Is Industrial Civilization a Pyramid Scheme?
If I said to you, "give me a thousand bucks today, and in 45 days I'll give you $1500," you'd think I was stupid or crooked or both. That kind of interest rate works out to a phenomenal 2466% per year, and it's what Carlo Ponzi offered investors in Boston in 1920.
If I said to you, "give me a barrel of oil today, and in a month and a half I'll give you a barrel and a half back," I'd be making the same deal--but, thanks to the generous Energy Return on Investment of oil back in the 1920s, I could have made good my promise. I could have used the energy in your barrel of oil to help drill a well, which would have returned to me 100 barrels of oil for every barrel I invested in the effort of extraction. (The EROI of U.S. oil back then was about 100:1.)
Too bad Ponzi wasn't an oilman. He went to jail for what he did. His spirit lives on, though, in economists who assure us that infinite economic growth is possible on a finite planet. And when you use EROI to think about what Ponzi did, you're led to some other interesting thoughts.
Carl Ponzi came to Boston from Italy in the early years of the twentieth century, and after a few decades of knocking about at the edges of the law, he figured out a sure-fire way to make money. The International Postal Union had been set up to facilitate the exchange of mail between countries, and was authorized to print and sell International Postal Coupons for use as postage (which it still does, since one country's postal system doesn't accept stamps issued by another's). In the wake of The Great War, the values of different national currencies were in flux, but the IPU hadn't adjusted the various national costs of their Coupons. Ponzi noticed that by arbitraging these coupons--buying them where they were cheap (like in Italy) and exchanging them for currency where they were expensive (like in the U.S.), he could make a profit. Quite a tidy profit: 400%, by his reckoning.
Arbitrage isn't illegal. Neoclassical (and other) economists tell us that arbitrageurs provide a valuable service: their actions tend to equalize the cost of investment and commodities across borders, which promotes efficiency (by equalizing marginal returns and costs, less transaction costs). Ponzi explained his scheme to a few associates and friends, and they gave him some money, receiving in return promissory notes that said very clearly: in exchange for $1000, Ponzi would pay 50% interest in 45 days when the note came due. (In theory, the plan could have worked--the changes in exchange rates had created a significant disparity--but it would have been stymied by transaction costs. Though the potential gains were large on a percentage basis, a 400% gain on a three cent stamp doesn't net a whole lot of money in absolute terms.)
Word of the good deal spread, and Ponzi had eager investors. He wrote his first promissory note in February of 1920; by March, he had taken in half a million dollars; by the early summer, he was taking in a quarter of a million dollars a day. Some newspapers celebrated the immigrant's egalitarian dream of sharing financial wealth more equitably; didn't bankers get rich by depriving little guys of their fair share of returns? Others--including Charles Barron, founder of the financial journal that bears his name--smelled a rat. To invest with Ponzi you had to ignore warnings that for his company to make good on the claims against it, it would have to be holding 160 million IPCs--and only 27,000 were actually in circulation.
It's not clear that Ponzi ever even bought any International Postal Coupons; from his point of view, he didn't have to. Thousands of people wanted to invest with him, and it seemed a simple matter to pay his old customers out of the proceeds of the incredible cash flow he got from his exponentially increasing base of new customers. And that's how Ponzi's business model became fraudulent--he started treating capital as current income.
As any accountant can tell you, treating capital influx as income is a no-no. Any company that cashes out its capital stock (sells off its productive assets, like factories and infrastructure) and treats the result as income is going to go broke.
And here's the connection with oil. The fossil fuels of the planet are a capital stock: they represent past solar income the planet received in its 4 billion year history, which wasn't consumed at the time, but was locked away as fossil energy. (Some geologists believe that the vast quantities of oil and coal that we received as our endowment was made from sunlight that was turned into biomass before herbivores evolved to eat it.) We're drawing down our capital stock and treating the inflow of money as income. Does this make our economy a pyramid scheme? Consider: anyone who offers you interest in exchange for a loan of money is betting that the economy will grow. (I borrow the price of a gallon of milk today, and promise to pay you a gallon and a pint next year. Multiply by billions: the economy has got to grow, has got to produce a gallon-and-a-pint next year for every gallon it produced this year, or someone is going to be left holding worthless claims.)
