☐macro

China's rise to the international stage is for domestic audiences only

 

IMF adds China's yuan to SDR

On the 30th November the International Monetary Fund (IMF) decided to include China's renminbi in its basket of elite global currencies or Special Drawing Rights (SDR). The new weights place the Chinese renminbi (10.92%) behind only the US dollar and the euro in terms of importance, with the newcomer leapfrogging ahead of both the British pound and the Japanese Yen.

China's rising international status

The immediate impact of the decision is likely to be fairly limited with the new weights only coming into play from 1st October next year. Even without the delay, few goods or services are priced in SDRs and China's inclusion in the basket seems to be largely for show. Andrew Walker, the BBC World Service economics correspondent has said 'More than anything this move is a symbol - a powerful one - of China's meteoric rise, from poverty to pillar of the global economy.'

However, all the talk of China's new place on the international stage fails to appreciate the drama playing out at home. Far from the western perception of a well-drilled army of technocrats, marching to the beat of Beijing's drum, China's government suffers from the same entrenched interests that any political system does. 

Real impact is domestic

It is for this reason that Arthur Kroeber, Managing Director of GaveKal Dragonomics, has argued that Beijing's real motivation in pushing to join the SDR was not 'as many media reports inaccurately suggest, a desire to make the renminbi a major global reserve currency. Rather, it was to force the pace of China's own financial deregulation.'

At the weekly State Council meeting on the 4th December Xing Yujing, head of a monetary policy department at the People's Bank of China (PBOC), echoed these sentiments marveling at the remarkable and rapid internationalization of the renminbi 'especially over the last ten months.' This has been no where more prominent than this August when, on Tuesday 11th, China's shock devaluation of the yuan, weakened the currency against the US dollar by almost two basis points. The official explanation given by the PBOC was that the move was a 'one-off' adoption of a market based approach to setting the yuan's value. However, the widespread perception at the time was that this was actually a desperate bid to revive a flagging economy. Timing is everything, however, and despite the weak export data that had come out over the weekend, just the previous Tuesday the IMF had issued a report which stressed that, with regards to its requirement that the renminbi be 'freely usable', 'significant work' was still needed to be done. In fact, at the press conference announcing the yuan's inclusion, IMF Director Christine Lagarde emphasized that, 'the renminbi's inclusion in the SDR is a clear indicator of the reforms that have been implemented and will continue to be implemented'.

Chinese reforms: two speeds.

The significance of the yuan's inclusion in the IMF's SDR then, is not for the symbolism abroad but rather its role in catalyzing aggressive financial reforms at home. As the Paulson Institute's Houze Song has described, reforms in China are at two speeds 'moving fast in banking and finance... but very slowly, if at all, in the real economy.' The hope in central government is that opening up Chinese financial institutions to foreign competition will force them to be more efficient in their capital allocation and in turn raise China's productivity. For a country suffering from bloated SOEs and debt-laden 'zombie' companies, reforming the real economy remains a monumental challenge but perhaps, with a little international assistance, it can be done.


China's financial reform experiments

Premier Li Keqiang focuses on financial reforms.

On the 2nd December Premier Li Keqiang meets with Chinese economists to discuss policy reform. [Photo/China News Service]

On the 2nd December Premier Li Keqiang meets with Chinese economists to discuss policy reform. [Photo/China News Service]

On the 2nd December, Chinese Premier Li Keqiang hosted a forum of economic experts where he emphasized that supply-side structural reforms, particularly those relating to financial support, were the key to promoting innovation and unlocking sustainable economic development. 

5 pilot financial reform projects

Two days later, on the 4th December, the State Council held its weekly policy briefing with several senior members of the People's Bank of China (PBOC) in which they discussed their pilot projects in financial reform. The projects are part of a larger framework of economic policy experimentation aimed at developing the three main types of economic region in China:

  1. Developed eastern and coastal regions.
  2. Central regions undergoing industrial transformation.
  3. Under-developed western and ethnic border regions.
4th December State Council weekly policy briefing.[Photo/Xinhua]

4th December State Council weekly policy briefing.[Photo/Xinhua]

First, in Jilin province, northern China, agricultural reforms include cooperative finance schemes, house property mortgage loans, the development of internet services to promote ecommerce, the introduction of agricultural insurance and perhaps most notably 'land benefit guarantee loans' which involve agriculture-related asset securitization opening the way for financing via capital markets.

Second in Taizhou, a city in Zhejiang province which lies on the east coast of China just south of Shanghai, PBOC has conducted a pilot project for small/micro businesses. Reforms include improving direct financing channels, promoting a social credit system in local areas, enhancing cross strait financial exchanges, developing insurance schemes and improving financial regulation and risk prevention.

Finally, free-trade zones (FTZ), like the one successfully introduced in Shanghai, have been proposed in Guangdong (near Hong Kong), Tianjin (near Beijing) and Fujian (near Taiwan). The aim is  to increase cross-border use of RMB by creating the systems and regulatory environment that would allow institutions in these FTZs to take on foreign debt.

Future possible financial pilot projects include programs around technology finance, inclusive finance and green finance.

Economic Structure & GDP/Capita

“The first problem for the government in carrying out an industrial policy is that we actually know precious little about identifying, before the fact, a ‘winning’ industrial structure. There is not a set of economic criteria that determine what gives different countries preeminence in particular lines of business. Nor is it at all clear what the substantive criteria would be for deciding which older industries to protect or restructure.” Charles Schultze, chairman of the Council of Economic Advisors under US President Jimmy Carter

This essay is going to present some research I’ve done recently on industrial structure or what I like to call ‘economic structure.’ A country’s economic structure describes what industries or economic activities it is involved in. We are used to classifying a country’s economic activity as either agricultural, manufacturing or services. Knowing the percentage of economic output that is either agricultural, manufacturing or services we then know the overall economic structure of the country. Of course this is only to a ‘3-industry’ level of detail. You could classify a country’s economic activities much more precisely and in fact in future essays I hope to look at data where a country’s economic activity has been classified to a ’12-industry’ level of detail. The aim of this essay though is to investigate the relationship between a country’s ‘3-industry’ economic structure and its GDP/capita. If there is a strong correlation this would suggest that the path to economic development is largely the same for all countries because for every level of development (i.e. GDP/capita) there is a specific economic structure. If there is a weak correlation this suggests that there are many paths to economic development and that a country’s success is not just a function of what it does but also how well it does it.

