Doughnut Economics: Seven Ways to Think Like a 21st-Century Economist

by Kate Raworth

  Setting the stage

  When Samuelson launched his 1948 classic Economics, one of its many novel contributions was the Circular Flow diagram, which turned out to be a hit for teaching the masses. No wonder it has since spawned a million imitations, with a variation of it in almost every economics textbook.

  As the first model of the macroeconomy that every economics student meets, this diagram gets the privileged ‘first lick’ of the beginner’s tabula rasa, as Samuelson so gleefully put it. So what message does this model convey about which actors count and which to ignore when it comes to economic analysis? Centre stage is the market relationship between households and business. Households supply their labour and capital in return for wages and profits, and then spend that income buying goods and services from firms. It is this interdependence of production and consumption that creates income’s circular flow. And that flow would be uninterrupted if it were not for three outer loops – involving commercial banks, government and trade – that divert some income for other uses. The model shows banks siphoning off income as savings and then returning it as investment. Government extracts income as taxes but re-injects it as public spending. Overseas traders need to be paid for the nation’s imports but in turn pay out for its exports. All three of these diversions create leakages from and injections into the market’s circular flow but, taken as a whole, the system is closed and complete – not unlike a circular set of plumbed pipes with water flowing round and round, as Samuelson first depicted it.

  The Circular Flow diagram, which for 70 years was the defining depiction of the macroeconomy.

  In fact the very year after Samuelson’s textbook was published, that likeness inspired an ingenious engineer-turned-economist, Bill Phillips, to construct such a hydraulic machine for real. His machine, known as the MONIAC (that’s short for Monetary National Income Analogue Computer), was made up of a set of see-through water tanks connected together by tubes flowing with pink water. Designed to bring the Circular Flow diagram to life, the MONIAC’s tanks and tubes represented the flow of income through the UK economy. It was the first computer model of an economy ever made and it was utterly brilliant, earning Phillips a teaching post at the London School of Economics.3 But as a model it was also utterly flawed, as will become clear.

  Bill Phillips and the MONIAC.

  The engineers may have got carried away with the plumbed pipes, but the Circular Flow diagram deserves its credit because there are good reasons why it became a classic. The diagram was, for starters, the first attempt to depict the economy as a whole, and so helped to establish the field of macroeconomic modelling. Samuelson intended the diagram to illustrate Keynes’s insight into how economies can spiral into recession: if household spending starts to fall (say, due to fear of hard times ahead), then firms need fewer workers: as they lay staff off, they cut the nation’s take-home pay, so reducing demand even further. The result is a self-fulfilling recession, which – Keynes argued – could best be averted by boosting government spending until things got moving again and confidence was restored. What’s more, the diagram also provides the basis for different ways of measuring national income in an accounting framework that is still used worldwide. It is, evidently, a handy picture, making visible many key macroeconomic ideas.

  The trouble, however, lies in what it leaves invisible. In the words of the systems thinker John Sterman, ‘The most important assumptions of a model are not in the equations, but what’s not in them; not in the documentation, but unstated; not in the variables on the computer screen, but in the blank spaces around them.’4 The Circular Flow diagram certainly needs to be introduced with this caveat. It makes no mention of the energy and materials on which economic activity depends, nor of the society within which those activities take place: they are simply missing from its cast of characters. Did Samuelson omit them on purpose? Unlikely: he was, after all, merely intent on illustrating the flow of income, and so they literally didn’t come into the picture. But with that, the stage was set.

  Scripting the play

  In 1947, the year before Samuelson published his iconic Circular Flow diagram, a small laissez-faire band of wannabe economic scriptwriters – including Friedrich Hayek, Milton Friedman, Ludwig von Mises and Frank Knight – gathered in the Swiss resort of Mont Pèlerin to start drafting what they hoped would one day become the dominant economic story. Inspired by the pro-market writings of classical liberals such as Adam Smith and David Ricardo they established what they called a ‘neoliberal’ agenda. Its aim, they said, was to push back hard against the threat of state totalitarianism, which was spreading fast thanks to the growing reach of the Soviet Union. But that aim gradually morphed into a hard push for market fundamentalism, and the meaning of ‘neoliberal’ morphed along with it. What’s more, when Paul Samuelson’s diagram appeared – depicting which actors were at the heart of the economy and which were pushed into the wings – it provided the perfect setting for their play.

  Scriptwriting began in the late 1940s with the launch of the Mont Pelerin Society, which lives on to this day.5 But Friedman, Hayek and the other hopeful playwrights knew they might have to wait some decades before their play could be performed. They took the long view: with backing from business and billionaires, they funded university professorships and scholarships, and built an international network of ‘free market’ think tanks, including the American Enterprise Institute and the Cato Institute in Washington, DC, and the Institute of Economic Affairs in London.6

  The big time came at last in 1980 when Margaret Thatcher and Ronald Reagan teamed up to bring the neoliberal script to the international stage. Both newly elected, they were surrounded by Mont Pelerin insiders: Reagan’s election team included more than twenty members of the Society, and Thatcher’s first Chancellor of the Exchequer, Geoffrey Howe, was a member too. Like the longest-running of Broadway shows, the neoliberal show has been playing ever since, powerfully framing the economic debate of the past thirty years.7 It is high time we met the cast of characters that star in its story, each accompanied here by a biographical note and a one-line character summary that – in true Shakespearean style – loads the plot from the get-go.

