Rethinking the concept of “economic rationality” in the 21st century

Photo by Ciprian Boiciuc on Unsplash

The rationality of self-interest hasn’t served humanity as well as initially thought

Considering the existential risks human civilization is facing in the 21st century, it is high time to fundamentally rethink the concept of “economic rationality” in finance and economics. Traditionally, the term “economic rationality” has been used to describe the preference of economic agents (e.g. consumers, producers, investors etc) to maximize their own utility, theoretically resulting in the “efficient allocation” of limited resources towards economic productivity. This idea has shaped the architecture of our current economic and financial systems, with standards, rules, incentive structures, and legal duties designed to promote (and even reinforce) the pursuit of economic self-interest. Of course, in the reality of everyday life, human motivation cannot be reduced to the rationality of self-interest. This would ignore the fact that various factors, such as personal values, a “sense of duty”, a normative rationality, or a survival will, for example, can compel humans to voluntarily cooperate for the greater good, even against their economic self-interest. Arguably, such an oversimplification of human nature might have been acceptable for as long as the “invisible hand” functioned at least well enough to generally benefit human societies more than it damaged them (rising inequality notwithstanding). However, almost 30 years after the first Earth Summit in 1992, in the middle of an escalating climate crisis, human societies are slowly but surely coming to the realization that the traditional concept of economic self-interest hasn’t served humanity as well as initially thought.

The predictability of an overheated engine

What has gone wrong? A closer look reveals that the traditional conception of economic rationality represents a rationality of short-term self-interest. The current economic and financial system design is such that the capacity of its agents to anticipate and adequately respond to long-term threats is rather limited, with a time horizon ranging from milliseconds for trading algorithms to perhaps 5–10 years in the context of institutional investing. Considering that the collective consequences of greenhouse gas releasing economic activities extend multiple decades (owing to tipping dynamics even millennia) into the future, it is as if we were able to look only a few meters ahead, while driving along a serpentine road with increasing speed. In an effort to extend our civilization’s field of vision, regulatory requirements for investors and companies to better account for long-term climate risks are on their way (e.g. in Europe). But even if economic agents could be compelled to look multiple decades ahead, it remains to be seen whether their risk assessments would fully account for the possibility of discontinuities driven by the twin threats of planetary heating and nuclear conflict. Absent a successful decarbonization of the global economy, the predictability of escalating armed conflicts between nuclear powers over security-critical resources is comparable to the breakdown of an overheated mechanical engine that is kept running without sufficient cooling/lubrication: Although we cannot exactly predict when it will happen, we can be relatively certain that it is only a matter of time (with increasing probability) until it happens. Eventually, the success of climate risk regulations will need to be measured by the measurable reduction of annual greenhouse gas emissions due to fundamentally changed capital allocations, going far beyond current ESG aspirations.

The economic irrationality of our current situation

It should be self-evident that the traditional definition of economic rationality presupposes an implicit and fundamental interest in the stability of the societal conditions that allow for the future possibility of continued economic activity. Until the late 20th century, there was relatively little reason to believe that the economic rationality of short-term self-interest would contradict the rationality of civilizational self-preservation. It was taken for granted that an “efficient” allocation of resources would be synonymous with an allocation that delivered the greatest long-term benefits for human societies. But as the 21st century unfolds, we are finding ourselves in a paradoxical situation: What used to be (and continues to be) commonly accepted as an “economically rational” activity, namely the profitable generation of greenhouse gas emissions, has turned out to be highly detrimental to the long-term continuity of human civilization. In the face of a potentially civilization-ending threat, the economically rational thing to do would have been to temporarily prioritize long-term self-preservation over short-term self-interest. This means, for example, that existing and planned fossil fuel assets worth hundreds of billions USD should never have been approved and funded in the first place — they must now be written down and replaced as soon as possible by additional renewable energy infrastructure which should have been built many years ago.

What should have happened?

Indeed, in an alternate timeline, in which human societies were largely governed by the economic rationality of self-preservation, the fossil fuel industry and its shareholders would have already yielded by now to the necessity of giving up a moderate amount of present economic value in exchange for preserving a substantial level of human prosperity in the future. In a globally coordinated effort, foresightful policy makers would have successfully re-aligned the rationality of civilizational self-preservation with the rationality of short-term self-interest by modifying the economic and financial systems’ legal frameworks (e.g. minimum standards, duties, bans, liabilities…) and incentive structures (e.g. taxes, subsidies, public spending,…). These changes would have enabled and catalyzed far-reaching reallocations of capital, and the accelerated electrification and decarbonization of the global economy. Seeing the writing on the wall, the fossil industry would perhaps have negotiated in good faith a reasonable compensation in return for accelerating the shutdown of its fossil fuel operations. Even if it had funded disinformation and lobbying efforts directed against effective climate policies, a sufficient majority of rational policy makers and their constituents would have firmly sided with the science. As a result, a substantial share of our global energy mix would be renewable, and global greenhouse emissions would be on a pathway to reach net zero well before 2050. Within the constraint of achieving climate neutrality in due time, the general pursuit of short-term self-interest could have continued as usual.

