Natural capital and economic growth

Published: August 21, 2008, 8:45 pm

Topics:

Environmental Economics (main)

IntroductionTwentieth-century economics has, in large measure, been detached from the environmental sciences. Judging by the profession’s writings, we economists see Nature, at best, as a backdrop from which resources can be considered in isolation. Moreover, macroeconomic (Natural capital and economic growth) forecasts invariably exclude natural resources. (When was the last time you read quantitative estimates of soil erosion, atmospheric pollution, or habitat destruction in a government report on the state of the economy?) Accounting for Nature, if it comes into the calculus at all, is an afterthought to the real business of “doing economics”. We have been so successful in this enterprise that, if someone today exclaims, “Economic growth!”, no one needs to ask, “Growth in what?”—we all know that they mean growth in gross domestic product (GDP).

Wetland. (Source: National Park Services)

The rogue word in GDP is “gross”. Since GDP is the total value of the final goods and services an economy produces, it does not deduct the depreciation of capital that accompanies domestic production. In particular, it does not deduct the depreciation of natural capital.

It is useful to think of natural capital in an inclusive way. Pollutants should be seen as the reverse side of natural resources. Roughly speaking, “resources” are “goods” (in many situations, they are the sinks into which pollutants are discharged—for example, the emission of carbon dioxide into the atmosphere), while “pollutants” (the degrader of resources) are “bads”. If, over a period of time, the discharge of pollutants into a sink exceeds the latter’s assimilative capacity, the sink collapses. Pollution is, thus, the reverse of conservation.

The practice of judging the progress and regress of nations in terms of GDP growth, or even in terms of the United Nations’ Human Development Index (HDI), has given rise to a puzzle.

On the one hand, if we look at specific examples of natural resources (fresh water, ocean fisheries, the atmosphere as a carbon sink—more generally, ecosystems), there is strong evidence that the rates at which we are currently utilizing them are unsustainable. During the twentieth century, world population grew by a factor of four to more than six billion, industrial output increased by a multiple of 40 and the use of energy by 16, methane-producing cattle population grew in pace with human population, fish catch increased by a multiple of 35, and carbon and sulfur dioxide emissions by 10. The application of nitrogen to the terrestrial environment from the use of fertilizers, fossil fuels, and leguminous crops is now at least as great as that from all natural sources combined. Ecologists have estimated that 40% of the net energy created by terrestrial photosynthesis is currently being appropriated for human use. These figures put the scale of our presence on Earth in perspective and reveal that Humanity has created an unprecedented disturbance in Nature in a brief period of a century or so.

On the other hand, it is often argued that, just as earlier generations in the West invested in science and technology, education, and machines and equipment so as to bequeath to the present generation the ability to achieve high income levels, the current generation is now, in turn, making investments that will assure still higher living standards in the future. It has been argued as well that the historical trend in the prices of marketed natural resources, such as minerals and ores, has been so flat that there is no reason for alarm. Economic growth has allowed more people to have access to potable water and enjoy better protection against water- and air-borne diseases. The physical environment inside the home has improved beyond measure with economic growth: cooking in the Indian sub-continent continues to be a major cause of respiratory illnesses among women. Moreover, natural resources can be so shifted round today, that dwindling resources in one place can be met by imports from another. Intellectuals and commentators use the term “globalization” to imply that location, per se, does not matter. This optimistic view emphasizes the potential of capital accumulation and technological improvements to compensate for environmental degradation. It says that economic growth, even in the form and shape it has taken so far, is compatible with sustainable development. This probably explains why contemporary societies are obsessed with cultural survival and are, on the whole, dismissive of any suggestion that we need to find ways to survive ecologically.

A great deal of my own research over the years has been to take both claims seriously and to construct quantitative models in which the interplay of ecology, demography, and economics fashion the pathways along which the two opposing considerations make themselves felt. And I have been particularly anxious to construct the models in such a way as to be sensitive to the particularities of poor countries. In this article, I want to demonstrate how very different the macroeconomic history of nations begins to look if Nature is included as a capital asset in production activities. I do that by summarizing research among a small group of ecologists and economists who have developed the correct way to study the progress of economies.