  Economics: the twentieth-century neoliberal story

  (in which we go to the brink of collapse)

  Staging by Paul Samuelson

  Script by the Mont Pelerin Society

  Cast, in order of appearance:

  THE MARKET, which is efficient – so give it free rein. As Adam Smith famously wrote, ‘It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.’8 When the market’s invisible hand is set free to work its magic of allocative efficiency, it harnesses the self-interest of every household and business to provide all the goods and jobs that are wanted.

  BUSINESS, which is innovative – so let it lead. ‘The business of business is business’ summed up Milton Friedman’s influential philosophy in the 1970s. Firms bring together labour and capital to produce novel goods and services and to maximise their profits. There is no need to look at what goes on in their factories and farms, so long as they play within the legal rules of the game.

  FINANCE, which is infallible – so trust in its ways. Banks take people’s savings and dutifully turn them into profitable investments. Furthermore, according to Eugene Fama’s influential ‘efficient-market hypothesis’ of 1970, the price of financial assets always fully reflects all relevant information.9 Hence financial markets are ever adjusting but always ‘right’ – and their smooth operation should not be distorted by regulation.

  TRADE, which is win–win – so open your borders. David Ricardo’s nineteenth-century theory of comparative advantage demonstrates that countries should focus on what they are relatively good at doing and then trade: if they do, both parties will gain from it, no matter how unequal they are.10 Hence trade barriers should be dismantled because they only distort the efficient workings of the internationa
l market.

  THE STATE, which is incompetent – so don’t let it meddle. When government tries to intervene in the market, it usually makes things worse, distorting incentives and picking white elephants instead of winners. If it tries to smooth the business cycle, in classic Keynesian style, its timing will inevitably be off, and the market will pre-empt its effects.11 Beyond defending the nation’s borders and its citizens’ private property, it is quite simply best for the state to leave things to the market.

  Other characters not required on stage:

  THE HOUSEHOLD, which is domestic – so leave it to the women. The household supplies labour and capital to the market, but there’s no need to lift the roof and ask what goes on within its four walls: wives and daughters kindly take care of domestic affairs and they belong in the home, as does this matter.

  THE COMMONS, which are tragic – so sell them off. In the 1960s, Garrett Hardin described ‘the tragedy of the commons’ in which shared resources – such as grazing land and fish stocks – tend to be over-exploited by individual users and so are depleted for all.12 Managing such resources sustainably therefore calls for government regulation or, better still, private ownership.

  SOCIETY, which is non-existent – so ignore it. ‘There is no such thing as society,’ Margaret Thatcher famously declared in the 1980s. ‘There are individual men and women and there are families.’13 And it is, of course, the market that connects them, as workers and as consumers.

  EARTH, which is inexhaustible – so take all you want. There will be no shortage of Earth’s resources, claimed the laissez-faire economist Julian Simon in the 1980s, if markets are permitted to do their job. A shortage of, say, copper or oil will raise its price, spurring people to use it more sparingly, search for new sources, and discover substitutes.14

  POWER, which is irrelevant – so don’t mention it. The only economic power to be worried about, argued Friedman, is monopoly power granted by the state when it meddles in the market, and the distortionary power of trade unions. The single best way to combat it is (no surprise) free markets and free trade.15

  It was, undeniably, a brilliant line-up – and almost a stitch-up. The market, promised the neoliberal script, is the road to freedom, and who could be against that? But putting blind faith in markets – while ignoring the living world, society, and the runaway power of banks – has taken us to the brink of ecological, social and financial collapse. It is time for the neoliberal show to leave the stage: a very different story is emerging.

  A new century, a new show

  To tell a new story let’s start with a new picture of the whole economy. Samuelson drew his iconic diagram in the late 1940s – in the wake of the Great Depression and the Second World War – and so was understandably focused on the question of how to get income flowing around the economy again. No wonder his diagram defined the economy in terms of its monetary flows alone. In doing so, however, it offered an extremely small stage for economic thinking, along with a stripped-down cast of characters. So let’s start afresh with an economic question better suited to our own times: what do we depend upon to provision for our needs? Here’s a visual answer to that question, summed up in a diagram that I have called The Embedded Economy, which brings into one picture important insights from diverse schools of economic thought.16

  The Embedded Economy, which nests the economy within society and within the living world, while recognising the diverse ways in which it can meet people’s needs and wants.

  What does it show? First Earth – the living world – powered by energy from the sun. Within Earth is human society and, within that, economic activity, in which the household, the market, the commons and the state are all important realms of provisioning for human wants and needs, and are enabled by financial flows. If this diagram sets a new stage, then here is the cast of characters that it calls forth.

