Thursday, January 29, 2015

The Development of Trade Networks, Network Effects, and Security Costs

In my last post, I rambled about transport costs, trade, the development of trade networks, and the role of infrastructure. This post will be somewhat of a continuation on the previous topic: it'll be about how different political systems treat, use, build around, protect, and develop these trade networks. The previous post's primary focus was on economics; the topic of this post will primarily be geopolitics.

As I discussed in my previous post, transport costs and infrastructure are a critical factor in the development of trade. We know that the cheaper the cost of transport, the easier it becomes to facilitate trade. However, there are other factors: network effects and the protection of trade. Transport costs may be low, but if you can't protect your stuff from getting stolen, it really doesn't matter how low transport costs are. So the security aspect of trade plays a huge role in the development of trade networks. Before I get into how the network effects play out and the protection of trade, I'll first talk about the development of trade networks.

Development of Trade Networks:
Recalling from my previous post, we know that trade by land is about 50-100 times the cost of trade by water. So the most obvious trading networks are trading networks that're supported by navigable rivers and large lakes or seas if we just take into account transport costs. The most obvious examples would be rivers like the Nile, Rhine, Oder, Mississippi, and others. Wealthy populations generally tend to be built on navigable rivers/waterways or around Seas--particularly before the advent of deep-water navigation simply because of transport costs. For example, the Roman Republic was built around the Mediterranean, the Middle Eastern civilizations were built around the Tigris and the Euphrates, the Egyptians near the Nile, and the list goes on.

There can also be other trade networks formed with infrastructure. If there's a portion of a river that's not navigable, but you build canals around and through it, you now have created a new trade network. Similarly, we can link cities/city regions/city-states with other cities/city regions/city-states by building roads/bridges and rail lines. However, these networks can only be established if the total trade created (and other benefits) from the newly-created network can offset the cost of building and sustaining the trade network. Obviously, we would expect the benefits to the creation of these trade networks to be highly nonlinear and they always are. In other words, the benefits of constructing the first rail line or road that links two city-states will be much higher than the 10,000th road and rail line.

In my post about economic basics and the accumulation of real wealth, I spoke about the importance of economies (on any scale) to be able to substitute inputs while diversifying across inputs and outputs. I also (lightly) touched on how this implies populations must cluster in certain regions for this to happen. In other words, they must accumulate in cities or city regions (I'll refer to them as city-states for the rest of this post). In order to substitute inputs and outputs, these city-states must be connected to other city-states. For the accumulation of real wealth, city-states must constantly be engaged in volatile trade with other similar places.

So the development of trade networks requires the linking of city-states with other city-states. Rivers, navigable waterways, seas, etc. make the linking of city-states simple and allow for the development of volatile trade between these city-states. However, these city-states can also be linked with infrastructure like road/rail networks, canal systems, and other projects. These are less natural, but can still be easily developed relatively easily.

Now that we have some basics down on the development of trade networks, I'll get into the economic network effects and security aspects of trade networks.

Network Effects and Security Costs of Trade Networks:
Since we have development of trade networks, it becomes important to understand that--understandably--network effects develop. The primary network effects that develop are in the protection of trade, the economic benefits of trade, and the cost of the protection of trade. Basically, one of the reasons we see the formations of centralized governments is to protect trade, protect basic property rights, enforce contracts, and protect the people/groups that stretch across trade networks. In order to understand the network effect that develops in the security costs of maintenance of the trade network, I'll use a simple model/example to show the point I'm trying to make.

Model/Example: Suppose we have a large lake or sea with many city-states surrounding it. Let's assume that the lake/sea is easy to trade over and that each city-state gains economic benefits by engaging in trade with one another. Let's also assume that we have 8 city-states evenly distributed around a circular lake with each city-state being the same size and structure. Suppose you also have three republics/empires fighting for control over this trade network with one republic/empire having 4 city-states, with one having 2 city-states, the third having one, and the final city-state in question being independent.