3-industry analysis

I did a 3-industry analysis of all the countries in the world I could find data on excluding countries that have populations of less than a million people. The reasoning for excluding them was partly because I didn’t have any data for them but also because intuitively I felt like small countries could have bizarre economic structures which might be very misleading. For example a country of just a few hundred thousand people might have an economy that is largely based on tourism which clearly for much larger countries, with tens of millions of people, is not scalable.

What we find is that the R², a measure of how well the data fits our statistical model, is 0.35 which is not bad but not great. Removing the ‘oil countries’ though we find the R² improves significantly to 0.47.

One puzzling aspect of the results is why the p-values are so low. Even after removing agriculture, especially as for many of the developed countries agriculture is just a few % of GDP, multicollinearity should be a big problem. This is because lowering manufacturing’s % of GDP should (in some cases almost 1-1) increase services’ % of GDP. However regressing manufacturing on services I find an R² of just 0.09 suggesting that there is no multicollinearity problem.

However, further investigation suggests that the t-tests are not valid because the errors are not normally distributed. Eyeballing the pnorm and qnorm graphs we can see the errors are clearly not normal.

Taking a look at a 3-D graph though it becomes clear that it is actually agriculture that does most of the explanatory work. Below you can see a top-down view of the 3-D graph where the red line represents the 1-1 trade-off between services and manufacturing. The closer a data point is to the red line the smaller agriculture contribution to GDP is and the larger the combined contribution of services and manufacturing is.

Taking a side-on view we can see that when agriculture is a high percentage, more than 10% of GDP, i.e. left of the blue line GDP/capita is very low. If agriculture is less than 10% of GDP suddenly GDP/capita is much higher. In fact if you compare the average GDP/capita of countries with agriculture that is more than 10% of GDP/capita to countries where agriculture is less than 10% of GDP/capita you find a stark difference. The more agricultural economies have an average GDP/capita of just $4294.8 whereas the less agricultural economies have an average GDP/capita of $26261.7. And in fact a regression on just % of GDP that is agriculture has an R² of 0.43 only slightly lower than the manufacturing and services regression R² of 0.47. As you can see below, as GDP/capita rises countries tend to have a larger Services % as compared to Manufacturing % but the effect is not as extreme as one might expect.

I think the real puzzle to me is why there is this turning point at around 10% agriculture. It cannot just be that the less productive agriculture is being phased out in favour of the more productive manufacturing and services. There must be something more fundamental going on but what exactly I’m not sure. Nonetheless I think you could make a good argument that the countries in the left column which have relatively low GDP/capita given their low % of GDP that is agriculture are perhaps on the verge of a massive economic growth as they race up the curve and join the countries on the right column.

10% Agriculture

I want now to try and investigate what is happening when countries agriculture drops below 10% and explain why GDP/capita rockets up so much once this threshold is breached. Unfortunately the Serbian and Argentina websites are not in English and so I was unable to find the data I wanted. Thailand, Macedonia and Malaysia on the other hand have only very limited data sets available. This leaves us with Turkey, Belarus, Tunisia and China.

Part of the problem is I’m not sure what I’m looking for. I suppose it seems like manufacturing and services suddenly become much more productive when agriculture dips below 10%. So why is this? Is it coincidence? Is that at that point enough labour transfers across? Is it that old industries suddenly become more productive or new industries become less productive?

Next steps a) Investigate countries around the 10% boundary. Why the sudden increase in GDP/capita b) Investigate whether countries historic development in terms of the turning point around 10% agriculture matches the current distribution. c) Investigate 12-industry data to see whether there is one path to economic development or multiple. Does economic structure determine GDP/capita?

Politics & Economics: An Initial Framework

Over the last few months I have been talking to a couple of economics research firms about possible jobs opportunities. One repeated theme in their research is that politics and economics cannot and should not be separated, they are intimately entwined. How then to think of them together? One approach is to think of economics as just one of many political tools to achieve political ends. However in this essay I want to explore thinking about politics through an economics lens. The brutal reality is that the, quite frankly astonishing, appetite for economics research is not borne from concern about the welfare of our fellow human beings but rather from a hunger for investment and financial understanding. In other words, how does politics inform economics? Not the other way around.

With that in mind the basic framework I came up with is to think of classifying governments within a 2 dimensional grid. One dimension is economic competence (the y axis). The other is governmental freedom of action (the x axis).

A country’s economic competence is ultimately just a judgment on the economic policies a government pursues and how those policies are carried out. Of course that judgment (at least in the short-run) is subjective and often depends upon which school of economic thought you subscribe too. Other factors matter too though, for example high levels of corruption where government officials pursue private ends over societal ones lowers economic competence whilst having lots of hard working and intelligent people in government increases economic competence. Remember this is politics and government policies judged through a purely economics lens and is not passing judgment on human rights are other societal and political objectives.

Governmental freedom of action on the other hand is to what extent can government do what it wants, particularly if what it wants is unpopular. Factors that might affect governmental freedom of action include the structure of government (democracy or dictatorship?), the size and economic strength of the country (big, strong economies mean bigger tax revenues and more ability to pursue big investment projects) and the values and beliefs of the society (if the public agree with your policies you can do more).

CASE STUDIES

To finish, I’d thought I’d explore the framework with a few case studies.

Mao’s China vs Deng Xiaoping’s China

Most modern-day economists agree that Deng Xiaoping’s decision to ‘open up’ China was a good one. It certainly coincided with the start of a stunning period of unprecedented economic growth in China that still continues to this day. Mao’s China in contrast was one where 5 Year Plans and the Agricultural Crisis of 59-61 had crippled China’s economy to the extent that economic growth between 1952 and 1971 was just 0.5% a year. Thus even though there was limited change (at least in the short-term) in the Chinese governments freedom of action there was a big change in its economic competency.

USA 1930’s vs USA WW2

The USA suffered years of sky high unemployment throughout the Great Depression but was ultimately saved by Keynesian policies that probably would not have been possible without World War 2. World War 2 and the threat from Hitler’s Germany created the political will and therefore gave the government the freedom of action it needed to – in purely economic terms – kick start the American economy.

