wand economics.
The most recent one is from Daron Acemoglu (at least, I had not read it before). He highlights that there may be systemic reasons for the direction of innovation to be distorted:
Negative externalities from certain technologies, like carbon emissions, can skew innovation towards them rather than cleaner alternatives. This can be corrected by the right (magic wand) policies. However, policy corrections (like carbon taxes or regulating AI) always need more technology.
Variances in markups across sectors may favour innovation in industries with higher markups, such as curative healthcare over preventative.
Social forces, including research preferences, may promote certain paradigms, like automation, over others, potentially neglecting human-complementary tools.
Market failures considering distributional effects and societal inequality concerns can lead to innovation biases.
Coordination failures among researchers and innovators can hinder diversification in research investments and pursuing more productive innovation paradigms.
You could argue that, although there are distortions, markets are more efficient than governments because we have (also) government failures. I agree. But that is my point: neither markets nor governments have the silver bullet (or the true magic wand).
Lastly, we have transition literature. Transition science is an interdisciplinary field focusing on understanding and facilitating transitions towards more sustainable and resilient systems, such as transitioning to a low-carbon economy or sustainable agricultural practices. It involves the study of complex societal transformations, exploring how societies can shift from unsustainable patterns to more sustainable ones. Transition science draws on various disciplines, including economics, sociology, political science, environmental science, and engineering, to analyze the dynamics of transitions, identify barriers and opportunities, and develop strategies for fostering change. Critical aspects of transition science include understanding the drivers of change, engaging stakeholders, fostering innovation, and promoting systemic transformations at different levels of society, from local communities to global networks.
It provides a diagnosis and offers some perspectives on transitioning from one state to another. Part of the literature (transition management) discusses new governance structures, like innovation, to get ‘things done’.
We also did an exercise (see below) to understand how Triodos Bank innovated in financing the energy transition. It is how it also looks: a little trial and error.
In conclusion, there are many reasons why the magic wand will not work. It is not enough to have the invisible hand conditions in place; you must also understand how they will evolve as innovation leads to disruption and new markets. And there is no guarantee that innovation will quickly bring the highly-needed solutions for sustainability challenges.
But in the end, it is about markets, money, power and ethics
So you might think, with so much thinking, we are done. No, we are not. In a blog on the IMF website, Nobel prize winner Angus Deaton names the most common flaws in economics as he sees it. He sees the five most significant flaws:
Power Dynamics: Our focus on free markets and technical progress overlooks the significance of power in determining prices, wages, technical advancements, and political influence. Understanding inequality and other aspects of modern capitalism becomes easier by analysing power.
Daron Acemoglu and Simon Johnson have recently argued that the direction of technical change has always depended on who has the power to decide;
Philosophy and Ethics: Unlike earlier economists who considered ethics and human well-being, modern economics has shifted towards a technocratic emphasis on efficiency. Little attention is given to the broader ends of economics, welfare, or philosophical views on equality. Well-being is often equated with income or consumption, neglecting other aspects necessary to people.
But in the end, seeing this as the sole task of economics is a shortfall of what well-being looks like. We all know it, and it is an ethical question. If we assume that more is always better, we should also question this pre-analytical assumption if outcomes are determined by it.
Efficiency Over Other Goals: While efficiency is crucial, it is often prioritised over other objectives. This approach, rooted in Lionel Robbins' definition of economics, usually leads to neglecting equity concerns. The pursuit of efficiency can result in upward redistribution, undermining social justice. Keynes emphasized the need to reconcile efficiency, social justice, and individual liberty, yet economics frequently sidelined social justice.
This focus on efficiency also determines how we try to find solutions for our most pressing problems. Sometimes (or quite often), efficiency is not the best guidance in sustainability transitions; this is, for instance, avoiding ecosystem collapse.
Empirical Methods: While econometrics has undergone a credibility revolution, contemporary methods like randomized controlled trials focus on immediate effects, overlooking slow-acting mechanisms with significant long-term impacts. With their understanding of contingency and multidirectional causality, historians often offer valuable insights that economists ignore.
In addition, focusing on empirical methods means that everything that cannot be measured also does not count: it leads to reductionism. And this data focus hinders sustainability transitions.
Humility: Economists often exhibit overconfidence in their conclusions. Despite the powerful tools at their disposal, economists should acknowledge competing viewpoints and the limitations of their assumptions, fostering a more humble approach to economic analysis.
I couldn’t agree more. No economist or policymaker can wave a magic wand. We have to be more humble and stay open to other ideas. We need to revisit the validity of the underlying worldview assumptions. Only an open debate about the best possible policies can help us avoid further ecological breakdown.
In the news
Scientists divided over whether record heat is acceleration of climate crisis: Record temperatures in 2024 on land and at sea have prompted scientists to question whether these anomalies are in line with predicted global heating patterns or if they represent a concerning acceleration of climate breakdown.
Shell weakened a 2030 carbon reduction target and scrapped a "perilous" 2035 objective, citing expectations for solid gas demand and uncertainty in the energy transition even as it affirmed a plan to cut emissions to net zero by 2050.
France’s lower house votes to limit ‘excesses’ of fast fashion with environmental surcharge: Legislation targets fast fashion's environmental impact, proposing bans on advertisements and penalties for its polluting practices.
The proposal singles out ultra-fast fashion (such as giant Shein) for its rapid production and vast product range, attributing it to environmental degradation and negative societal effects.A piece of Ernst Hobma and I discussed the circular economy as the optimistic degrowth strategy that works for us all. Even with very optimistic assumptions regarding policy and technological developments, the Global Resources Outlook shows that it's impossible to limit resource demand to a sustainable level if the economy continues to grow. For a sustainable future, including a decrease in resource demand, we must think about achieving this without relying on ever-increasing economic activity. Since economies rely on stable ecosystems as their foundation, we can opt for an economy within planetary boundaries with a corresponding sustainable resource demand. Living well with lower resource demand can be achieved by implementing economic circular principles.
That’s all for this week.
Take care.
Hans