Sustainable development: theory

The starting point for reconciling the conflicting intuitions that I have just sketched is the notion of sustainable development. The term became commonplace after the publication of a report by the World Commission on Environment and Development, widely known as the Brundtland Commission Report, where sustainable development was defined as “... development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” The idea is that, relative to their respective demographic bases, each generation should bequeath to its successor at least as large a productive base as it inherited from its predecessor. If it were to do so, the economic possibilities facing the successor would be no worse than those it faced when inheriting productive assets from its predecessor.

An economy’s productive base includes not only its [[capital] assets] (stocks of manufactured, human, and natural capital; knowledge), but also its institutions (including its cultural coordinates). Together, they offer the infrastructure open to people, even as they produce, consume, and trade. A society’s productive base is the source of its well-being. We should note that the productive base is a diverse collection of durable objects, some tangible and alienable (buildings and machinery, land and animals, trees and shrubs), some tangible but non-alienable (human beings, the oceans), some intangible but alienable (codified pieces of knowledge, such as patentable ideas), some intangible and non-alienable (air, skills, the legal framework, and cultural coordinates), and some that involve both human capital and mutual expectations (institutions, social capital).

But how is a generation to judge whether it is leaving behind an adequate productive base for its successor?

Why GDP and HDI will not do?

It is easy to see that focusing on GDP or HDI will not do. An economy’s productive base is its stock of capital assets and institutions. By capital assets, we mean not only manufactured capital, human capital, and knowledge, but also natural capital. We will presently discover what to look for in order to check whether an economy’s productive base is expanding or contracting. It is evident though, that an economy’s productive base will shrink if its stock of capital assets depreciates and its institutions are not able to improve sufficiently to compensate for that depreciation. It is certainly possible for a country’s productive base to grow while its GDP increases or its HDI improves (this will be confirmed when we come to study Table 1), which is, no doubt, a path of economic development we would all like to follow; but it is also possible for a country’s productive base to shrink during a period when GDP grows and its HDI improves (this will also be confirmed when we come to study Table 1). The problem is that no one would notice the shrinking if everyone’s eyes were riveted on GDP or HDI. If the productive base continues to shrink, economic growth will, sooner or later, stop and reverse sign and, sooner or later, its HDI will begin to fall. The standard of living will then decline, but no one would have suspected that a fall was in store. So, growth in GDP per head and improvements in HDI will encourage us to think that all is well, when it is, in fact, not. Both GDP and HDI can mislead.