Democracy vs Not

Governmental freedom of action is hugely important I believe in determining economic outcomes. Niall Ferguson argues that American democracy is superior to the Chinese system of government in everyway (particularly human rights) except that the Chinese government can think, plan and invest long term in a way an American government with elections every four years cannot. I have even gone as far to argue (in my piece on Justin Yifu Lin’s Comparative Advantage Following strategy of economic growth) that rather than hurting China’s economic future Mao’s policies laid the foundation for them. Mao though was blessed with a society unique in its ability to endure terrible hardship and human suffering, an ability which gave Mao an unprecedented freedom of action in choosing his economic policies.

This is a freedom of action that western economies with their large welfare states, bad bank balances and frequent democratic elections are unable to match. Only in wartime is political will (and therefore governments freedom of action) sufficient to have democratic nations really embarked on awesome public investment projects like the Space programme or the Manhattan Project. I think it is worth pointing out that although Western countries would consider themselves democratic there is no such thing as a pure democracy, everything is on a sliding scale. For example the United States if it had biannual Presidential elections would be a more democratic state, but every agrees that this would be crazy and that it is worth sacrificing a little bit of democracy for stability in leadership.

Although this framework is only concerned with economic outcomes it is important to recognise government freedom of action is usually determined by non-economic considerations. Democracy itself is structured to fight against those in power having too much of it or for too long. After all, as the well-worn phrase goes, power corrupts. In fact, according to Presidential historian David McCullough George Washington, Founding Father and the first President of the United States, greatest act was leaving office when he could have stayed. Like Rome’s Cincinnatus he ‘returned to the farm’ and in doing so not only created a precedent of just two terms in office but also helped protect America’s, at the time, still fragile democracy.

Going forward therefore, it might be cool to first try and classify all the governments of the world within this framework and second evaluate any changes in government leadership or policy in terms of how it affects a country’s position within the axes of economic competence and freedom of action. This might offer an interesting perspective on which countries you might want to invest in or which countries you think will have strong economic growth.

Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway

‘It’s a very interesting problem, that our founders coped with in just how democratic you wanted the system. My favourite political system in terms of being adapted to its particular circumstances successfully is Singapore. I think Singapore is the single most successful governmental system that exists in the world. They’ve taken a small swamp to a very credible place… I think Singapore’s habit of stepping hard on things that will grow like cancer is the correct way to govern. In America we tend to wait until things are unfixable… And finally you reach a tipping point where the better people leave and then I don’t think you can solve the problem… I don’t think it is a pure democracy. I think our system has worked but… Let me tell you my story… I take a political science course [at university] and everybody teaches the more people that vote the better the systems will work and having a contrarian streak I’m not so damn sure that civilization doesn’t work better when a lot of people don’t vote… If you want to study, take Singapore: terrible malaria problem. It’s a swamp! He [Lee Kuan Yew] drains the swamps, he does not care if some little fish dies. He has a drug problem. He searches the world over for the right solution to the drug problem. He finds it in the United States, imagine someone in Singapore reading books on the United States and thinking the United States is the answer to Singapore’s problems. He copied the military’s drug policy so that anybody in Singapore will pee in a bottle instantly and if they fail they will immediately go to a tough compulsory rehab. Away went the drug problem. Just time after time after time he made these winning decisions. He wanted the place to prosperous. He figured out who he wanted to come in and he made the civilization very user friendly to what he wanted to attract. And it worked! Then it’s 70% Chinese and 30% Malay. And every Chinese thinks that the Chinese are superior to the Malays and he thinks thats terribly counterproductive if anybody should ever say so. So he passes a law. You can’t say if you’re Chinese in Singapore that you think there is any superiority in the Chinese. I think that’s a very sensible law for Singapore to have but of course it has some infringement of free speech! …I mean so this is a very unusually successful man with a very unusually successful history. So while I can’t answer your question if you will make a study of the life and work of Lee Kuan Yew you will find one of the most interesting and instructive political stories in the history of mankind. This is better than Athens. This is an unbelievable history. And you will learn a lot that will be useful in your own life. So my answer to you is don’t ask Charlie Munger. Study the life and work of Lee Kuan Yew. You’re going to be flabbergasted.’

Thoughts on the Tradeoff between technology growth and employment

INTRODUCTION

As the developed countries of the world limp out of yet another crippling recession, macroeconomics has been forced to do some soul-searching. Graduating from the London School of Economics with a degree in Economics our departmental commencement speech, in front of friends, family and graduates alike, was a sombre one: impressing the need to manage the public’s expectations about what Economics and Economists are able to do. Put bluntly, despite all the great minds that have applied themselves for decades against the Economics grindstone the holy grail of creating a ‘no recession, no unemployment and steady growth economy’ has remained elusive.

In this essay I argue that the economies of the future are going to look vastly different from the ones we have today. In particular, I believe there is a trade-off between technology growth and full employment and that if we want the former we shall have to give up on the latter. We shall need to adapt to a society, and a politics, where most people, probably north of 90%, do not work at all in their entire lives. I argue that this is not only not a bad thing, but actually something we should work towards.

A FUTURE WITH TECHNOLOGY GROWTH

So first of all, let’s start with the assumption that for the foreseeable future, let’s say the next hundred years, we shall have strong technology and productivity growth. This is obviously a strong assumption and so we shall not neglect the alternative, that our future might be one with limited or perhaps even no technology growth, in fact this is something we shall examine in the second half of this essay. For now though, although perhaps optimistic, assuming technology growth is a useful place to start out our discussion.

My argument, which I have summarised in the table above, is that technology growth will lead to a net decrease in the ‘number of jobs’. The reason for this is simple: technology growth destroys jobs faster than it creates them.

This was not always the case, for example during the Industrial Revolution advances in farming equipment meant lots of farm workers were put out of jobs but this destruction of farming jobs was offset by the creation of lots of manufacturing jobs in the factories.

Now it is worth drawing a distinction between developed countries and developing countries. Developing countries in Africa or even countries like China and India could get away with doing nothing innovative for decades to come but still have fantastic ‘technology growth’ because they are simply imitating and executing ideas from the developed countries. This is most certainly worth doing and has resulted in massive improvements in material living standards for billions of people across the planet and hopefully will continue to do so. However, eventually these developing countries will catch up and become developed and then will face the same problem that we in the West are already facing now; which is to have sustained technology growth we need to keep coming up with new things.