The reality of our broken timeline

In contrast to “what should have happened”, the reality of our broken timeline is that even at the beginning of the 2020ies, short-sighted institutional investors and governments still continue to fund greenhouse gas releasing (i.e. “brown”) projects and companies for short-term economic/geostrategic gain. Large corporations still continue to sell their products and services to a well-paying fossil fuel industry despite ambitious commitments to reduce their own operational greenhouse gas emissions to netzero. The fact that the fossil fuel industry is still able to maintain and even expand its economically irrational operations (mostly with regard to oil and gas, as coal is already on the decline) represents an unparalleled market and regulatory failure. By successfully delaying greenhouse gas emissions regulations, the fossil fuel industry has only managed to increase the height of its predictable future fall, which is tragically threatening to take the hope for human progress towards a more civilized, peaceful and prosperous world down with it. No amount of money can probably come close to the liabilities and damage compensations that brown industries’ directors and major shareholders — many of whom are collectively culpable of gross negligence at best and wilful misconduct at worst — will need to be held accountable for one day. It is a matter of justice to 21st century born generations that irrational economic and financial activities are sooner rather than later firmly established as liable breaches of fiduciary duty, e.g. through an ecocide law and/or a relatively small modification of corporate law.

The crux with “market rate” risk-adjusted returns

Of course, it is possible even within the current financial and economic system design to generate “market rate” risk-adjusted returns while sustainably contributing to a positive net impact at the same time. Recent market dynamics and technological advancements have begun to rapidly expand the universe of investable greenhouse gas emissions reducing (i.e. climate impact) assets. But this development is coming decades too late and needs to become much faster and forceful than is currently the case (as suggested by a groundbreaking report by Rewiring America). Despite a historically unprecedented oversupply of low-cost capital, too many greenfield/small-scale renewable energy infrastructure projects or natural climate solutions are not being developed and financed yet due to not meeting mainstream investors’ “market rate” return expectations (especially in developing and emerging economies), resulting in a perceived shortage of “investable” climate impact opportunities. Normally it would be an insult to our intelligence if someone tried to explain to us that measures necessary for the sake of our collective survival could only be realized if they were profitable enough. Yet we have designed an economic and financial system which is so “efficient” at driving short-term performance that there is little leeway for economic activities and investments that may be critical for humanity’s survival but happen to deliver sub-market rate returns. Especially when taking into account that the same market that has determined these thresholds has utterly failed to properly internalize the future costs, damages and risks of the climate crisis into present price levels, we can see that current “market rates” are deeply flawed benchmarks with regard to brown assets (which generally appear more attractive than they rationally should be) and climate impact opportunities (which often appear not as attractive as they rationally should be). In order to allow markets to facilitate “truly rational” capital allocations, which are not working against but for human progress, systemic adjustments of brown/green risk-return profiles are needed (e.g. through effective carbon pricing and catalytic public spending).

The need to push the envelope

There is an inspiring saying: “When dreams are not scary, they are not big enough”. Given how long the world has ignored the climate crisis, the same must now be said about individual, corporate, national and international decarbonization aspirations. The economic rationality of self-preservation compels business and political decision makers to push the limits in terms of the speed and scale of their climate neutrality ambitions. Even when this may seem costly in the short-term, at a societal level, those costs are far exceeded by long-term rewards in terms of job and income creation as well as future costs, damages and risks avoided (or reduced). Companies that are part of the problem will either need to rise to the challenge and restructure, transform or downsize in due time or accept a rationally justified market exit, while those that are part of the solution will need to scale faster and bigger than they might have ever anticipated. We need to keep in mind that — for as long as the climate emergency persists — the deliberate decision to prioritize sustainable greenhouse gas emissions reductions over short-term profits and returns represents a defiant act of “true” rationality within a deeply irrational economic and financial system. As architects of their own social system designs, human societies can theoretically put an end to this madness, and establish ambitious climate policies (such as the energy innovation and carbon dividend act, for example) and transformational, mission-driven standards and investment programs. For this to happen, a critical mass of determined decision makers needs to come together as concerned human parents (in an abstract as well as in a concrete sense) and put short-term interests aside. Instead of still arguing about the reality of catastrophic planetary heating, we could then have a long overdue discourse about our legacy — the future burden we can reasonably want to put on our children and their descendants, versus the burden we are willing and able to accept for their sake in the present.

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Young-jin Choi

Young-jin Choi

https://www.linkedin.com/in/ychoi3/

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