There are only two ways an economy can grow. It can suck up a larger flow of matter and energy, or it can achieve internal efficiencies--keep the rate of uptake of matter and energy stable, but lose less to waste and entropy within the productive cycle.
That's it. There are no other ways. And there are limits to both of these avenues. When we increase the rate at which the economy sucks matter and energy out of nature, we increase the economy's ecological footprint--which has already exceeded a sustainable level. And while there is still plenty of room for additional efficiencies in how we use that matter and energy, we achieve those efficiencies within physical limits. Many of the things we make we could make using less matter and energy; we cannot make things using no matter and energy.
When debt--a claim on the future productivity of an economy--grows faster than that productivity grows, then somebody who holds a claim is going to have to have that claim go unfulfilled. There are some basic ways this happens in an economy: inflation and bankruptcy. You could, with some effort, correlate the amount of debt that is erased by inflation and bankruptcy every year to the difference between claims on future income and actual increases in productivity. It would be interesting to examine the recurring inflationary episodes and bankruptcy crises of the American system in this light--from the Savings and Loan scandals of a few decades ago, through Enron, on up into the SubPrime mortgage crisis. It seems that the system is always shedding claims on future income, because it systematically allows claims on that income to grow faster than the income itself can grow.
Ecological Economists talk about this stuff. Neoclassical economists do not. From this perspective, compounding interest is a wager that says we will continue to increase our economy's ecological footprint. Or, to see it from another angle: one of the strong drivers of our economy's rapacious draw-down of natural capital in all its forms (including our loss of ecosystems that provide crucial ecosystem services) is the practice of charging interest on loans.
(For those of you who are interested, Frederick Soddy was a pioneer in thinking about the perverse relationship between a monetary convention--charging interest--and the physical laws that rule economics. See the discussion of Soddy in Herman Daly and John Cobb,For the Common Good, or see Daly's earlier piece on Soddy in the Journal of the History of Political Economy.)
So, an hypothesis: for much of the twentieth century, the essential relationship between money and physical reality was obscured by the increasing exploitation of fossil fuel with a high Energy Return on Investment.
EROI is a fundamental measurement that we're all going to learn more about as we face the end of the oil era. A particular energy source may or may not be economically viable, but that's an accident of the market, which is a human construct: economic viability is determined by market prices, which are influenced by human thinking, government subsidies, the degree to which an energy source's negative and positive externalities either are or aren't reflected in its monetary price.
A sturdier measure of an energy source's viability is its EROI ratio. How much energy does it take to get a unit of usable energy into the economy? When it takes a barrel of oil to get a barrel of oil out of the ground, refined, and transported to market, the Era of Oil will be over, no matter what its monetary price happens to be.
When I looked into EROI and learned that in the 1920s the EROI for U.S. oil averaged something like 100:1, several things became clear:
If you could invest one valuable unit (like, say, a dollar) and get a 100% return, you'd have to be a fool not to make money. And look at the history of the U.S. in the twentieth century: quite an impressive record of wealth creation. From one perspective, that wealth creation was the result of long, hard struggle, which neoclassical economists and others attribute to the virtues of our free-market system, with its impetus to innovation, invention, and entrepreneurship. Sure, no doubt it was a struggle, and no doubt free market institutions and the quality of American character played a role. But if you were party to a deal in which someone regularly gave you $100 bucks for every $1 you invest, well, you'd have to be stupid or crazy not to end up with quite a pile of money. With the EROI of oil, the U.S. could hardly lose.
Certainly the people who trusted Ponzi were naive, but maybe they weren't completely stupid. Oil was giving stunning returns; why shouldn't some other form of investment do the same? I'd be interested to read a good social history that put the phenomenon of Ponzi and his scheme into some kind of broader, socio-economical-historical context. Were people's expectations of large returns encouraged by the experience of oil?
When you think of the economic history of the U.S. this way, you're led to wonder: what did all that energy wealth buy? What do we have to show for it?
It's no accident that oil barons--Rockefeller, Getty--became some of the richest people on earth. Some of that wealth went into millionaire extravagance: mansions, yachts, Adirondack lodges, balls, parties, other forms of material self-indulgence. Some went to philanthropy: it built museums and libraries and universities. And some, through taxes, went to creating our country's impressive infrastructure: bridges, railways, water systems, public buildings and parks. As we watch our infrastructure age, as we begin calculating what it might cost to replace it, we're led to this sobering thought: we'll never have that oil wealth ever again.