Peter Thiel, co-founder of PayPal and billionaire investor in companies like Facebook, argues that the problem is there has been a failure of imagination. Thiel grew up on the science-fiction of the 50’s and 60’s which imagined a 21st century of underwater cities, colonies on Mars, as well as intergalactic trade and exploration. A world where we could extend lives into the hundreds of years, mind-share ideas and skills instantaneously and dare I say it teleport (‘Beam me up, Scotty!’). As the motto of his venture capital firm ‘Founders Fund’ wittily points out ‘We wanted flying cars, instead we got 140 characters.’

Although I agree that such projects, if possible, would be both very cool and worthwhile, I do not think they would create a lot of jobs. You only have to look at the most innovative companies of today like Google and Apple which employ workers, admittedly very high-skilled workers, in the 10,000s, not the millions, hardly sufficient to find jobs for the billions of people on the planet.

This is a problem because I believe there are three types of technology growth.

  1. Build new stuff e.g. iPhone
  2. Automation e.g. car manufacturing
  3. More productive employees e.g. computer

Both ‘automation’ and ‘more productive employees’ types of technology growth, as we shall see, both lower the number of jobs. Previously these forces were kept in balance by the first type, building new stuff but now when we build new stuff we don’t require lots of workers because most of the job creation is in the innovation of the product not in the manufacture or production of it, and for that you just need a few highly skilled workers. It is obvious why ‘automation,’ at least temporarily, destroys jobs because it involves the direct replacement of human labour with machines and robots. A classic example of this is the manufacture of cars where much of the production now is automated, whereas previously it was very labour intensive.

Why ‘more productive employees’ type of technology growth destroys jobs is more subtle. In economics, one of the key assumptions is unlimited demand with the only constraint being the budget constraint, i.e. not having enough money. With this assumption, even if people are unemployed new industries and products will develop to take advantage of these unused resources and to meet our insatiable demand. Of course, in the short-run there may be structural unemployment but in the long-run full employment is always possible, as with education and retraining workers are able to find work in the new industries being created. Now of course, for most of human history this is a fairly accurate picture and it is still probably an accurate picture for most people today, consider the Chinese rice farmer or the Brazilian favela housewife, I’m sure, if only they had the money, they would be buying fancy cars and going on luxury holidays. However, we are already seeing the effects of another constraint, a constraint that has usually gone unaccounted for and that is time. Limited time is easiest understood in the creative arts. Only so many people can earn a living as authors, or musicians or artists because you only have so much time to consume these things. And as everything is so scalable now why listen to the average pub singer in your local bar when you can listen to Adele on your iPod? This same principle extends to other areas outside of the creative arts. And as workers become more productive it will be possible to reach our ‘limited demands’ with fewer and fewer workers.

The question then is, faced with the reality of a world with fewer and fewer jobs, what should we do next? I would argue that rather than try and continue to pretend that economies with both high employment and technology growth are possible we should embrace the change. In fact, those same science-fiction novels that Thiel grew up on also imagined another change: that we would all be working single digit hour work weeks because robots had replaced all the menial tasks and allowed us to live lives of leisure. ‘The Jetsons’ a cartoon tv show in the 60’s that imagined a typical American family 100 years in the future (2062 to be exact) not only had a full-time robotic house-maid called Rosie but also had George Jenson, the patriarch of the family with a workweek, typical of his time, of just one hour a day, two days a week!

There is a practical aspect to such a society which is that there needs to be transference of ‘income’ from the robots, that are automating all the tasks that are currently being done by humans, to the humans who are now ‘unemployed.’ It is worth pointing out that the robots will not mind being paid nothing, because they are robots! This most likely would be done through a huge welfare state, where perhaps 90%+ of people would spend their entire lives without working. Now obviously, welfare states often get a bad reputation because there are always people who abuse the system and the unfairness of taxing those who work to support those who do not work. In particular, although the production of most things will be done by robots, the machines obviously do not collect a wage and so the actual transference of income will be from the entrepreneurs who made the robots to the masses of unemployed, and with taxes north of 95% I’m sure economists around the globe will be having fits over the lack of incentives.

There are a few counterarguments to this. To start with I absolutely recognise humanity’s need for inequality, something that is perhaps even greater than its need for equality. First of all in a world where everyone has a high standard of living and does not need to work, money will matter less and there will be other avenues for ‘inequality’ or less cynically ‘a diversity of identity’ to be expressed, like through hobbies and interests. Furthermore, in a world where most people do not work but a few highly skilled entrepreneurs, scientists and artists do, there would be arguably too much inequality rather than too little, so forgetting all the baggage we have about tax rates, there should still be sufficient incentives to motivate great projects, even if taxes are at 95%. It is worth noting that it is not the single mum working 3 jobs who is being taxed 95%, she is now living a life of leisure, but rather the Bill Gates’ and Warren Buffetts of the world. Some may argue that a life of leisure is not fulfilling, work provides meaning and fulfillment which sitting at home and watching TV can never do. This I absolutely agree with but I think it is worth noting that most people do not have jobs anything close to our ideal of fulfilling work. Even in America, the most developed of nations, most people do very menial jobs. As the education reformist John Taylor Gatto in his ‘The Underground History of American Education’ points out the top ten most common jobs in 2020 is predicted to be, according to the US Bureau of Labour Statistics:

  1. Retail salesperson
  2. Registered nurse
  3. Cashier
  4. General office clerk
  5. Truck driver
  6. Managers
  7. Janitors, cleaners, domestic servants
  8. Nurse aids, orderlies, general attendants
  9. Food counter workers
  10. Waiters

So given that most people do unfulfilling, low-skill work I think the best thing is if we as a society try to automate each of these jobs. Google’s self-driving cars might be a step in the right direction in terms of replacing Truck Drivers, or supermarkets having self-checkouts, a first step in automating Cashier work.

With time as all these jobs are automated, people, with a guaranteed high standard of living, will then be free to pursue not only lives of leisure but also have the chance to improve themselves and both discover and follow their passions. I know I certainly would take more risks pursuing my entrepreneurial dreams if I was not so scared of, essentially, getting a bad job. Peter Thiel argues that increasingly, higher education is not about learning anymore but rather about insurance, which says that if you have a degree certificate you will not, what he describes as ‘fall through the cracks in society.’ So rather than damage incentives there may be actually more innovation and more production. Just think of the number of Marlon Brandos who never tried to become actors because they were scared of spending their lives as waiters! Now as I argued previously most people will not be world class in anything, that by definition is rare but with the freedom to fail there is nothing wrong with that.

