Wednesday, October 29, 2014

Worldwide Supply-Demand Imbalances, Inflation/Deflation Risks, and Feedback Loops

There's been many calls for hyperinflation or high inflation, particularly from libertarians and others who don't like the Fed (but not everyone who doesn't like the Fed, including me). These statements are usually highly politically motivated comments by people who have no idea of basic balance sheets--as I've addressed before. I'm just writing this initial part to point out that not only are such calls complete nonsense, but worldwide inflationary risks are effectively at all time lows--with a few countries like commodity exporters/LDCs and Japan being exceptions.

As I've pointed out in my economic and geopolitical posts about China, it's China that's driving the demand for the world's commodities. We're seeing Chinese growth rates come down sharply and they're not going up any time soon. In other words, we're likely to see commodity prices plummet. What does this mean? It means that countries who use commodity prices as inputs are likely to get a benefit by seeing deflation on the supply side.

We're also likely to see falling energy prices as we see capacity and production levels collapse across the world. Natural resources used for energy are economic inputs in production, so falling production levels and expectations of falling production levels will place downward pressures on energy prices. Energy importers will see a boost while countries with excess capacity or those heavily reliant on exports (particularly commodity or energy exports) will get hit very hard. Although we live in a world with excess capacity and little demand, the falling production levels will only end up pushing worldwide demand even lower.

This brings up the next question: why would falling production levels cause falling demand?
As I stated, increases in supply create increases in demand, but not necessarily increases in net demand. If the supply corrects very sharply towards the downside, all of the demand that was created by the excess supply will correct. However, it is very important to notice that even though supply and demand could (and probably will) fall sharply together, net demand will go up because of how sharp the correction would be. Simply put, production and consumption will fall, but production will fall faster than consumption.

It's also important to note that, in many countries, the kind of demand increases that we've seen are exactly the kind of demand increases that we don't need. The kind of demand increases we've seen (particularly in countries like China) have come because of sharp, unsustainable increases in capacity. As you increase capacity and supply, it's natural for demand to increase as well since the increase in production (productive or not) results in more workers to produce whatever is being produced. In other words, you do get an increase in demand, but it's net demand that the world needs--not demand stemming from unsustainably rising capacity.

If we take the United States as an example in the Great Depression, we see how sharp this correction can be. In 1920's, the US had the highest trade surplus in history at around .6% of GDP and accounted for around 36% of the world's GDP. From 1929-1933, US NGDP fell by almost 50%. That's how these kind of corrections can occur--although the US case is an extraordinary example.

To put this in perspective, China accounted for around .5% of the world's trade surplus in the 2000's while China currently accounts for <12% of the world's production. The current investment boom in China is unprecedented in both scope and scale. China no longer runs as large trade surpluses as it used to, but it effectively replaced the export model by sticking shovels in the ground to put up high rise condos. The sharp increase in investment fueled much of the commodity price boom over the past decade or two, which has caused a massive increase in private sector debt. China has effectively turbocharged investment by massively increasing bank lending to finance this ridiculous investment boom (see my economic post on China for more details).

Note that it's very possible China won't correct the same way the US did in the 30's (sharply and quickly). I think there's a good chance China corrects in a slow and orderly manner with very low growth rates over the course of 15-25 years--like we saw Japan correct after the 90's.

Inflation Risk:
Basically, we're in a situation where falling production levels put downward pressure on input costs. In most of the world, we're likely to see falling input costs combined with stalling (or falling) demand. How are we likely to see higher inflation? The reality is that we're not. If anything, we live in an extremely deflationary world.

There could be particular countries that may experience cost push inflation (like Japan or commodity exporters), but the world as a whole is in the midst of a deflationary scenario that we haven't seen anything like since The Great Depression.

Feedback Loops:
The world is littered with excess capacity and very little demand. Every country in the world has been trying to simultaneously boost production at the exact same time while there's no demand that can sustain the current production levels. In other words, most of the countries in the world are effectively stuck in situations whereby they've been locked into certain policies that have created feedback loops. In order to sustain the rising worldwide gap between production and consumption, we've seen massive increases in the real debt burden that has created a worldwide boom. We've seen a positive feedback loop, but debt cannot rise faster than debt servicing capacity forever. In other words, what we're seeing will correct.

Not only did we see a feedback loop on the way up, but we're also likely to see a feedback loop on the way down. Falling production levels will lead to falling real demand and the massive debt burden will no longer be able to keep growing. We will see massive bankruptcies (both private and public) that will put downward pressure on demand and capacity. Falling capacity will place further pressure on worldwide aggregate demand. Just like we had a feedback loop on the way up, we'll have a positive feedback loop on the way down.

All of the countries that "rose" together (these are primarily, but not necessarily, countries that have tied themselves to China) will fall together. A slowdown in one country will cause a slowdown in the other, which will again create another feedback loop. These feedback loops will, in all likelihood, continue until some event causes a shift. That event could range from a sovereign restructuring to revolutions to a war to a whole bunch of other possibilities.