And from that perspective, it seems that perhaps too much of that wealth was spent on current consumption: on Gilded Age excess, on mansions and armaments and war, and--yes, the wealth did trickle out into the general culture--on the development of a consumer society in which people measure their happiness by how much they can buy, how many material belongings they have, how fast they can cycle through the irreplaceable resources of the planet.
Oil gave us a once-in-the-history-of-the-planet chance to build a sustainable industrial infrastructure, one that would provide a high standard of living by running on current solar income rather than by drawing down the planetary stock of capital, and so far, we've blown it. We've been like Ponzi, meeting current expenses out of capital rather than true income. Like him, we've built a system that has to grow or it will crash; and like him, we've built a system that cannot grow forever, and so it must crash.
Ponzi went to jail, and when he got out he moved around the world, eventually dying in poverty in South America. He survived the crash of his eponymous scheme--not well, but he survived. Here's hoping that industrial civilization does half as well.
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jerry r Hamrick - 3/26/2008
I experienced something very like the situation you describe about 20 years ago when I developed a series of computer systems for a new company which utilized a multi-level marketing strategy. Many people think of such sales efforts as being a pyramid scheme like Ponzi's. But there are laws in all the states that, if honored, prevent it from becoming such a scheme. The founders of the company thought that they could make money honestly in their approach, and they did. But they believed that there was no practical limit to their growth. They could continue to recruit new sales people for many, many years. But they did not anticipate their own growth rate, in their second 48 months they grew 64 times what they grew in the first 40 months.
I had an interest in the company so I warned the founders repeatedly that such a moment would come. Fortunately for us all they found a buyer just before sales flattened out. Nothing was illegal. All the facts were on the record. The business was absurdly simple, so the buyer made a mistake. He bought an income stream that declined rapidly, as competing companies began to steal business that could not be replaced because of the flat sales force. The buyer made a multi-billion dollar mistake. Which brings up another economic theory: that of the "greater fool."
Andrew D. Todd - 3/26/2008
I think Eric Zencey misunderstands the nature of industrial civilization. The essential resource of industrial civilization is not energy, but human capital. Further, he focuses on oil, which is even more of a dispensable resource. Electricity is far more ubiquitous. There are large number of machines which run on electricity only-- most notably computers. Oil is a fairly minor source of electricity, and the electric supply is within feasible reaching distance of going zero-carbon-emissions, simply by wider adoption of technologies which are already in widespread use. The essential character of industrial civilization was already established, well before large quantities of oil came into use. Automobiles were not the first mass-production manufacture, or even the second, being preceded by firearms, sewing machines, watches, phonographs, typewriters, cameras, bicycles, and a whole series of other items. Suburbia was already in existence, built around railroads. Even in the one field dominated by oil, transportation, electricity plays at least a minor role, with the potential to become much more important.
It has been noted that automobile mileage is enormously skewed, with about a quarter of the population driving two hours a day, for a distance of seven hundred miles a week-- in other words, gasoline is overwhelmingly used for one specialized activity, long-distance commuting. There is a correspondingly large class of drivers (about 30%) who only use automobiles for their personal convenience, and only manage to go forty miles a week or so (*). This latter figure, one might add, is well within the capacity of a battery-powered electric car, without postulating any technological breakthroughs or drastic changes in organization (**). From 1950 to 1985, vehicle miles per capita in the United States increased about 150%, and subsequent increases have been fairly modest (***). The drastic growth in vehicle mileage was not associated with industrial civilization per se, so much as it was associated with the incipient decline of industrial civilization, and the rise of post-industrial civilization. A factory worker needs at least ten times as much workspace as an office worker. Multistory factories are not very satisfactory, on account of the difficulties of moving material and machines in and out. There are very definite limits about how many factory workers one can cram together in a small space. The classic geographical form of industrial civilization is the mill town. An industrialist found a suitable and reasonably rural location, set up a factory, and allocated space for worker quarters. Often, there was an initial phase in which the employer owned the housing, in baronial fashion, but that soon passed. Factory workers normally lived a mile or less from the factory-- if the workers drove to work, they did not drive huge distances. The college town can be viewed as a kind of survival of the mill town. Even an industrial city, such as Detroit or Chicago, tended originally to be an agglomeration of mill towns. In a place like Pittsburgh or Cincinnati, this is even more explicit. There are long strips of factories along the rivers, with their associated railroads, and worker housing up the hillsides, and upper-class housing at the very top of the hill. Long-distance commuting was associated with the office worker and the skyscraper, at a time when the factory was declining. More specifically, it was associated with the industrialization of the office, the breaking out of paperwork into large numbers of specialized and/or nondiscretionary jobs. It tended to involve people doing jobs which could eventually be done by computers. Eventually, bureaucratic competition, or courtiership, superseded the paper factory, as declining businesses became progressively sclerotic.