A FUTURE WITH NO TECHNOLOGY GROWTH

With the transition to a world where we have less than 2 children per woman population growth is no longer going to be an engine of economic growth anymore. This is a good thing as resource constraints would probably mean anything above this would end in a Malthusian catastrophe. Furthermore changing demographics, notably the boost to our economy that bringing women into the workforce has had has now largely run its course. Thus, in the developed world at least, the buck has officially been passed and further economic growth will require technology growth.

It could be argued that a world with no technological growth is not such a bad thing. After all material living standards were largely the same from the Roman times all the way through to the beginning of the Industrial Revolution, the last 200 years have been the exception rather than the rule. And furthermore, there is more to life than material things.

Nonetheless there are I think good reasons for wanting economic growth. Firstly it is nice not only for individual people but for humanity as a whole to progress. Also everything from our politics to our economics works better when we have it. As Peter Thiel points out, if we have no economic growth, i.e. the proverbial pie is not getting any bigger, then suddenly democracy, which is based on a spirit of win-win compromises, turns into a zero-sum world where for one party to do better another has to do worse, a breeding ground for societal division and even political extremism.

So given that we have established technology growth and the economic growth it brings is worth having the question then is who is going to give it to us? There are a number of candidates.

Government

With limited technological growth our politics have become increasingly zero-sum. Given our transition to a welfare state as well as the high debt levels it is extremely difficult for governments to have the political capital and financial capital to invest in big technology projects. In the past, this was not the case with the government being instrumental in, for example, both the Manhattan Project and the Space Race. However, both of those programs were possible because there was an outside threat to motivate them (Japan and the Soviet Union respectively). I heard that both China and India are looking to ramp up their own respective Space programmes so it possible this could be a productive rivalry although the obvious downside is the threat of real war.

There is also the usual argument of creating ‘innovation friendly’ tax codes and laws. Peter Thiel has argued that areas like energy and medicine have suffered because of over regulation where the government has tried to prevent bad outcomes at the cost of eliminating the chance for good ones. There is a trade-off because innovation is messy and requires lots of experimentation, even something as scientific as science, and arguably we have become too risk averse. In contrast, the only two areas that were not regulated were the only two areas that experienced innovation: computers and finance, although with finance we perhaps got the balance too far the other way!

Universities

Universities are unique in that a lot of research that goes on has no immediate payoff. This is good for two reasons 1) there is more to life than creating technology growth and 2) a lot of the most valuable projects are those with no immediate payoff and therefore outside the scope of business. Even though I do not think it is possible for everyone to be employed in high skilled jobs (among other things because of the time constraint) clearly education is very important for future technological progress. I think one measure that would be useful would be to outsource some of the undergraduate lectures because not only might it improve the quality of teaching but more importantly it would also free up more time for professors, to do what they do best, which is to focus on their research (I have written a long article on this topic and I also have a little start-up project on this, contact me for details: hellolao8n@gmail.com).

Economists

I think the fundamental problem with Economics is that is operates at the 2nd order, its’ about fine-tuning but does not have the power to make big changes to economies. Progress towards more and better economic theory will therefore also be of 2nd order importance. At the heart of Economics is the fundamental assumption that if Economists (largely through governments) do good economics, that creates the best possible conditions for growth then growth will happen. I would argue however, that most of the big macro variables we care about are ultimately out of the control of both our Governments and our Economics.

Start-ups

Start-ups are wonderful because they allow new ideas, products and methods to be tested with limited risk (from a society standpoint). Some of the most famous companies today including Disney, Amazon, Apple and Google were literally founded in garages. And there are several more that were founded at university or by drop-outs such as Facebook, Dell, Microsoft, Virgin, Oracle, McDonalds, Slok Group, Hutchinson Whampoa and General Electric. I certainly believe that much of the technology required to automate many of the ‘menial jobs’ we discussed above may come from start-ups as they are probably primarily robotics and software problems which are not too capital intensive.

Nonetheless many of the biggest and most important projects, particularly some of the more fanciful science-fiction projects, require investments into the hundreds of millions or even billions well beyond the scope of most start-ups with even the best possible venture funding. As an example, Elon Musk who made more than $300,000 million co-founding PayPal could not find sufficient outside investment to fund his rocket ship company Space X and his electric car company Tesla and instead had to invest all of his personal fortune to save the two companies in the Financial Crisis of 2008. Clearly if we require big projects to be tackled by billionaire entrepreneurs who are willing to risk all their personal fortune then we are greatly limiting our chances for technology growth.

Big Companies

So really our best bet should be big companies. Peter Thiel in an event on technology growth with Google’s Eric Schmidt argued that Google’s failure to invest the $50 billion or so it has sitting on its balance sheet proves that Google has insufficient vision to put that money to good work. Schmidt countered that Google has done lots of innovative projects and that there are other limits to innovation than a lack of money.

The most obvious of which are diseconomies of scale and the well documented failures of big companies to innovate. Robert Lutz of General Motors Company who led the development of Chevrolet’s electric car ‘the Volt’, after seeing the success of Tesla Motor’s electric car, said it was embarrassing that it took Elon Musk’s Tesla, a start-up car company in Silicon Valley to show what was possible before General Motors a company with billions of dollars in revenue to make the same leap. Especially as General Motors, with competition from the Koreans and the Japanese, had presumably very strong incentives to innovate. One problem I think Management as a discipline should look to solve is how to build firms that do not suffer from diseconomies of scale, whether the solution is the right incentives, the structure of the firm etc. Part of the problem I think is that academic research is often impenetrable, if for no other reason that the volume of research, to an ordinary entrepreneur, who with limited time already, is not going to be able to sift through to find relevant papers that could help him run his company better. One alternative firm structure that I think that might work is rather than the top-down approach to resource allocation which you have in most companies, where people play politics to get into positions of power and influence, you could instead have a venture capital model of resource allocation within companies where ‘managers’ would be pitched to by teams of employees who want investment for projects. These ‘start-ups within companies’ could then benefit from all the economies of scale of big companies without the downsides.