If the final city-state is suffering from security issues or is having difficulty finding trading partners, it can join any one of those empires. However, it can have trade with 4 city-states, two city-states, or one city-state. Obviously, trade with 4 city-states creates more of an economic benefit than trading with two or with just one. Also note that the empire with 4 city-states now has 5 city-states on the same region, but the economic links don't expand from 4 to 5. The first amount of economic linkages was 6, but now the total amount of economic linkages are 10. If the republic gains another city-state, the economic linkages expand from 10 to 15. In other words, the amount of economic activity for the ruling government expands NONLINEARLY at a rate of O(n^2) as n becomes large (comment down below if you want me to explain the math behind my calculations). So there's an obvious network effect in the economic benefits, but there's also security benefits.

From a security perspective, the more of the sea you control, the less someone else controls and the less power they have to boss you around/tell you what to do/dictate where and how your trade has to flow. If you have 2/8 city-states next to each other in the same governmental network while someone else has 6/8, there's a very high risk of your trade being in danger. If you control 6/8 next to each other with someone else having the other 2/8, there's much less of a risk AND there's more of an economic effect that allows you to fund a military to protect it. Similarly, control over the entire network drops security costs by a lot because there's no one else to take your stuff.

Notice that in my model, I made a lot of assumptions with the primary assumption being that all else is equal. Obviously in the real world, all else is not equal and the real world is (much) more complex. However, using this simple model, we can see how network effects develop. We can also see how natural monopolies can come into place in these regions. The more of the network you control, the more economic benefits you gain while your security costs drop. Military costs, in other ways, also drop, but that's a different topic for a different day.

Conclusion and Implications:
In the real world, we see costs like infrastructure development and other factors (ex. weather, food transport, water transport, natural resources, environmental costs, etc.) that factor in to this equation. However, we can clearly see how it's easy for one government to control entire trading networks. Particularly when if we add in the assumption that it's impossible/extremely difficult for capital and real wealth to be accumulated in areas that don't have large populations.

What this implies is that governments can come about as ways to protect and let economic systems develop by taking advantage of network effects. Even though the model above assumes a sea, there can be natural trade networks across land where we see similar effects including the development of infrastructure--particularly if the trade would go to zero without the infrastructure.

Monday, January 12, 2015

Transport Costs, Trade, Trading Networks, and Infrastructure

Often times, we hear economists talk about trade and its benefits/costs. However, they don't seem to understand all of the costs, benefits, and risks involved. They also (almost always) ignore transport costs and trade networks. This is also a problem when we talk about infrastructure because we rarely talk about how transport costs will be impacted by infrastructure even though, often times, the purpose of infrastructure is to reduce transport costs. This post will be split up into four separate parts:
1. Transport Costs
2. Trade and Trading Networks
3. Infrastructure
4. Impacts of Infrastructure

1. Transport Costs:

First, I'll start off with the most basic fact: the cost of shipment via trade is much cheaper than shipment via land. There are many reasons why, including physical factors like friction (buoyancy) and infrastructure development. For the purposes of this blog, I'm going to ignore the reasons why because I'm not a civil/mechanical engineer who specializes in fluid dynamics and because that's not what I'm interested in looking at. Just by the cost of operation, transport by land is 10-15 times the cost of transport by water. When you add in the cost of the infrastructure like road/rail networks required to make trade by land possible, it's uncommon to see trade by land cost about 50 times more in flatland. In highlands/deserts/harsh terrain, this cost can be 100 times more expensive. The chart shown on the left is for American transport costs.

Also note that not only is water easier to trade across, but rail is cheaper for shipping items than truck. On top of this, the construction of a rail network is also cheaper than construction of a road network. So when we talk about constructing infrastructure in our country as an investment, we must look at all of these factors.

First off, I'll start by discussing the impacts that navigable waterways can have. In the US, the cost of maintenance for all waterways is <$3 billion/year according to the Army Corps of Engineers. The cost of maintenance for the interstate road network (which only accounts for ~25% of the total driven miles) is >$150 billion/year. If we add in the costs of constructing the roads, the service stations, and the insurance costs, it easily becomes >$300 billion/year. In other words, transport via water is just orders of magnitude cheaper.

