The Bubble Economy: Is Suitable Growth Possible?

By Robert U Ayres

How can risk spreading from the bankers to their customers or the taxpayers be reversed? Below, Robert U Ayres argues that part of the answer must be to change the incentives, and suggests ways forward.

 How can risk spreading from the bankers to their customers or the taxpayers be reversed? Part of the answer must be to change the incentives. Two recent EU decisions may point the way forward. One is to allow the European Central Bank to deal directly with troubled banks, as the US Federal Reserve has been doing since 2009. This transfers bank debt to the central bank, but not to the taxpayers, at least not directly. The question confronting political and business leaders with ever greater urgency is: what will drive future economic growth? Of course, stabilizing the global financial system is a necessary condition for long-term economic growth. In my opinion, separating the functions of investment banks and commercial banks—back to Glass–Steagall—would be the biggest single step in that direction.

The arguments used by banks to defend their high leverage risk-taking are not based on economic theory or evidence.


The other important EU decision was the agreement to “bail-in” bank creditors (bondholders), namely to make them share up to 8 percent of liabilities in the event of major losses that would otherwise require tax-payer or IMF bailouts. Banks (especially in Europe) also need to be recapitalized to increase reserves, especially in the biggest banks that would cause the greatest economic damage in case of failure. The current 3 percent requirement is too low. The arguments used by banks to defend their high leverage risk-taking are essentially self-serving, not based on economic theory or evidence. Here there are two problems. The Basel rules properly demand that reserves be risk-weighted so that the riskiest loans require more capital in reserve than less risky loans. But currently big banks are given too much freedom to define their own risk-weighting rules. The other problem is that the Basel rules favor loans to governments, government-sponsored institutions, financial institutions, and real estate, in preference to loans to business, especially small and medium-size enterprises. As a partial answer to this problem, I suggest that something like the Federal Deposit Insurance Corporation (FDIC) could be created to insure small business loans. The banks need not be bailed out completely in the event of a default by the borrower, but a recovery by the bank of perhaps 90 percent of the loan value in case of default (perhaps more for smaller loans) would be very helpful in that domain. I think the executives of banks or other financial firms should be made individually responsible for losses, at least to the same extent that they are now qualified for bonuses. This would work best at the departmental level. Thus government bond traders (for instance) should be responsible, to some extent at least, for losses in the government bond-trading department. Similarly traders of corporates, or derivatives should be at least partially responsible for losses. By the same token, banks that sell complex financial products should also provide some sort of guarantee, much as any reliable merchant will guarantee its merchandise. A “take-back” law, similar to the law that is now in effect for many merchandise sales, except for a longer trial period, could be the answer. While the banks play an essential role in recovery, they cannot drive growth. It was the discovery of enormous new energy resources and the new technologies that were developed to utilize those resources that drove economic growth during the first two industrial revolutions. The explosive growth of the information age exemplifies an economic phenomenon that has been dubbed “the rebound effect” with a special case known (in the literature) as “backfire.” The rebound effect is what happens when an energy efficiency improvement results in lower costs that, in turn, stimulate greater demand. For example, if cars become more fuel efficient, people may drive more, thus negating some of the energy savings that might have been expected from the efficiency improvement1, 2, 3. In general, the greater demand stimulated by greater efficiency can be counted as economic growth4. There are in fact a few cases in history where the rebound effect of an efficiency improvement did not just negate part of the energy savings but sharply increased energy use by cutting costs to the point where new markets for the product opened up. The rising price of useful energy from fossil fuels, especially petroleum, implies that renewable energy technologies will be increasingly viable competitors to fossil fuels, without government subsidies. To be sure, there are skeptics out there who will bet that costs will never get low enough (despite that rapid declines we have observed in the past) and besides (they argue) “there is an ocean of oil (or gas) out there” just waiting for drillers and pipelines. But most skepticism is financial. It strikes me that my first bet is a lot safer than the bet that drove the madness of 2003 to 2007, that real estate prices would continue to rise indefinitely. I think that governments can (and should) redirect global finance away from other goals (e.g., roadworks or home- ownership) to one primary goal: to break the global “addiction” to oil and to the internal combustion engine. There is a pot of gold out there in the economic fog. The good news is that money spent on “green” (nonnuclear, nonfossil energy) technologies should be very profitable in the long run if oil (liquid hydrocarbon) prices continue to increase as I believe they will.