The lack of innovation from big companies may also be due to a lack of high skilled labour. This may be in part because genius is rare; it may also be an education problem. I do think another problem that needs to be solved is the importance of ‘culture’ and teamwork skills within firms. To put it bluntly a lot of ‘creative people’ are not ‘corporate people’ and so that genius is left untapped because unless they found a company themselves (like Steve Jobs) they do not get past the interview stage or climb the management ranks. One answer could be to systematically introduce teaching these soft skills into the education system. Another alternative might be to structure firms so the soft skills matter less.

CONCLUSION

If our future is one without technological growth then I think our best bet is to try and transition to an economy with technological growth, where we have big companies, start-ups and universities focusing on automating our list of ‘menial jobs.’

With this successfully achieved we can then transition to an economy and society where most people do not work, living off the transfers from the welfare state. Even if my proposition is only partially true that still might mean economies with 20 or 30% unemployment, numbers that would be intolerable today. There will still, of course, be scope for big technology projects as well as the more general progress in the arts, science and business although their high-skilled nature and ‘the time constraint’ will mean these will not be particularly labour intensive.


If Technology Growth does lead to unemployment then what then?

I wrote an article in which I argued that technology growth will lead to mass unemployment and sent it to my friends asking their opinion on it. Although it was a radical and very contrarian view no one thus far has been able to convince me that it’s obviously wrong (pending further feedback!). Therefore after a couple of months I suddenly thought it might be cool to try and think through what, if on the off-chance my narrative about technology destroying jobs is correct, what that would mean for the world and crucially what the required transition to that new form of society and economy would look like. I think the end equilibrium of a society with mass unemployment is actually quite an attractive one, my Dad even joked that I thought up this essay because I want to live in a world where I don’t have to work! However, the more I think about the transition the more I think it will be fraught with difficulty. Ideally I’d want to be able to outline a blow by blow account of what I expect to happen but the big issue I’m struggling with is the sequencing of events. It would be cool if there was some framework to help think through the issues but I don’t know of any. So, instead in this essay I’ll try and outline a few dimensions that I think are worth considering.

SOCIETY/GOVERNMENT ACCEPT OR NOT ACCEPT HIGH UNEMPLOYMENT SOCIETY

I think if the Government still maintains the opinion that the country is capable of continuing as a low unemployment economy then there is a real danger of misguided Government Policy. In an interview with Charlie Rose legendary fund manager Jeremy Grantham argues that even now the government is too optimistic:

Jeremy Grantham: ‘I think Bernanke is whipping this donkey that can only grow at 1%, because he thinks that it’s a race-horse that should be growing at 3. So he’s gonna keep whipping this donkey. Charlie Rose: ‘This donkey can’t run.’ Jeremy Grantham: ‘Until it either drops dead or turns into a racehorse.’ Charlie Rose: ‘And you’re betting on dead.’

Accordingly if the Government expects low unemployment it may in an effort to stimulate the economy print too much money leading to inflation or go into unmanageable debt trying to stimulate the economy. Perhaps dangerous is the fact that with high unemployment there could be great political instability and perhaps even the potential for extremism to take hold as we saw in 1930’s Germany after the Great Depression. If my assertion is correct it is therefore vital that everyone is educated and persuaded that a low unemployment economy is no longer possible.

GRADUAL TECHNOLOGICAL CHANGE MEANS GRADUAL UNEMPLOYMENT?

Although I suspect the long-run equilibrium of high unemployment might be fairly stable with those who work only being those who enjoy it and/or earn extremely high returns for their work in the short and medium term there is potential for huge instability.

I think a central problem is that even if most menial jobs eventually get automated this will be a gradual process. As an example, I heard that efforts are being made to create a gate like the one that you walk through at airport security which as you push your trolley through scans all your items and bills you automatically. So let’s assume this technology works and therefore the cashier job is one of the first to go. Suddenly you have a lot of unemployed people. Can you start giving them the high standards of living that would be possible in a full roboticised society? Well if you did increase the welfare benefits to a comfortable level then suddenly all those people working in the undesirable, low paid jobs that have yet to be automated, let’s say cleaning jobs would choose not to work. Leading to either much higher wages for these undesirable jobs or perhaps those jobs just not getting done. Alternatively if you keep welfare at a low level then I think as unemployment year on year increases you will get more and more unrest potentially leading to the political instability and extremism already cited.

I think one idea would to help foster a more peaceful transition would be to have education extend later and later into life and retirement to occur earlier and earlier. This gradual erosion of the number of working years might act as a escape valve for all that unemployment pressure.

INTERNATIONAL COMPETITION

However, I think even the long-run equilibrium is fraught with a major problem which is international competition over tax revenues, i.e. the tax paying companies and workers. Countries in a bid to attract the limited number of companies and workers lower taxes because if the tax base is very small then welfare benefits have to be lowered potentially leading to civil unrest from the unemployed. Even if successful in attracting said companies and workers it comes with a cost which how did you get those workers and companies? Well lowered taxes and therefore lower welfare benefits and potentially the same problem as before of civil unrest among the unemployed.

Even if international cooperation and taxes could be agreed upon there are other factors that lead to the choices of where companies and people choose to locate. As it is impossble to have a completely equal distribution of companies and people across different countries this could lead to conflict. The only solution I can imagine is for a world wide tax and welfare system which would require such radical changes in our government and societies it’s hard to see it happening smoothly, if at all.

My first exposure to Economics came in the afterglow of 10 years without recession and discussion in the UK that Gordon Brown had finally beaten the boom and bust cycle. However, just at the moment I started studying Economics the greatest Depression since the Great Depression happened so inevitably I, like many of my generation, am on the look out for other assumptions that are perhaps unfounded. Although I’d hate to be pessimistic I think it is an interesting thought experiment to wonder what it would take for two major powers to go to war with each other. I suspect differences in ideology is unlikely to be a sufficient criteria (especially if one of the parties is a democracy) but economic unrest caused by mass unemployment and international migration of the best workers and companies seems unfortunately very plausible.

MICRO

Finally, I think there is a question about the nature of identity and a good life in a world where most may never work. I think given the previously mentioned issue this is a relatively minor issue and ideas about how to have a fulfilling life are ones that I’ve explored in my previously cited technology leads to mass unemployment essay.