  Economics: the twenty-first-century story

  (in which we create a thriving balance)

  Staging and script: a work in progress by economic re-thinkers everywhere

  Cast in order of appearance:

  EARTH, which is life-giving – so respect its boundaries

  SOCIETY, which is foundational – so nurture its connections

  THE ECONOMY, which is diverse – so support all of its systems

  THE HOUSEHOLD, which is core – so value its contribution

  THE MARKET, which is powerful – so embed it wisely

  THE COMMONS, which are creative – so unleash their potential

  THE STATE, which is essential – so make it accountable

  FINANCE, which is in service – so make it serve society

  BUSINESS, which is innovative – so give it purpose

  TRADE, which is double-edged – so make it fair

  POWER, which is pervasive – so check its abuse

  What follows is a biography for each of these parts – longer than the twentieth-century ones because these new roles are not yet nearly so familiar. It is time to meet the twenty-first century’s economic actors anew.

  EARTH, which is life-giving – so respect its boundaries

  Far from floating against a white background, the economy exists within the biosphere, that delicate living zone of Earth’s land, waters and atmosphere. And it continually draws in energy and matter from Earth’s materials and living systems, while expelling waste heat and matter back out into it. Everything that is produced – from clay bricks to Lego blocks, websites to construction sites, liver pâté to patio furniture, single cream to double glazing – depends upon this through-flow of energy and matter, from biomass and fossil fuels to metal ores and minerals. None of this is news. But if the economy is so evidently embedded in the biosphere, how has economics so blatantly ignored it?

  Earth’s importance for the economy was self-evident to the early economists. In the eighteenth century, François Quesnay and his fellow Physiocrats took their name from their belief that agrarian land was the key to understanding economic value. Yes, these early economists based their ecological thinking narrowly on agricultural land alone, but at least the living world got a mention. From there, however, things began to go awry, and there are many theories as to why.

  Adam Smith, father of classical economic thinking, drew on the Physiocrats’ work, believing that a nation’s potential for wealth ultimately depended upon its climate and soil. But he also thought that the secret to productivity lay in the division of labour and so focused his attention on that. David Ricardo likewise believed that the ‘original and indestructible powers of the soil’ made scarce agricultural land a key determinant of economic value.17 But as new lands were cultivated in Britain’s colonies, he decided that land scarcity was no longer such a threat and so, like Smith, switched his attention to labour instead. John Stuart Mill also clearly saw the importance of Earth’s materials and energy in all economic production, but he wanted to distinguish social science from natural science and so (rather unhelpfully) proposed that the field of political economy focus on the laws of the mind, not the laws of matter.18 In the 1870s the radical American thinker Henry George pointed out that land gained value for its owners even if they did nothing to improve it, and so he advocated a land-value tax – prompting his influential (and land-owning) opponents to downplay the importance of land in economic theory from then on.19

  The upshot of all this? The classical economists, led by Smith and Ricardo, had recognised labour, land and capital as three distinct factors of production. But by the late twentieth century, mainstream economics had reduced the focus to just two: labour and capital – and if ever land did get a mention, it was as just another form of capital, interchangeable with all the rest.20 As a result, mainstream economics is still taught today with scant attention paid to the living planet that supports us and the blazing star whose energy we depend upon.21 It relegates ecological stresses such as climate change, deforestation, and soil degradation to the periphery of economic thought, until they become so severe that their da
maging economic impacts demand attention.

  So let’s restore sense from the outset and recognise that, far from being a closed, circular loop, the economy is an open system with constant inflows and outflows of matter and energy. The economy depends upon Earth as a source – extracting finite resources like oil, clay, cobalt and copper, and harvesting renewable ones like timber, crops, fish and fresh water. The economy likewise depends upon Earth as a sink for its wastes – such as greenhouse gas emissions, fertiliser run-off, and throwaway plastics. Earth itself, however, is a closed system because almost no matter leaves or arrives on this planet: energy from the sun may flow through it, but materials can only cycle within it.22

  Redrawing the economy as an open subsystem of the closed Earth system is the major conceptual shift introduced by ecological economists such as Herman Daly in the 1970s. And it’s a paradigm shift that has become increasingly important, given the economy’s ever-growing scale. When Adam Smith published The Wealth of Nations in 1776, there were fewer than one billion people alive and, in dollar terms, the size of the global economy was 300 times smaller than it is today. When Paul Samuelson published Economics in 1948 there were not yet three billion people on Earth and the global economy was still ten times smaller than it is today. In the twenty-first century we have left behind the era of ‘Empty World’, when the flow of energy and matter through the global economy was small in relation to the capacity of nature’s sources and sinks. We live now, says Daly, in ‘Full World’, with an economy that exceeds Earth’s regenerative and absorptive capacity by over-harvesting sources such as fish, and forests, and over-filling sinks such as the atmosphere and oceans.23