2. Trade and Trading Networks:
Once we understand transport costs, it becomes easy to see how trading networks develop. The most obvious consequence is that natural trade networks end up being built in areas that're near a coastline that can be navigated or navigable rivers. This is exactly how almost every single ancient civilization began. The primary reason was transport costs and the mobility of populations across these networks.

Even today, almost all (I can't think of one that's not) financial centers are built around either navigable waterways or near a coastline. This is not a coincidence. Much of the trade and capital generation centers around these regions simply because of transport costs and access points for particular countries or regions. The easiest and cheapest way to get to a distant country is via water. When we add in oceans, it becomes impossible to develop networks to navigate across these things and air transport is expensive for lots of reasons.

Basically, the most obvious place for civilizations, cultures, and cities to cluster around are near navigable waterways.
Note: Capital cities are the exception to this rule. Capital cities can hold together mainly because that's where the guns are and that's where the taxes go to. They do not need to be economically beneficial (and often times aren't).

3. Infrastructure:
Now, is this to say that these roads shouldn't be built or maintained? Of course not. These roads allow for transportation and trade networks that wouldn't be available. Basically, it's not always a great idea to build roads and bridges in the name of "investment". Socialists/statists particularly like to make these kinds of claims like there's no possible downside from building infrastructure, but if the trade networks and other economic benefits don't provide enough value for all of the costs involved, you end up seeing massive value destruction. This is particularly important when we're talking about building connecting infrastructure for sparsely populated areas with harsh terrain.

Another problem with "investment" in infrastructure is the possible destruction of natural trade networks. For example, the Chinese government decided to stick a dam in the middle of the Yangtze River (Three Gorges Dam), which is the only navigable river in China that isn't located in Southern China. They said it would generate enough power to pay for everything. However, the costs associated with the project include environmental damage, social impacts, and a spike in transport costs that's never included in the cost of the infrastructure project from all of the possible trade that was made impossible by the construction of the dam. Edit: Note that the dam was designed to reduce navigation costs by allowing large ships to pass across, but it will make the river completely unnavigable until the dam to Shanghai in a few decades.

On the other hand, there are also projects like the Erie and Panama Canals. The Erie Canal allows for a trade network to be formed and allows for more trade by water. In other words, the construction of the Erie Canal allowed for an increase in capital generation. The Panama Canal allowed for the Atlantic and the Pacific Oceans to be linked without having to circle Argentina or Canada (trade around those areas is difficult and can be impossible depending on the time of year and weather patterns). If it weren't for the Panama Canal, trade between the East and West Coast of the US would be much more difficult.

4. Impacts of Infrastructure:
One major role for infrastructure is in the security of a country. Often times, the security structure provided by having better water transport systems or better irrigation systems is invaluable. Having a road network can not only help trade, but help the transportation of military vehicles across long spaces which may be necessary from a national security standpoint.

Infrastructure can also be useful in properly managing natural resources (ex. water) and in securing supply lines for trade or for military purposes and in securing the transfer of key resources like food and energy to large population centers. Infrastructure can also help provide and keep trade networks open. It can create new trade networks and can be very beneficial economically.

Infrastructure spending to manage water systems better, to prevent soil erosion, energy infrastructure to secure the transportation of natural resources can be extremely valuable. It's best if these infrastructure projects are kept localized and small in order to be kept efficient. Large scale infrastructure projects can, often times, end up being a complete waste because of small, unforseen errors that can either cause blow-ups, large cost overruns, or other unforseen consequences.

Basically, the importance of the way infrastructure projects are designed and undertaken is extremely important. The best way to deal with infrastructure is to decentralize the scale of the projects as much as possible. However, this isn't always possible and infrastructure must sometimes be centralized. Ideally, centralization in infrastructure should be done primarily for defense purposes.