Table 1. The progress of nations Country/regionI/Ya (%) % annual growth rate 1970–2000 ?HDIc Population (per head) TFPb Productive base (per head) GDP (per head) Sub-Saharan Africa ?2.1 2.7 0.1 ?2.9 ?0.1 + Bangladesh 7.1 2.2 0.7 0.1 1.9 + India 9.5 2.0 0.6 0.4 3.0 + Nepal 13.3 2.2 0.5 0.6 1.9 + Pakistan 8.8 2.7 0.4 ?0.7 2.2 + China 22.7 1.4 3.6 7.8 7.8 + UK 7.4 0.2 0.7 2.4 2.2 + USA 8.9 1.1 0.2 1.0 2.0 +Adapted from Arrow et al. 2004a Inclusive investment as a share of GDP (average over 1970–2000)b Total factor productivityc Change in HDI between 1970 and 2000 (Natural capital and economic growth) ===What about price signals?=== You could counter that a fixation on GDP or HDI should not prevent anyone from looking up prices. You could even argue that, if natural resources really were becoming more scarce, their prices would have risen, and that would have signaled that all is not well. But if prices are to reveal scarcities, markets must function well. For many natural resources, markets not only do not function well, but they do not even exist (we call them missing markets). In some cases, they do not exist because relevant economic interactions take place over large distances, making the costs of negotiation too high (e.g., the effects of upland deforestation on downstream farming and fishing activities); in other cases, they do not exist because the interactions are separated by large temporal distances (e.g., the effect of carbon emission on climate in the distant future, in a world where forward markets do not exist because future generations are not present today to negotiate with us). Then, there are cases (the atmosphere, aquifers, the open seas) where the migratory nature of the resource keeps markets from existing (they are open-access resources); while in others, ill-specified or unprotected property rights prevent markets from being formed (mangroves and coral reefs), or make them function wrongly, even when they do form (those who are displaced by deforestation are not compensated). The side-effects of human activities that are undertaken without mutual agreement are called externalities. Our dealings with Nature are full of externalities. The foregoing examples suggest that the externalities involving the environment are mostly negative, implying that the private costs of using natural resources are less than their social costs. Being underpriced, the environment is over-exploited. In such a situation, the economy could enjoy growth in real GDP and improvements in HDI for a long spell, even while its productive base shrinks. As proposals for estimating the social scarcity prices of natural resources remain contentious, economic accountants ignore them and governments remain wary of taxing their use. ===How to estimate the productive base?=== Economic development is sustainable if, relative to its population, a society’s productive base does not shrink. How can one tell whether economic development has been sustainable? We have noted that neither GDP nor HDI will tell us. So what index would do the job? A society’s productive base is its institutions and capital assets. As we are interested in estimating the change in an economy’s productive base over a period of time, we need to know how to combine the changes that take place in its capital stocks and in its institutions. Let us keep institutions aside for the moment and concentrate on capital assets. Intuitively, it is clear that we have to do more than just keep a score of capital assets (so many additional pieces of machinery and equipment, so many more miles of roads, so many fewer square miles of forest cover, and so forth). An economy’s productive base declines if the decumulation of assets is not compensated for by the accumulation of other assets. Contrariwise, the productive base expands if the decumulation of assets is (more than) compensated by the accumulation of other assets. The ability of an asset to compensate for the decline in some other asset depends on technological knowledge (e.g., double glazing can substitute for central heating up to a point, but only up to a point) and on the quantities of assets that the economy happens to have in stock (e.g., the protection that trees provide against soil erosion depends on the existing grass cover). Clearly though, capital assets differ in their ability to compensate for one another. Those abilities are the values we would wish to impute to assets. We need to have estimates of those abilities. This is where an asset’s social productivity becomes an item of interest. By an asset’s social productivity, we mean the net increase in social well-being that would be enjoyed if an additional unit of that asset were made available to the economy, all other things being equal. Putting it another way, the social productivity of an asset is the capitalized value of the flow of services that an extra unit of it would provide society. An asset’s value (Value theory) is simply its quantity multiplied by its social productivity. As we are trying to make operational sense of the concept of sustainable development, we must include in the term social well-being not only the well-being of those who are present, but also of those who will be here in the future. There are ethical theories that go beyond a purely anthropocentric view of Nature, by insisting that certain aspects of Nature have intrinsic value. The concept of social well-being I am appealing to here includes intrinsic values in its net, if required. However, an ethical theory on its own would not be enough to determine the social productivities of capital assets; that is because there would be nothing for the theory to act upon. We need descriptions of the states of affairs too. To add a unit of a capital asset to an economy is to perturb that economy. In order to estimate the contribution of that additional unit to social well-being, we need a description of the state of affairs both before and after the addition has been made. In short, measuring the social productivities of capital assets involves both evaluation and description. Imagine now that you have adopted a conception of social well-being (e.g., by adding the well-beings of all persons) and that you have an economic scenario of the future in mind (e.g., business as usual). In principle, you can now estimate the social productivity of every capital asset. You can do that by estimating the contribution to social well-being (the evaluative part of the exercise) that an