Tuesday, June 27, 2017

20th Century Economic Models (ex. Fascism, Communism) Fail in 21st Century

Recently, one of my personal favorite historians (Adam Tooze, whose books are excellent and what all of you should read) had a great post on the structure of the Phillips curve today. That is an excellent start to transition to the topic for this post: traditional 20th century economics (ex. Phillip's curve) may not apply in today's world. I will hammer this point home in this post and how the difference in structures has created a totally different kinda world.

I'm gonna use three key cases to demonstrate where the old models don't work:
1. Impact of Global Supply-Chains and Falling Transport Costs
2. Phillip's Curve Doesn't Exist
3. Increasing Productive Manufacturing Capacity Needs Private Capital and Labor Partnership
4. Conclusion

1. Impact of Global Supply-Chains and Transport Costs:
First off, we live in a world where transport costs have collapsed. What does that imply? It means that, as a result, supply-chains have become very elongated--especially in technology. If you take a look at your typical smartphone or computer, it's constructed in ~800-1,500 factories across ~30-50 countries. In other words, supply-chains are constantly reorganizing and capital has become global.

So if we were to look at 20th century economic models that were used by many governments (notably most common in authoritarian regimes) as a way to mobilize a large industrial workforces as a way to deal with unemployment, they basically used excess labor for direct increases in infrastructure and manufacturing capacity. Supply-chains were relatively small and short, so that means it's easy to redirect production to the whims of the government without huge disruptions provided you could secure the raw materials.

Today, supply-chains are much longer, which means that increasing manufacturing capacity basically means onshoring more of your supply chains. Taking up nationalist policy to centrally direct and produce industrial equipment with rapid increases in manufacturing capacity by forcibly allocating savings will drive capital out of the country, leading to offshoring of supply-chains. In other words, 20th century policies to increase industrial output and manufacturing capacity sharply will actually lead to less productive output in manufacturing and industry.

Instead, the way to onshore supply-chains today is by lower regulatory costs for firms to operate, creating incentives for global capital to onshore supply-chains (like cutting corporate taxes), and by providing other incentives for domestic investment more generally (which can come in the form of financial repression, like we saw last decade in China (that no longer exists)). The nationalization of capital to be used for productive industrial build-out will fail because capital will simply fly out.

2. Phillip's Curve Doesn't Exist:
Historically, the Phillip's curve has signaled a short-term tradeoff between employment and inflation. Today, we live in a world of unwinding excess capacity (as I've written previously). So if there's excess capacity that can't be sustained with demand, it means the costs of inputs begins to come under serious downward pressure. The reason is because inputs are, by definition, used in the production process. So if input prices got bid up on expectations of rising capacity after decades of rising capacity, the minute capacity starts falling and expectations of further rising capacity shift, critical inputs like industrial commodities or energy begin to fall precipitously.

If you're in the part of the world that's undercapacity or under full utilization, expanding productive capacity modestly will place upward pressure on employment and productivity. Expanding productive capacity is also deflationary for consumer prices cuz production is rising faster than consumption. The kicker here is that rising capacity normally means rising input prices, but if the world has unwinding excess capacity, the modest input price increases that should come from rising productive capacity simply get dwarfed. In other words, input prices are unaffected, which further places downward pressure on consumer prices.

So we're in a particular situation in much of the Anglo-sphere (and India) wherein it is possible to see higher employment, higher growth, higher producitivity, and falling prices by increasing productive capacity. In other words, it is possible to see falling unemployment and falling inflation, which violates the logic expressed in the Phillip's Curve.

Another way to think about this is that the economies across much of the Anglo-sphere (and India) are in a suboptimal equilibrium where there's less growth and less employment at the same (or higher) rate of inflation. The logic and reasoning of 20th century economic ideas would tell us that this is absurd on its face. But alas, this is the world we live in.

3. Increasing Productive Manufacturing Capacity Needs Private Capital and Labor Partnership:
In the 20th century, both Communism, fascism, and many other ideas were built off labor and capital having divergent interests (in the Marx-based sense). So the political battles that were set up were those where capital and labor came into constant conflict. In today's world, for manufacturing or tech labor to do well, they must work with capital looking to invest in that. There's a need for more mutual gain than there is for animosity.

If the old movements relying on animosity are tried, capital will simply fly out because capital is global. If you want firms to hold more of their supply-chains in your country, closing off your country to capitalists, seizing their assets, and telling them to "f*ck off" will create outflows of both capital and skilled labor. Firms will simply not cooperate by onshoring part of their supply-chains. They'll go elsewhere where they're treated better. When supply-chains are small, it's easy to takeover and command where things need to go provided the resources and manpower are available. When elongated, capital has options.

If you do see governments resort to takeover of capital and over the means of production, their build-outs will not be, and cannot be, productive in today's world. Instead, they will have chosen to take their economies back by 50 years and send them into a world of permanent backwardness until those policies are reversed. It will lead to a drop in the currency, capital outflows, and the holders of monetary assets in the banking system (usually households) to take the hit. Actually, this is what's happening in Europe with these "bail-ins". That's probably what Italy's "bank bailout" will look like as well.

4. Conclusion:
To sum all of this up, the fundamental underlying financial and economic structures of the 20th century have totally fell apart. Those fundamental factors began to shift in ~1970 after the fall of the USSR and the beginning of the globalization of capital, especially American capital. The entire precipice of Bretton Woods was capital controls. When Nixon closed the gold window, we went to a world of floating exchange rates. In other words, financial openness and globalization of capital took the day.

In the mean time, transport costs (especially across oceans) have fallen precipitously. That means firms can elongate supply-chains, which means supply-side structures are much more flexible with respect to movement across borders. If any country tries to impose borders to restrict capital (provided it's not tiny or an international financial center) without giving some corresponding handout to capital, it will be tough for that country to improve its domestic manufacturing capacity productively.

The result ends up with the traditional short-term trade-off between inflation and unemployment as nowhere near reality. Instead, the possibility of multiple equilibria has been opened up. In this world, capital imbalances tend to drive trade imbalances (doesn't apply to energy and commodity imports used in production processes IMO).

In today's world, increasing manufacturing capacity requires creating a partnership between workers and capital. Using old mid-20th century tactics from fascist or Communist governments to centrally push up industrial capacity instantly and rapidly, it will fail. It will not allow any country to get high on the value-added chain and will dissuade those with knowledge or skills or access to the social networks to be able to do so.

 Note that capital today is global, not national. So it means governments need to basically work with capital and labor. For example, governments providing better education and training for capital helps firms onshore due to more accessible labor. Governments that provide health insurance take it off the back of companies to provide it for their workers, hence making firms more competitive. Other policies like liberalization and elimination of distortions in supply-side structures or distortions in the tax code and so forth.