Economics Has Lulled Us Into a False Sense of Security
And Trump has weaponized their ignorance
By now, everyone is worried about the impact on the global economy of losing the supplies of energy that pass through the Strait of Hormuz. But why weren’t we worried about it beforehand? If we had been, then even Trump’s advisors would have been wary about attacking a country that could reduce the world’s energy supplies by a third.
There are many reasons for our pre-War complacency, but one of them surely is that mainstream economic theory led us to believe that the global economy is robust. It did this, not through real analysis, but through fantasy. The two key fantasies that mainstream economics promulgates on this front are:
That every commodity is homogeneous and has a multitude of suppliers; and
That inputs to production can easily be substituted for one another.
The first myth springs from what mainstream economics describes as the ideal market structure of “perfect competition”. The second springs from the way in which mainstream economics models production.
Before I continue, I have to remark that the sheer craziness of Donald Trump makes it almost impossible to function. Less than an hour ago, I saw this post:
I had to check that this wasn’t AI, and AI confirmed that it wasn’t AI (though it could of course be someone equally loony who has access to his Twitter/Truth Social account, and both Stephen Miller and Pete Hegseth qualify).
Now the odds are that, unless Trump withdraws this threat—or US officials with both integrity and balls, if there are any left, depose him—then Iran will follow up with its threat to destroy the energy infrastructure of the Gulf States 24 hours earlier.
If that happens—and also if Trump carries out his threat—then the consequences I analyse in this post will come to pass. Global economic output will plunge, and a global famine will occur, and hit countries that would never have imagined that they could face collective starvation.
Now I’ll try to continue with this post… Its punchline is that, though a tyrant has put us in this position, the fact that he was able to do so reflects our own collective ignorance, before this ridiculous war he started, of just how fragile the global economy is.
The Homogenous Product, Multitude of Suppliers Myth
Textbooks describe 4 types of markets—Perfect Competition, Monopolistic Competition, Oligopoly, and Monopoly—but the emphasis is always on the model of “Perfect Competition”. As Mankiw says:
Despite the diversity of market types we find in the world, we begin by studying perfect competition. Perfectly competitive markets are the easiest to analyze. Moreover, because some degree of competition is present in most markets, many of the lessons that we learn by studying supply and demand under perfect competition apply in more complicated markets as well. (Mankiw 2009, p. 67)
Figure 1: Mankiw’s classification of industry types (Mankiw 2009, p. 351)
Perfect competition is a mythical market structure in which there are numerous producers who all produce a homogeneous product. Mankiw’s Microeconomics textbook puts it this way:
(1) the goods being offered for sale are all the same, and (2) the buyers and sellers are so numerous that no single buyer or seller can influence the market price …
There are some markets in which the assumption of perfect competition applies perfectly. In the wheat market, for example, there are thousands of farmers who sell wheat and millions of consumers who use wheat and wheat products. Because no single buyer or seller can influence the price of wheat, each takes the price as given. (Mankiw 2009, pp. 66-67)
If this described the real world, then there would be no problem with a war that knocked out, say, 30% of wheat production, apart from an increase in the price of wheat. The remaining 70% of producers could easily take up the slack. It doesn’t describe the real world, but that’s what economists teach us is reality, and most people just accept it. It is embodied in perhaps the most successful meme in human history, the “supply and demand diagram”.
According to this meme, if there’s a fall in supply, then the equilibrium price rises and quantity falls, if there’s no change in demand, and if demand is flexible. Because of an earthquake(!), the supply of ice cream falls, and those ice creams cost more each.
Figure 2: Mankiw’s supply and demand curves
Figure 3: How economists model a supply shock
Even if demand were inflexible—so that the equilibrium quantity remained constant—this drawing implies that the market could still supply the same quantity, though at a much higher price. All we would have to worry about with an earthquake-like event—and closing the Strait of Hormuz certainly qualifies as an earthquake—is inflation. Supply would still continue.
In reality, most industries are dominated by a small number of large firms, with a large number of small firms taking up the rear, and products are not homogeneous, but dramatically differentiated. This also applies to the energy industry, where many of the producers are agencies of national governments. The products, even if they have generic names like “petroleum”, are also dramatically differentiated. You cannot simply substitute Saudi Arabian oil for Venezuelan oil: if supplies of one plunge, the other cannot make up the difference.
The Substitutable Inputs Myth
Why do economists think that a shock to the supply of energy won’t cause production to fall so much that the goods society requires simply can’t be produced? It’s because their model of production asserts that, if one input to production falls, it can be substituted by using other inputs more intensively.
This is manifest in the “Cobb-Douglas Production Function”, which shows output as being produced by a combination of technology (called “Total Factor Productivity”), labour, and capital. There are 3 critical aspects of this model.
Firstly, the inputs are multiplied together, which means that its predictions of output are based on the product of these three inputs—so if one goes down, one of the others can compensate by increasing, leaving the total amount of output unchanged.