Note: None of what I'm saying applies to commodity exporters. As I've previously written, these countries could actually see inflation because collapsing worldwide aggregate supply and falling demand (stemming from the falling supply) will reduce the demand for commodity prices as commodity prices will (and have been) falling. The capital inflows that came from the explosion in commodity prices in these countries has been reversing and I suspect that trend will continue. The capital outflows from these countries will put the currencies of these countries under pressure. On top of this, these countries will (and have been) experience falling production while consumption costs could very well increase from the depreciating currency causing rising input costs.

Note #2: Up until around 2007-08, much of the world's capacity was sustained by large increases in debt in order to finance consumption. In particular, this applies to the US. Due to the nature of the boom (a relatively decentralized consumption boom), debt capacity constraints are reached relatively quickly to prevent the boom from getting too out of hand. The year 2008 marked the moment that the US consumer could no longer borrow in order to consume much of the world's excess capacity (primarily coming from China).

Tuesday, October 21, 2014

Killing Terrorists vs Wiping Out Terrorism

For some reason, the idea that wiping out every terrorist on the planet does little to wipe out terrorism is something that many people have difficulty understanding. However, the inability of many people to understand this concept is one of the leading causes to why terrorism, particularly the radical Islamic version, continues to spread and become larger.

In order to first tackle this issue, we must ask the question: why does terrorism grow?
The primary factors for the growth of terrorism consist of (but are not limited to) ignorance, lack of basic education among the people who take up such ideologies, oppressive governments ruling minority populations with an iron fist, or even a battle for natural resources.

So how do we attack and fight terrorism?
Many would respond that if we just kill terrorists, there'll be less terrorists to kill in the future. Of course, this view completely neglects second and third order effects. In order to deal with terrorists and kill them, you need either boots on the ground (actual troops to fight insurgencies) or you can directly use airstrikes. If airstrikes are used, there is a relatively large probability of a miss. A miss can (and has) resulted in civilian casualties while the people who decide where and when to strike do not suffer any negative consequences if they miss. If they happen to hit some child or home in Pakistan that only holds civilians, then the people who were struck are the only ones to suffer. In other words, we have a typical asymmetry in incentives.

On the other side of the coin, civilians see a bomb randomly striking an innocent person's home with American shrapnel flying off. In other words, you're creating an incentive for civilians to turn to terrorism. By bombing places randomly without any proper concern, we actually end up fueling terrorism even though we may end up occasionally killing terrorists. We must recognize that poor, uneducated populations (particularly youth) without sufficient infrastructure are the ones most likely to resort to terrorism.

In order to fight and attack terrorism, what we really need are a new set of ideas. Resorting to bombing places or supporting authoritarian regimes (ex. Saudi Arabia, now Turkey) or boots on the ground--turning the US military into a nation-building force--are not the solutions. Instead, we need ways to educate the populaces of these regions. We need ways to actually change the way that the people and groups in the region think and behave.

Obviously, changing the way that the people in the region think is easier said than done. We need ways of constructing proper infrastructure so that groups like the Islamic State can't influence the hearts and minds of the populace they attempt to control by helping build infrastructure and provide social services.

What about nation-building?
As a way to fight insurgencies and terrorist organizations, we've seen the US military take a role in sending large amounts of troops to fight these insurgencies (ex. War in Afghanistan and Iraq). What the US was really doing was nation-building. The US literally tried to build stable governments as the US military provided security for the region. This is a short-term way to deal with terrorism, but the longer you stay in a foreign land, the more people will get pissed off. Again, this is a long-run way of fueling terrorism although it suppresses volatility in the short term.

Another problem with this strategy is the sheer cost. We have places in the US like California that have rapidly deteriorating infrastructure that we completely ignore fixing while we're building infrastructure in highly politically unstable countries that only show a shed of stability and security due to our military force that isn't even working as a military force (it's working as a security force). Obviously, none of these solutions make any sense and have ZERO chance of working over any extended period of time.

Basically, we need to avoid the urges to call for nationalism and worry about our problems at home. We need to throw out ideas that turn the free republic into an authoritarian empire as imperialism is inherently unsustainable and will eventually make the country poorer. Using large scale capital inflows to fund deficits and fight wars IS NOT sustainable in the long run and provides little increase in productivity to pay off the debt servicing costs.

Running up trillions of dollars in debt while simultaneously ruining hundreds of thousands of lives in order to sustain nations that really have no reason to exist doesn't make any sense. Quite frankly, it's straight up stupid. Unfortunately, this stupidity has been the hallmark of American foreign policy over the past 3-4 decades.

Wednesday, October 1, 2014

On Independence and Secessionist Movements

There was a vote on September 18, 2014 for Scottish independence from the UK. The vote was relatively close and required a simple majority (>50%) of the voters to grant Scotland independence, but the vote was a (close) no with around 53% of the population voting no. Similarly, the Chinese central government seems hellbent on controlling everything going on and we're starting to see peaceful protests in Hong Kong as the central government tried to place certain restrictions on candidates that run in the Hong Kong elections.