Frodo Risk

FRODO RISK PART 1 – THE EYE OF SAURON, RECESSION PREDICTION AND MY BI-ANNUAL SYSTEMIC RISK REPORT

I’m a big science fiction and fantasy fan and one of the towering works of the genre is J.R.R. Tolkein’s The Lord of the Rings. At its heart the story is about the battle between good and evil pitching a fragile alliance of men, elves and dwarves against the rising powers of evil led by Sauron and his orcs of Mordor. Sauron does not have a physical body but rather takes the form of a great, all-seeing eye perched on top of a tower in Mordor, the so-called Eye of Sauron.

He is forced to take this form because he was actually killed many thousands of years before but had managed to survive on by tying his life force to the ‘one ring.’ This ‘one ring’ is paradoxically both the source of his strength but also the eventual tool of his destructive. Frodo Baggins, the most unlikely of heroes being just a hobbit from the Shire, takes the ‘one ring’ and after a terrible journey across Middle Earth manages to destroy the it in Mount Doom and with it Sauron himself.

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The story is instructive I think because it has similarities with the recent recession. Sauron, I’m sure knew that he would die if the ‘one ring’ was destroyed and therefore should have considered all the ways that this might happen, despite the fact it would have seemed very unlikely. In fact, knowing that the ‘one ring’ could only be destroyed in Mount Doom he should have started with the ‘one ring’s’ destruction and worked backwards to consider all the possible scenarios that this highly unlikely event might happen and crucially what the tell-tell signs leading up to the event might be because oftentimes you can only see something if you are actively looking for it. Returning to the recent recession, although of course econometrics, statistical programs and economic modelling are all very powerful tools they do have the very obvious drawback that they fundamentally work by assuming that the future will look like the past therefore all it takes to lead them astray is the historically unprecedented! I believe that econometrics modelling should be complemented with what I like to call ‘Frodo Risk’ analysis.

Bi-annual report

My idea then is for a bi-annual report that would be bought by investors to give them a systematic overview of the world economy and possible causes of systemic risk. It would only be bi-annual because a) the report would likely take a long time to prepare and b) investors do not have that much time to be constantly reading updated research. Ultimately the aim is to help highlight possible long-term build-ups of systemic risk and so the limited frequency I think would not be a problem. It is important the report would, at least attempt to, be systematic because I think one problem with a lot of current macroeconomics research is it feels like in-depth journalism. However, much like how the ‘eye of Sauron’ can be distracted from seeing Frodo, I believe sometimes journalism can be distracted from seeing the build-up of systemic risk by the latest hot topic.

The report would be divided into 100+ mini analyses. These would be structured thus:

Obvious categories of potential systemic risk to consider would be: ‘asset class bubbles’ ‘war/terrorism’ ‘environmental/weather/global warming’ ‘natural resources, energy crises’ ‘inequality, democratic political unrest’ ‘debt’ ‘bankruptcy of major companies’

Conclusion

In just writing that small piece on a potential bubble in American University education I already find myself being forced to think hard about issues that otherwise I might not. I think a report of a 100+ or so of these potential causes could realistically hope to, within that hundred, catch any major cause of global economic systemic risk. For the potential investor therefore to, on a bi-annual basis, read a report on all these potential causes would, I think, help very much in first offering alternative perspectives on their portfolio’s risk profile and second possibly inspiring their own research into a specific asset class etc.


FRODO RISK PART 2 – RESEARCH FIRM

[Michael Burry’s] got Asperger’s syndrome which makes him even more interesting because in fact it ties him back to the other characters. All the characters are in one way or another socially cutoff, isolated either by volition or by syndrome. And as a result they are not hearing the signals, they are not hearing the same music that you and I would, ‘they’re looking at data’ ‘they’re looking at data or they are filtering it through their own peculiar imaginations. But they aren’t part of the Wall Street social world. And in some way or another they are not hearing the propaganda. Asperger’s syndrome is not a bad metaphor for what it was about them, this isolation, this self-isolation’ ‘uncomfortable in social situations’ ‘or didn’t like them.’ Michael Lewis in an interview with Charlie Rose on his book The Big Short and the people who correctly predicted the 2007 sub-prime Financial Crisis.

This essay is a follow-up to my previous article on ‘Frodo Risk.’ In that essay I argue that the problem with statistical approaches is that they rely upon the assumption that the future, at least in some way, mirrors the past. This assumption leaves them exposed to the historically unprecedented. Much like how Sauron, the evil leader of Mordor from the Lord of the Rings, fails to predict (and prevent) Frodo Baggins from destroying the one ring in Mount Doom I believe that standard macroeconomic modelling approaches fail to predict recessions because recessions usually have some element of the historically unprecedented. It is like the famous quote that ‘generals always fight the last war.’

It should be emphasized that the failure of macroeconomic modelling is not partial but total. I recently read an article written in 2012 by IMF economist Prakash Loungani in which he points to the astonishingly appalling record that economists have in predicting recessions.

In 2000, I wrote in the Financial Times that “the record of failure to predict recessions is virtually unblemished.” A dozen years and many recessions later, there is little reason to change my assessment. My initial conclusion was based on my findings that only two of the 60 recessions that occurred around the world during the 1990s were predicted by private sector forecasters a year in advance. About 40 of the 60 recessions remained undetected seven months before they occurred. As even as late as two months before each recession began, about a quarter of the forecasts still predicted positive growth for the country concerned. With my colleagues Jair Rodriguez and Hites Ahir, I’ve since looked at the record of forecasting recessions over the decade of the 2000s and during the Great Recession of 2007-09. Let’s consider the 2000s first and restrict attention to forecasts for twelve [sic] large economies—the G7 plus the ‘E7’ (emerging market economies–Brazil, China, India, Korea, Mexico, Russia and Turkey), which together account for over three-quarters of world GDP. There were a total of 26 recessions in this set of countries. Only two recessions were predicted a year in advance and one of those predictions came toward the turn of the year. Requiring recessions to be predicted a year ahead may seem like an unreasonably high bar to set.

This should be incredibly surprising. After all, alongside delivering sustained economic growth, the most important contribution macroeconomics could make to society would be the prevention and eradication of recessions from our economies. Failing that, macroeconomics should at least be able to deliver long-term, accurate prediction but as we have just seen from the Loungani article this is not the case. Some would argue that economics is just too complicated, human systems are just too complex, which I concede they just may be. But I still think it is fascinating to note that in no other area of human endeavour have you had so much raw brain power, human expertise and competitive incentive systems (academia and finance) and yet had so much failure.