Secondly, labour and capital inputs are raised to a power, where the exponent represents the share of total GDP that each input receives, and where the sum of the exponents is one. Since workers get about 70% of GDP as wages, with capitalists getting the remaining 30%, the exponent for labour is normally 0.7, and for capital it is one minus 0.7, or 0.3. This leads to the prediction that a 10% fall in Labour will reduce output by 7%, whereas a 10% fall in Capital will reduce output by 3%
Thirdly, by default, energy is not included. However, when economists do consider energy, they include it as a third “factor of production”, and treated the same way as Labour and Capital. Since Energy makes up about 5% of GDP, its exponent is 0.05 (while Capital’s exponent is reduced from 0.3 to 0.25). This means that the model predicts that a 10% fall in energy will reduce output by a mere 0.5%. I know that this will sound ridiculous to you if you’re not in the habit of reading economics textbooks and papers, so here’ a screenshot from an academic paper to show that I’m not making this up:
“production is quite insensitive to energy E as expected” (Bachmann et al. 2022, Appendix, p. 5)
This is arrant nonsense. Production is not merely sensitive to energy, but utterly dependent on it. As I wrote in “A Note on the Role of Energy in Production”:
labour without energy is a corpse, while capital without energy is a sculpture. (Keen, Ayres, and Standish 2019, p. 41)
Technically, this means that energy is not an independent input to production to labour and capital, but an essential input to both labour (predominantly in the form of food) and capital (predominantly in the form of fossil fuels), without which they can do no work. A 10% fall in energy inputs means therefore at best a 10% fall in output.
The empirical data make it overwhelmingly clear that the relationship between energy and GWP (“Gross World Product”—the global sum of Gross Domestic Product) is 1 for 1. If GWP goes down by 6%--as it did during Covid—then if energy goes down by 6%. If energy falls by 2%—as it did during the second oil shock in 1979, then GWP falls by 2%
Since we are facing a drop of the order of 10% in global energy supplies thanks to Trump’s insanity in the Gulf, we face a similar fall in GWP.
The next graphic contrasts the Neoclassical model of production with a stylized version of the Leontief-based system that I use in my modelling. This shows the inputs to production as not substitutes but complements: if any of them fall, then output falls by that amount. I firstly reduce energy input by 10%, then capital input by 10%, and finally labour input by 10%; then I restore them to their original values in the same order.
The “Keen” production function shows output falling by 10% as soon as energy falls by 10%; the Neoclassical function instead shows output falling by just 0.5%. When Capital input falls, nothing more happens according to the Keen function, because the fall in energy has in effect left 10% of the machinery idle anyway. In the Neoclassical model output falls a further 3%. In the Neoclassical model, only when Labour input also falls by 10% does total output fall by 10%: all 3 factors have to be reduced by 10% to cause a 10% fall in output. In the Keen model, dropping the Labour input doesn’t matter because the 10% fall in energy availability has already made those workers idle.
From Models to the Real World
I was expecting a decline of this scale in output and beyond from climate change. Instead, it looks like we could get a dry run of this effect this week, courtesy of letting a malignant narcissist take over the world’s once most powerful nation.
It will take time for the disruptions that Iran’s retaliation on Gulf Oil states to percolate through to the rest of the world, because at the moment other countries have existing stocks of oil and other inputs that pass through the Strait of Hormuz. And of course the blockage of that Strait has already cut off supplies from the Persian Gulf for the last 2-4 weeks.
But once those stocks are exhausted, then the global capacity to produce output will fall. The scariest of the lot is a fall in global food output, because of a roughly 30% fall in fertilizer supplies. The most damaging over time could be the fall in sulphur dioxide output, since sulphuric acid is such a critical input to so many production processes. The most damaging for the future of human society could be the fall in Helium output—again by about 30% of global usage—because it is critical to the production of silicon chips, and the operation of high tech equipment, like not only MRI machines, but also many machines in high tech production facilities.
The next two days are potentially the most dangerous days in the history of humanity. I hope sense prevails—which can really only occur if Americans invoke Section 25 of their Constitution, or find some other means to remove Trump from office before the military follows his illegal orders. But if sense doesn’t prevail, then this week will be the beginning of the end of advanced human civilisation.
(2) Bachmann, Rüdiger, David Baqaee, Christian Bayer, Moritz Kuhn, Andreas Löschel, Benjamin Moll, Andreas Peichl, Karen Pittel, and Moritz Schularick. 2022. ‘Was wäre, wenn…? Die wirtschaftlichen Auswirkungen eines Importstopps russischer Energie auf Deutschland; What if? The macroeconomic and distributional effects for Germany of a stop of energy imports from Russia’, ifo Schnelldienst, 75.
(3) Keen, Steve, Robert U. Ayres, and Russell Standish. 2019. ‘A Note on the Role of Energy in Production’, Ecological Economics, 157: 40–46.
(4) Mankiw, N. Gregory. 2009. Principles of Microeconomics (South-Western College Publishers: Mason, OH).