The consequences of poor infrastructure can end up with results like water depletion, soil erosion, farmland destruction, or a collapse in economic activity stemming from a destruction of the trade networks.

Note: Keep in mind that for trade and trade networks, you don't necessarily need roads or rail from point A to point B everywhere. If you have a point C that's closer to point A and links to point A (or a point D near point A) via water, all you have to do is build a network to get from point A to point C and then take it from point C to point A (via point D if necessary). In other words, a small amount of infrastructure can do quite a bit of good, but a further ramp-up in infrastructure can be quite dangerous.

Monday, January 5, 2015

The New Geopolitical Order

We are currently witnessing a new geopolitical order developing, but in order to see what the new order is going to look like, we must first understand the previous order. So I'll start this post with a basic history lesson.

The Previous Geopolitical Order and How We Got to the Current One:
The previous order was built at the end of World War II. Before the 2nd World War, the world was effectively run by the Europeans (even though the Americans were powerful since the mid 19th century, they really didn't care).

There really was universal trade between all the countries of the world, but there was trade within each of the imperial regimes that was protected by the militaries of those imperial regimes. For example, the British military protected British trade within the British Empire, the French military protected French trade within the French Empire, and similar things were done by the Russians, Dutch, and others. This geopolitical set-up meant that a war between countries in Europe meant a massive World War. This setup culminated in the Second World War.

After World War II, basically every single boat was in the bottom of the ocean except for the Americans, which led us to the Cold War era. At Bretton Woods in 1946, the Americans set up an alliance network that guaranteed security and protection of trade to every member of the network in order to fight the Soviet Union. The US also provided a market for every member in the network without demanding reciprocity (effectively bribing other countries). For lack of a better word, this geopolitical order will be referred to as the "free trade order" for the rest of this post.

The Current Geopolitical Order:
Ever since the end of the Cold War, the American support for the free trade order has been dwindling. The geopolitical benefits deriving from the free trade order have been falling while the economic costs have been rising. As I've detailed before, the economic cost of the free trade order comes about because of the international monetary system and its hallmark as the US Dollar being the reserve currency. Basically, the USD being the reserve currency forces the most capital rich country--the United States--to import capital which creates asset bubbles, demand leakages, asset bubbles, and eventually excess unemployment.

Notice that the Cold War ended about 25 years ago. The only real advantage the US has had from the current geopolitical order/monetary system over the past 25 years was that it allowed the US to secure its energy supplies as the US was a massive importer of key economic inputs, primarily oil. Now, the US is the world's largest producer of crude oil and natural gas due to the breakthrough in hydraulic fracturing (fracking) that is rapidly changing the energy landscape of not only the US, but the world as a whole. Even though the US is still a net importer of crude oil, the US no longer needs energy from countries like Saudi Arabia and others in the Middle East. All of the necessary oil the US economy needs can come from North America and will soon do so. Actually, the Saudis now preposition oil tankers in the Gulf of Mexico because the Americans no longer need their oil and they haven't been called for it in a while.

So we're now in a situation where the world's current geopolitical order serves absolutely no purpose to the people in charge (the Americans). The current order was designed for a different time and era with different threats. The leader of the current order, the US, was gaining geopolitical benefits at a longer term economic cost. As time passes, the geopolitical benefits to the US continue to dwindle while the economic costs continue to worsen. On top of this, the US is experiencing demand leakages during a time of worldwide depression. Naturally, this is leading to an inevitable shift in the way the world operates.

Over the past few years, we've seen the US pull out of Afghanistan and Iraq while being much more hesitant to promote "stability" in other regions (it seems like the US government only cares about destabilizing regions to undermine foreign governments, but that's a different topic for a different day). We've also seen countries like Japan and China follow economic development models designed to take advantage of the American economic system by accumulating large amounts of reserves using an undervalued currency while the US becomes forced to run large current account surpluses. The USD ends up being strong in the FX market while American business loses demand and production to foreigners.