Long distance commuting is of course not the same thing as long distance commuting by automobile. Looking at a table of average automobile mileage by states, and doing a fair amount of conjecturing, I find, provisionally, that there are certain characteristics of states which have high or low average mileage. New Jersey, for example, is stereotypically suburban-- it is Benjamin Franklin's old "keg tapped at both ends." However, New Jersey has comparatively low mileage, reflecting the fact that so many people take the train into New York or Philadelphia. Characteristically high-mileage states are Texas, Georgia, and Minnesota, the newly urbanized states. Dallas, Houston, Atlanta, and Minneapolis are big cities with lots of big skyscrapers, but they have outrun their public transportation infrastructure. An electrically-powered commuter railroad, if done right, can do things which automobiles simply cannot do, save on a VIP basis. For example, it can penetrate into the basements of skyscrapers, shopping malls, and airport terminals. Compared to the parking place which the average office worker could actually afford, anything up to a mile away, taking a train out to a suburban station, anything up to forty or fifty miles away, and driving from there, is an attractive proposition.
Thus, there are not one, but two alternative models of transportation in the United States, which work for many people, and which involve the consumption of minimal quantities of gasoline. Of course, with the rise of electronic telecommunications, in the shape of the internet, other possibilities are available. Still other possibilities have been, from time to time, proposed, which involve spending public money for new kinds of highways compatible with the electric car. When one considers all the work necessary to build a modern suburban street (typically including electric power lines, two sets of telecommunications cables, water, natural gas, sidewalks, and two sets of sewers, storm and sanitary), the lack of trolley wires or the equivalent is at the level of a deliberate omission. We have an oil problem largely because the appropriate corrective responses involve public property, and the public subsidies which are characteristic of declining industries, and, as such, these responses cannot be much better than the quality of our government.
(*) Pierre Bouvard and Jacqueline Noel, _The Arbitron Outdoor Study: Outdoor Media Consumers and Their Crucial Role in the Media Mix_, 2001. An advertising research study which turned up some important results as a side effect of its intended purpose
(**) In particular, a so-called "plug-in hybrid," essentially an electric car with gasoline fallback, can be used without relying on the availability of electric charging stations away from home. Of course, this kind of driving does not involve using very much gasoline, so the potential savings are minimal, and the design does not address the issues of the kind of people who actually use a lot of gasoline.
(***), Stacy C. Davis and Susan W. Diegel, Transportation Energy Data Book,, 22nd edition,Sept 2002, U. S. Department Of Energy, Oak Ridge National Laboratory, Center for Transportation Analysis. table 11-3
mark safranski - 3/25/2008
It isn't more obvious because "infinite expansion" a false premise based on static assumptions.
Ted Parvu - 3/25/2008
Having been a free market zealot for most of my youth it dawned on me one day that our economy must grow without bounds in order to remain "healthy".
Yet, our economy is based on the conversion of Natural Wealth (nature) into Artificial Wealth (money and goods). But Natural Wealth is finite, so we couldn't possibly create an infinite amount of Artificial Wealth.
Which means our economy must collapse.
Yet, for centuries it there was such an abundance of Natural Wealth that it appeared we would never run out, or at least not in the foreseeable future.
Yet, here we are with over 6,000,000,000 humans and growing and our oceans and forests dying. Many of us can now see an end within a few human generations.
Why can't more of us see this? Why did it take me so long to see this? When are we going to wake up? It would seem that it is probably already too late to save Civilization and one has to wonder why we would want to in the first place.
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