Nobel Prize winning economist Paul Krugman has - and correctly so - stated that economics has failed to predict the economic crisis of 2008/09 that led to a reduction in GDP all around the world, with very few exceptions. He says that "few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy." We definitely agree with this assessment.
Where we struggle a little, is with Mr. Krugman's understanding of the problems behind this failure and with his conclusion that we need to include irrational behavior, Keynes and financial markets into the picture of economics: "So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics."
We don't think this is completely inaccurate, and some of our own research clearly points into the same direction. However, we are afraid that his assessment only gets half of the picture. What is missing is the key problem of most macroeconomic concepts, the non-existence of boundaries. On the one hand, we are talking about limits in financial and debt markets - revolving around the question of systemic ceilings in a world where debt obligations grow much faster than underlying economies. This reality, which is logical for every budget counselor trying to help people who struggle with debt, is hardly acknowledged when looking at private or government debt in aggregate, yet we see no reason why it shouldn't apply there.
On the other hand we look at physical limits to economic activity. Unfortunately, a traditional Cobb-Douglas style economic production function is limitless in its concept, as long as either quantitative inputs or efficiency can grow, or lower cost substitutes can be found - and according to many economists, one of the three will always be possible. The reality of human activity, however, is full of hard and impenetrable boundaries. The key overlooked aspect is that the creation of everything, be it a good or a service, requires energy and other physical materials as inputs, of which some - particularly fossil fuels - have no future substitutes that are even closely comparable in price per energy unit. If those inputs become scarcer and/or more expensive, the models that worked in the past won't work in the future.
In the early Seventies, a book called "The Limits to Growth", by D.H. Meadows, D.L. Meadows, J. Randers, and W.W. Behrens III, introduced the concept of resource limitations to a broader audience, and it was part of an entire movement of new economic theories related to biophysical limitations and to the inception of a global think tank called The Club of Rome. Under the impression of the global oil crisis in 1973, many people believed that we indeed have to accept that human societies, populations and economic output cannot expand forever. However, in the 1980s, energy prices returned to pre-crisis levels, seemingly contradicting the theories of Meadows et.al.. When talking to economists today, we often hear that Limits to Growth has been proved wrong by history. What few people realize though is that this actually isn't true (yet). As Hall and Day conclude in their paper "Revisiting the Limits to Growth after Peak Oil" (PDF below), the baseline scenario created in 1972 did actually predict further growth for quite some time. A number of their bell curves were peaking around the year 2010. Now.
What traditional economics have done - and mostly done very well - is to describe economic systems on the uphill slope of the curve. As long as no significant limitations were apparent, a limitless economic function does not pose problems. The model works, but unfortunately it will stop functioning from one day to the other once a systemic limit is reached - irrespective of the problem being related to financial markets or to physical resources. Exactly that is what we think happened in 2008.
The answer for Paul Krugman's problem lies thus in a very simple and mostly ignored truth. Human activity cannot ignore the limits imposed by the physical availability and accessibility of resources, because once we get close to those limits, shortages or price increases will be the consequence, and the traditional model of substitution from a limitless world will no longer work. The same is true for financial markets. It is impossible to imagine a world where an economy's debt can grow faster than GDP each year and never reach a ceiling where it becomes impossible to serve and ever pay it back. From our perspective, we have to redesign some key macroeconomic concepts based on those two realities; and that most likely means starting over from scratch.