The Coming Shifts in the Geopolitical Order:
Essentially, we're seeing the American support for the global free trade order dwindle. The Americans no longer want to be the world's policeman, which means that the geopolitical order will have to shift. What we are interested ìs how the world's order will shift and what will be the impact of the shift. Since the end of the Cold War, the US has used the international order to guarantee security to guarantee trade to guarantee energy. The US no longer needs the energy any more which means that we no longer need to guarantee trade so there's no reason to guarantee security.

What does this upcoming shift imply? It implies that every country that has relied on American protection for its trade is in trouble. This will affect countries that are reliant on external protection for both economic inputs and economic outputs. The first countries to experience trouble, as I've already discussed, are countries that're heavily reliant on exporting commodities for different reasons that happen to be primarily economic.

The countries who are in the most trouble after large scale commodity exporters go down economically are countries that import large amounts of economic inputs. The first countries that come to mind are countries like China and Japan. Other countries that're in trouble are countries like Saudi Arabia and other major energy exporters who rely on American protection for shipments will be in major trouble.

Also note that the American protection of global trade allowed for certain countries to import food at relatively cheap prices (primarily in the Middle East). Many of these Middle Eastern countries have exploding populations with very high fertility rates while importing most of their calories. In a world without global free trade, we're likely to see famine return (see map below from this link). In other words, we're likely to see large population corrections in many of these countries. Groups like ISIS will become more prevalent throughout the world--particularly in the Muslim world. Much of the Islamic world is in a whole heap of trouble.
Note: In the map from the attached link, countries in the red (horrible) and orange (bad) are net calorie importers while countries in green (good) and blue (better) are net calorie exporters. The countries in purple (okay) are relatively flat.

The Return of Empire and Possible Empires to Look Out For:
We're also likely to see a return to neo-colonialism across the world. If you're a country with guns/technology and rely on importing key economic inputs, the obvious solution is to go to a country that doesn't have the guns/technology to fight you, hold a gun to their head, and effectively take what you need as an economic input. This primarily applies to the Europeans. Even though they are fading away from power and effectively destroying themselves, they still have guns and many of these countries need energy. So it makes sense for a country like Italy to take over the Eastern part of Libya (the region held by the rebels) and use its natural resources for its own gain. Similarly, we could see Algeria returning to France. Note that these regimes may not be the exact same as what they were previously, but the regimes in these countries could develop into proxies of European governments that eventually become imperial

Russia is doing this with the countries in its region and is effectively recreating the Russian Empire (this has been called the Eurasian Union). I touched on this issue in my previous post on Ukraine, but I only touched on it. The countries in Eurasia are landlocked, sparsely inhabited, and consist of harsh terrain, but they do contain lots of natural resources. Integration with Russia just makes sense for most of these countries. The countries in question are Kazakhstan, Armenia, Belarus, Kyrgyzstan, and possibly Tajikistan. 

We could also end up seeing a recreation of the Persian Empire. Notice that most of the oil/natural gas reserves are located around the Persian Gulf (see first map below) and the location of these reserves are all Shia population zones (see second map below). As we've previously discussed, the Arab countries are heavy importers of food and heavy exporters of natural gas/oil who're strongly disliked by the Americans at a time when the Americans are no longer willing to police the world. In other words, Persian interests are starting to align with Americans once again. We could easily end up seeing a return of the old Persian Empire that spans across modern-day Iraq with Baghdad to the northeast and spanning across the Persian Gulf to the Eastern edge of the Arabian peninsula.

What I'm basically saying is that we're going to see history return with a twist. What's the twist? I don't now. We can never know what will happen, but we do know that the current landscape will not hold.

Note: Countries who are relatively insulated from external demand shifts and don't rely on importing lots of natural resources will be relatively okay. If you do need to import a lot of natural resources, guns and technology make the job a lot easier. If you lack food, but have guns/technology/money (or some weird combination) you can find ways to make sure your population gets enough to eat.

Note: These are not predictions. They are possible scenarios and things to look out for. We do not know what will happen, but we can--at least to some degree--determine the possible risks we face.