Energy-efficient technologies (EETs) come in all sizes and shapes, but they have a common feature: they save energy and (consequently) cut emissions of greenhouse gases. Once the investments are made the savings per unit of activity are permanent. EETs are mainly just applications of existing technologies—such as combined heat and power (CHP) insulation, double-glazed windows, back-pressure turbines, heat pumps, and heat exchangers—to existing systems as well as new ones. The prestigious management consultancy McKinsey and Co. recently undertook a major survey of opportunities for conserving energy in the US called Unlocking Energy Efficiency in the US Economy5. Its central conclusion was that opportunities exist that could save $1.2 trillion from 2010 to 2020, well above the front-end cost of $520 billion. Those opportunities would result in savings of 23 percent of estimated energy demand and reduce GHG emissions by an average of 1.1 gigatons annually (less at first, more later). The McKinsey studies have largely settled the “double-dividend” issue by identifying and quantifying a great many of them. Given the number and availability of previous studies, I do not attempt to discuss the pros and cons of all of the EETs in detail. For readers who want more, David Mackay’s book Sustainable Energy without the Hot Air (free on the Internet) is technically very authoritative6.

The first example of an EET is decentralized combined heat and power (CHP). The industrial economy needs a lot of electrical power, of course, but it also needs heat. It needs medium temperature heat for purposes such as cooking, laundry, steam cleaning, and some chemical processes. One idea behind decentralized CHP is to utilize high-temperature heat from industrial waste streams and convert it into electric power. High temperature waste heat is available from a number of industries, including metal smelters and refiners, petroleum refineries, petrochemical plants, cement plants, silicon refiners, brickworks, ceramics, and glassworks.

Industrial efficiency can also be increased in several other ways apart from CHP. One major source of inefficiency is pumping systems, which are very important for steam distribution, as well as water, gas, and other fluids. A recent analysis by McKinsey and Co. based on research at Argonne National Laboratories suggests that costs for the battery pack used for electric cars will probably decline from the current level of $500 to $600 per kwh to $200 per kwh by 2020 and to $160 per kwh by 20257. Nevertheless, the need for fuels will not go away entirely and the climate challenge means that renewables must replace coal and oil in coming decades. Why should the tycoons and bankers of the world care about these issues? The reasons are quite simple. When oil (i.e., energy) prices rise, the economy slows down. This reduces profits. The central banks usually respond with cheap money. Cheap money is less effective at “kick-starting” growth than the Keynesians like to think, because it enables speculators to make bad or unwise investments (e.g., real estate bubbles).

Reprinted by permission of MIT Press. Excerpted from The Bubble Economy: Is Sustainable Growth Possible? by Robert U. Ayres. Copyright 2014. All rights reserved.


About the Author

Robert U. Ayres is the Sandoz (Novartis) Professor Emeritus of Economics, Political Science and Technology Management, at INSEAD. He has been a visiting Professor at Chalmers Institute of Technology in Gothenburg, Sweden and he is currently an Institute Scholar at the International Institute for Applied Systems Analysis (IIASA) in Laxenburg, Austria.



1. Khazzoom, J. Daniel. 1980. “Economic Implications of Mandated Efficiency Standards for Household Appliances.” Energy Journal no. 1 (4):21-39.

2. Brookes, Len. 1990. “Energy Efficiency and Economic Fallacies.” Energy Policy no. 18 (2):199-201.

3. Saunders, Harry. 1992. “The Khazzoom-Brookes Postulate and Neoclassical Growth.” Energy Journal no. 13 (4):131-148.

4. Ayres, Robert U., and Benjamin S. Warr. 2009. “Energy efficiency and economic growth: The “rebound effect” as a driver.” In Energy Efficiency and Sustainable Consumption, edited by Horace Herring and Steve Sorrell, 121-137. London: Palgrave Macmillan.

5. Granade, Hannah Choi, Jon Creyts, Anton Derkach, Philip Farese, Scott Nyquist, and Ken Ostrowski. 2009. Unlocking energy efficiency in the US economy. McKinsey & Company.

6. Mackay, David J.C. Sustainable Energy — Without the Hot Air. UIT Cambridge 2008.

7. Hensley, Russell, John Newman, and Matt Rogers. 2012. “Battery technology charges ahead.” McKinsey Quarterly.


The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.