additional unit of each capital asset would make, all other things being equal (the descriptive part of the exercise). Economists call social productivities of capital assets their shadow prices, to distinguish them from prices that are observed in the market. Shadow prices reflect the social scarcities of capital assets. In the world as we know it, estimating shadow prices is a formidable problem. There are ethical values we hold that are probably impossible to commensurate when they come up against other values that we also hold. This does not mean that ethical values do not impose bounds on shadow prices; they do. Which is why the language of shadow prices is essential if we wish to avoid making somber pronouncements about sustainable development that amount to saying nothing. Most methods that are currently deployed to estimate the shadow prices of ecosystem services are crude, but deploying them is a lot better than doing nothing to value them. I shall call the value (Value theory) of an economy’s stock of capital assets, measured in terms of their shadow prices, its inclusive wealth. The term inclusive serves to remind us that not only has natural capital been included on the list of assets, but also that externalities have been taken into account in valuing the assets. Inclusive wealth is the sum of the values of all capital assets. It is a number, expressed, say, in international dollars. If we now wish to determine whether a country’s economic development has been sustainable over a period of time, we have to estimate the changes that took place over that period in its inclusive wealth and its institutions—relative to the population of course. Changes in knowledge and institutions over time are reflected in changes in what economists call an economy’s total factor productivity (TFP). Economists have shown how to estimate movements in an economy’s TFP from macroeconomic data. So we break up the procedure for estimating changes in an economy’s productive base relative to population during any period of time into five stages: * First, estimate the value of changes in the amounts and compositions of manufactured capital, human capital, and natural capital, which I shall call inclusive investment. (If inclusive investment is found to be positive, we may conclude that manufactured capital, human capital, and natural capital, taken together, grew over the period.) * Second, estimate the change in TFP. * Third, transform the two figures in a way that enables us to calculate the effects of the two sets of changes on the productive base. * Fourth, combine the two resulting estimates into a single number that can be taken to reflect the change that took place in the economy’s productive base. * Fifth, make a correction for demographic changes to arrive at an estimate for the change that took place in the economy’s productive base relative to population. I have so worded the five steps that they apply to a study of the past. But, of course, the five steps can be applied with equal validity to forecasts of the future. The procedure outlined here is essential for anyone who wants to know whether the economic pathways we are currently pursuing can be expected to lead to sustainable development. ==Sustainable development: application== Hamilton and Clemens have estimated inclusive investment over the past three decades in a large number of countries. They have done that by adding net investment in human capital to existing country-wide estimates of investment in manufactured capital, and then subtracting disinvestments in natural capital from that sum. (That’s step 1 above.) The authors used official estimates of net national saving as proxies for net investment in manufactured capital. For estimates of investment in human capital, they used expenditure on education as a proxy. To quantify disinvestments in natural capital, they considered net changes in the stocks of commercial forests, oil and minerals, and the quality of the atmosphere in terms of its carbon dioxide content. Oil and minerals were valued at their market prices minus extraction costs. The shadow price of global carbon emission into the atmosphere is the damage caused by bringing about climate change. That damage was taken to be $20 per ton, which is, in all probability, a serious underestimate. Forests were valued in terms of their market price minus logging costs. Contributions of forests to ecosystem functions were ignored. The list of natural resources in Hamilton and Clemens is very incomplete. It does not include water resources, fisheries (Fisheries and aquaculture), air and water pollutants, soil, and ecosystems. The notion of human capital that they deployed is inadequate because health does not enter the calculus. And their estimates of shadow prices are very very approximate. Nevertheless, one has to start somewhere, and theirs a first pass at what is an enormously messy enterprise. In an earlier study (Dasgupta 2001), I used the Hamilton–Clemens estimates of inclusive investment to determine whether economic development in some of the major countries and regions in the rich and poor worlds has been sustainable in recent decades. What I want to do here is to adapt figures published recently by a group of ecologists and economists (Arrow et al. 2004), who refined my earlier estimates. Table 1 reports data that are, in turn, a refinement of Arrow et al. These data form a crude beginning to the study of sustainable development, but they are a start, and they reflect progress. ===Has economic development in recent decades been sustainable?