In my last post, I introduced the biophysical interpretation of the economy by augmenting the standard circular flow model with energy. In this interpretation, energy is only partially substitutable with capital and labour, and there is a lower bound to substitution. Whereas the standard economics model is taken as a closed system in equilibrium, the biophysical model is an open system in disequilibrium. Open systems can exhibit complex and unpredictable behaviour patterns that are far from equilibrium. Economic activity is sustained through the consumption and dissipation of energy.

In order to explore this model further, I used Australian data from 1940 to 2016. I used Giraud and Kahraman’s simple algebra, described here. Giraud and Kahraman’s take GDP, population and energy, shown in equation 1. The left hand term is simply per-capita GDP, and the right terms are per-capita energy consumption, and energy productivity of the economy.
At first glance, equation 1 seems trivial. But if we take the change in each of parameters, given in equation 2, the equation permits growth of per-capita GDP to be decomposed to growth in per-capita energy consumption and change in energy productivity. The change in per-capita GDP is perhaps the single most important parameter in a nation’s standard of living. In the developed world, there has been a marked decline in per-capita growth, leading to falling real income growth and contributing to income inequality, commonly described as secular stagnation. Australia’s decline has been masked by a high immigration rate, which increases the headline GDP growth numbers, and remains the figure of focus by the mainstream media and political process.

 

I took Australian data from 1940 through 2016, and applied equation 2, giving figure 1. As can be seen, the (red) per-capita GDP bar is the sum of the change in per-capita energy and change in energy productivity. At this point, it should be noted that the model I am describing is a mathematical relation, which may, or may not, demonstrate causative relations between the variables. However, the relation makes clear the model described in equation 1 in which energy drives economic activity. The efficiency with which energy is converted into economic value adding is important but doesn’t diminish the role of energy. The long-run change to a service economy has not change this fundamental dependence.

Several observations emerge from figure 2. Per-capita economic growth up until the 1980s was driven almost entirely by increasing energy consumption, which was derived from a decline in the real price of energy and associated development. In the post-80s period, economic growth was dependent on improving energy productivity, or the efficiency with which the economy converted energy into economic value. The shift from the 1980s can possibly be attributed to the economic reforms of the Hawke-Keating governments.
From the 1980s, the per-capita energy consumption growth remained positive for the entire period up to around 2000, except for the recession of the early 1980s. However, post-2000, the trend has been downward, and since the global financial crisis, turned negative.
From the data, and accepting the biophysical hypothesis, the contemporary phenomena of Australian secular stagnation can be largely attributed to falling per-capita energy consumption. A part explanation for the declining energy use is the dramatic increase in energy costs. Usually, a decline in energy would be a good thing, provided it is accompanied by a commensurate increase in energy productivity. The application of Giraud and Kahraman’s simple relation demonstrates the importance of taking a broader view of energy and economic activity.
Several lessons stand out –

1. It is essential to focus on energy end-use efficiency as a key driver of energy productivity and economic growth.
2. Energy prices rises have a negative impact on economic growth.
3. A shift to a service economy has not change the fundamental reality that civilisation is like any other physical process; that is, as an open thermodynamic system that is sustained by the consumption and dissipation of energy (see Garrett for an excellent discussion here).
4. Any policy that increase energy costs, including carbon pricing, needs to be considered within the broader suite of policy objectives.
5. The large falls in unit costs of renewable energy may be important for meeting these objectives, but must be considered with reference to the effect on total system costs.