As I've spoken about in previous posts, the world is currently in the midst of a depression wherein the world is filled with excess capacity and little demand. To add fuel to the fire, China has been driving the world's economy since 2008 when the American consumer proved unable to fill the void after a massive (and unsustainable) debt bubble. As I've discussed in my post about China's economic system, China has done this by creating a massive investment, infrastructure, and commercial real estate boom and has driven commodity prices skyward during this entire process (as I discussed here). In other words, countries that're heavy commodity exporters could find themselves facing major internal struggles, particularly in regions where oppressed minorities are being oppressed by authoritarian governments.

Why do I bring up these economic issues? These economic issues create political and social unrest down the line as these booms and bubbles start to unwind and eventually burst. We're not even halfway through this depression, which means we're likely to see an increase in social and political unrest coming up. I've also spoken about the possibility of fragmentation in large countries like Russia and China while we're seeing the countries in the Middle East fragment into smaller tribal states. Both Russia and China are (and will continue to) experience difficult economic circumstances. In other words, we're likely to see an intensification of separatist movements in China and Russia. It's not just China and Russia either. As I stated earlier, China is driving many parts of the world economy. If we see economic troubles in China, we're likely to see more secessionist and independence movements across the world.

Does it make sense for a Chinese central government to control every aspect of regions that don't want to be under their control, have a completely different view of society, and don't need anything that the central government actually provides? Of course not. Similarly, Russia is having lots of issues of controlling its population in places like Dagestan and Chechnya with highly Muslim populations. In response to the oppressive nature of governance in these areas, you're seeing a rise in radical Islam. It's a similar situation in places like Xinjiang and Tibet, which are currently under Chinese control, where the population is mostly Muslim or Buddhist under the oppressive rule of an atheist leadership/government. It makes little sense for these areas to be under Chinese control for any purpose other than buffer regions. Even if they are buffer regions, is it okay for the populace of these countries to be oppressed by governments just because a few people in those governments want to hold those areas as buffer regions? Does it make any sense and can the current situation hold for an extended period of time? I find the answer to all of those questions to be a simple and obvious no.

We're also seeing secessionist movements come to power in places like Balochistan (from Pakistan), there have been secessionist movements in Eastern (heavily Shiite regions) Saudi Arabia away from the rule of the House of Saud for a while, the Kurds want to separate away from Turkey and Iran (where there have been standoffs with the Iranian government and the Peshmerga--the Kurdish military), and in many other areas. In regions like Tibet, the younger population particularly favors independence much more so than the older population.

What should the role of foreign governments and, in particular, the US be?
It makes sense from almost every single perspective for other foreign governments and the US to support these movements, especially if these movements are peaceful.

Why should these secessionist movements be supported?
The most obvious argument is a risk argument. Decentralized systems are more robust because the costs remain localized. In decentralized systems, failure is small and localized which means that the error of a state or group of people don't have the same systemic impacts as would otherwise be the case.

If you have one centralized state with a 10% chance of failure/unit time (we'll use one year in this example), the expected time of survival is 1/10%=1/.1=10 years (or whatever units of time). If you have n decentralized states where the probability of failure is 10% and the failure of each state is independent, the failure rate for the collective system is .1^10=10^(-10) while the expected time of survival for the unit as a whole goes to 1/(.1^10)=10^10.

If we generalize the case to n different states each with an independent probability of survival p (p<1), the chance of failure for the system as a whole is p^n. The expected time of survival for the system becomes 1/(p^n)=p^(-n)>1. In other words, the more decentralized the system the more robust the system becomes at an exponential rate with respect to the number of states as long as the states are run independently.

Secondly, there are certain events that we want to completely eliminate (like the risk of world war). Any time we have large centralized units in control over large areas, we create risks of conflict between two or more large, powerful regions at once. The consequences for not just these regions, but for the planet as a whole, can be disastrous. If there's irreversible damage, we (as the human race) could potentially end up being screwed. Trying to eliminate events like war is stupid because you can't control every part of the world all at once. Rather than trying to prevent events that're obviously out of our control and understanding, we need to work to limit their impact. So having individual states fight small wars with one another doesn't create the same level of tail risk as having large states fight in large scale wars. It's important to note that we may see more small scale wars this way, but that's okay. We cannot (and should not) try to control everything and try to prevent it with naive interventionism as we do not know the costs of such policies. What we should do is to prevent the costs of any possibility to be much larger than anything we can handle. In other words, we shouldn't focus on the probability of being wrong and instead focus on the maximum costs IF wrong. Encouraging large-scale decentralization is the first step to realizing this goal.

Thirdly, authoritarian regimes that oppress peoples and other societies shouldn't be tolerated. Why shouldn't they be tolerated?
1. They don't share our views of a proper society
2. It's common to see authoritarian regimes not have any sort of fluctuations in their political systems. What ends up happening is that the oppressive nature of these regimes leads to pushing all small fluctuations underneath the surface while hidden risks are allowed to accumulate.
3. These regimes often have less changes, but when the changes do happen, they happen suddenly, unpredictably, and the changes are often very costly (both monetarily and in terms of human casualties).

Nassim Taleb has an excellent paper called The Black Swan of Cairo where he discusses the issue of volatility suppression with regards to matters of oppressive authoritarian regimes and foreign policy.