=== The places in question are sub-Saharan Africa, Bangladesh, India, Nepal, and Pakistan (all poor countries); China (a middle-income country); and UK and US (both rich countries). The period under study is 1970–2000. The first column of numbers in the accompanying table consists of refinements of the Hamilton–Clemens estimates of average inclusive investment as a proportion of GDP, expressed as percentages (step 1). The second column gives the average annual population growth rate. The third column gives estimates of annual growth rates of TFP, which we are interpreting here as the annual percentage rate of change in a combined index of knowledge and institutions (that is, step 2). I have used the figures in the first three columns to arrive at estimates of the annual percentage rate of change in the productive base per capita (which involves a combination of steps 3–5). They are given in the fourth column. Before summarizing the findings, it will be useful to get a feel for what the numbers in the table are telling us. Consider Pakistan. During 1970–2000, inclusive investment as a proportion of GDP was 8.8% annually. TFP increased at an annual rate of 0.4%. As both figures are positive, we can conclude that Pakistan’s productive base was larger in year 2000 than it had been in 1970. But take a look at Pakistan’s population, which grew at a high 2.7% rate annually. The fourth column shows that Pakistan’s productive base per capita declined in consequence, at an annual rate of 0.7%, implying that, in year 2000, it was about 80% of what it was in 1970. In contrast, consider the US. Inclusive investment as a share of GDP was 8.9% a year, which is only a tiny bit larger than Pakistan’s figure. Growth in TFP (an annual 0.2%) was even lower than Pakistan’s. But the population grew at only 1.1% a year, meaning that the productive base per capita of the US grew at an average annual rate of 1%. Economic development in the US was sustainable during 1970–2000, while in Pakistan, it was unsustainable. Interestingly, if you had judged their economic performances in terms of growth in GDP per capita, you would have obtained a different picture. As the fifth column of Table 1 shows, Pakistan grew at a respectable 2.2% rate a year, while the US grew at only 1.1% a year. If you now look at the sixth column, you will find that the United Nations’ Human Development Index (HDI) for Pakistan improved during the period. Movements in HDI tell us nothing about sustainable development. The striking message of the table, however, is that during 1970–2000, economic development in all of the poor countries on our list was either unsustainable or barely sustainable. To be sure, sub-Saharan Africa offers no surprises. Its inclusive investment was negative, implying that the region disinvested in manufactured, human, and natural capital, taken together, at 2.1% of GDP. The population grew at 2.7% a year and TFP barely advanced (annual growth rate 0.1%). Even without performing any calculation, we should suspect that the productive base per capita in sub-Saharan Africa declined. The table confirms that it did, at 2.9% annually. If you now look at the fifth column of numbers, you will discover that the GDP per capita in sub-Saharan Africa remained pretty much constant. But the region’s HDI showed an improvement—confirming, once again, that studying movements in HDI enables us to say nothing about sustainable development. Pakistan is the worst performer in the Indian sub-continent, but the remaining countries in the region just barely made it when judged in terms of sustainable development. Inclusive investment in each country (Bangladesh, India, and Nepal) was positive, as was growth in TFP. The two together imply that the productive base expanded in each country. But population growth was so high, that the productive base per capita just about grew—at annual percentage rates of 0.1%, 0.4%, and 0.6%, respectively. Even these figures are most likely to be overestimates. The list of items that Hamilton and Clemens used in order to estimate inclusive investment did not include soil erosion and urban pollution, both of which are thought to be problematic in the Indian sub-continent by experts. Moreover, the human desire to reduce risk, as mentioned earlier, implies that the downside risks of natural capital degradation ought to be given a higher weight than a corresponding chance that things will turn out to be better than expected. So, if we allow for risk aversion, estimates of inclusive investment would be lowered. One cannot help suspecting that economic development in the Indian sub-continent was unsustainable during 1970–2000, but you would not know that from the figures for GDP per capita and HDI there. The former grew in each country in the region and the latter improved. Inclusive investment in China was 22.7% of GDP—a very large figure in the sample of countries in the table. Growth in TFP was a high 3.6% annually. The population grew at a relatively low 1.4% annual rate. We should not be surprised that China’s productive base per capita expanded—as it happens, at 7.8% annually. Per capita GDP also grew at an annual rate of 7.8%, and HDI improved. In China, GDP per capita, HDI, and the productive base per head moved parallel to one another. There is little to comment on the UK and the US. Both are rich, mature economies. Inclusive investment during 1970–2000 was modest, but then so was low population growth. Growth in TFP was low. Although the figures imply that the productive base per capita expanded in both countries, we should be circumspect because, as noted earlier, Hamilton and Clemens costed carbon emissions at too low a rate. GDP per capita increased in both countries and HDI improved there. The figures we have just studied are all rough and ready, but they show how accounting for natural capital can make a substantial difference to our conception of the development process. In Table 1, I have deliberately made conservative assumptions regarding the degradation of natural capital. For example, a price of $20 per ton of carbon in the atmosphere is almost certainly a good deal below its true shadow price (or cost). If we were instead to take the shadow price to be the not unreasonable figure of $50 per ton, all of the countries in Table 1, with the exception of China, would show a decline in their productive base per capita during 1970–2000. The message is sobering: over the past three decades, sub-Saharan Africa (home to 750 million people today) has become poorer if judged in terms of its productive base per capita; and economic development in the Indian sub-continent (home to over 1.4 billion people today) and in the UK and the US was either unsustainable or just barely sustainable. That said, it would be wrong to conclude that people in poor countries should have invested more in their productive base by consuming less. The production and distribution of goods and services in the poor world are highly inefficient. It would be wrong to regard consumption and investment in the productive base there as competing for a fixed quantity of funds. Better institutions would enable people in the poor world to both consume more and invest more (inclusively, of course!).

Citation

Dasgupta, P. (2008). Natural capital and economic growth. Retrieved from http://editors.eol.org/eoearth/wiki/Natural_capital_and_economic_growth