My solution to this problem of predicting recessions is to start with imagining all the possible causes of systemic risk, with the guiding principal of: if it is big just imagine what would happen if it would go bad? Then with this list of hundreds of potential ‘Frodo Risks’ you would then try to work backwards and crucially figure out what would be the tell-tell signs that the imagined crisis is slowly developing. Finally you would then track all of these hundreds of potential ‘Frodo risks’ and try to spot potentially systemic threats as they develop. Of course, underpinning this approach is the idea that recessions are long-term predictable which again I concede they may not be. The timing issue is interesting, and my initial idea about how to guess the time of when the market cottons on is to track FT or Economist articles about the issue and correlate an uptick there with a market wide understanding.

WHAT WOULD THE IDEAL SYSTEMIC RISK RESEARCH FIRM LOOK LIKE?

Culture/mentality

There are four guiding principals to my idealized systemic risk research firm.

The first is that you cannot see something unless you are actively looking for it. I think this is especially true in economics where any coherent economic model will almost always have plausible explanations for whatever is occurring. In fact, the standard economic modelling approach of current equilbrium + trend + exogenous shocks makes it very easy for long-run build ups (for example in leverage) to be justified because well look it’s only slightly higher than it was six months ago and six months ago it was perfectly fine!

The second is the value of the outsider, someone who isn’t hearing the music. The problem is how to acquire a detailed understanding of something and yet not become indoctrinated into that way of thinking. One of the advantages that outsiders have is that they can risk asking the stupid beginner questions that an expert cannot because it could potentially reveal an embarrassing lack of basic understanding. I would also add that being an outsider is not just in the sense of a specific industry but also in terms of personality. If you think about most of the examples of people who saw the housing bubble as profiled in Michael Lewis’ ‘The Big Short’ and Gregory Zuckerman’s ‘The Greatest Trade Ever’ many of them had serious social problems. The best example of this is probably Michael Burry who has Asperger’s syndrome and a full suite of personality quirks. In most of working life, particularly in big corporations, eccentricities are punished and it tends to be the socialized and like-able that rise to positions of power and influence. When it comes to something like economics research though the hiring preferences can and should be a little different.

The third is that creativity, as suggested by Steven Johnson in his book ‘Where Good Ideas Come From’, is largely a function of diverse influences bashing together. Therefore to be more creative you need to proactively expose yourself and your ideas to a diverse range of influences.

The fourth is the importance of what Robert Greene in his book Mastery calls negative capability. This is the ability to be comfortable with not immediately understanding something. This is the idea of not giving in to the need to have an opinion about everything but instead continuing to wrestle and play with the idea. In my own small way, many of my best and most status quo challenging ideas have come only after months of mulling them over. John Cleese, of Monty Python made the same point when he gave a lecture on creativity

Well, let me tell you a story. I was always intrigued that one of my Monty Python colleagues who seemed to be (to me) more talented than I was {but} did never produce scripts as original as mine. And I watched for some time and then I began to see why. If he was faced with a problem, and fairly soon saw a solution, he was inclined to take it. Even though (I think) he knew the solution was not very original. Whereas if I was in the same situation, although I was sorely tempted to take the easy way out, and finish by 5 o’clock, I just couldn’t. I’d sit there with the problem for another hour-and-a-quarter, and by sticking at it would, in the end, almost always come up with something more original. It was that simple. My work was more creative than his simply because I was prepared to stick with the problem longer.

Work practices

To produce a bi-annual report the working year would be broken into two six month parts. There would be a 5 week break over Christmas and an 7 week break over Summer. This would allow every six months for twenty weeks of working time to produce a report. This would be a sizable increase in holiday time compared to a typical employee which I think would offset the relative inflexibility of when people can take their holidays. One major advantage of such long holidays is that I think it would allow people to spend part of the year living in different countries. I watched a TED talk with the founder of a prestigious design firm who every seven years closed down the firm for a year to allow him and his staff to have a year sabbatical and be exposed to new influences. Clearly an economics research firm cannot just take a year off but I think it could valuably benefit from the long holidays.

Each 20 week block would be divided into 10 fortnight working weeks where the team would work from Monday of week 1 and through the weekend to Tuesday of week 2 to make 9 straight days of working. This would be finished with five days of weekend. The value in this I think is proper recovery from the working week in a way that I think it is harder to do with just two days of rest every seven. Hopefully by having five days of rest per fortnight as opposed to the normal four people will be more willing to switch. I also think the five days could realistically be used for short holidays around the world which, I know myself in particular, would love to take advantage of to go and visit all the friends I have dotted around. The 9 days of work would be demanding with long twelve hour days starting at 8am and finishing at 8pm. The exception would be the working weekend where finishing at 5pm would allow employees to not completely lose their weekend every other week. You would probably allow for an additional three of four days in each six month period so people can have at least some flexibility with the working year. Of course, a lot of people would not be willing to work like this but I think given that research firms are very small and only need to be about ten people this should not be a problem. Additionally I think being different has the optimal advantage of helping keep people feeling like an outsider and not tied to the system.

It is really important to have a lot of exposure to diverse influences so every day there would be three hours allocated to reading time, maybe from 11am to 1pm just before lunch and another hour in the afternoon. This would be supplemented by perhaps one afternoon per fortnight where employees could work on essays and develop ideas of their own choosing (much like Google’s 20% time). All this reading would help give employees a regular diet of different influences and the opportunity to develop new insights. Perhaps to create a diverse team of researchers peoples’ reading and interests might be tracked in an effort to maintain diversity and breadth in thinking. Clearly, although there would be a heavy bias away from fiction towards non-fiction and academic literature, you would want to allow the reading to be as varied as possible. Warren Buffett of Berkshire Hathaway said that

I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So I do more reading and thinking, and make less impulse decisions than most people in business. I do it because I like this kind of life.”

Charlie Munger, Buffett’s partner at Berkshire Hathaway said something similar

In my whole life, I have known no wise people who didn’t read all the time – none, zero. You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.

Everyday there would be a team lunch at 1pm for an hour and a half where people can get closer and exchange ideas. In general I think I would probably be against having regular formal meetings because I believe that having to defend ideas that challenge the status quo in their nascent stages is very counter-productive as ideas (especially early on) are inherently very fragile, even to the lightest questioning. Nonetheless eating together and the more informal conversation that would involve would not only bring a family atmosphere but could also be a good way to share ideas and create diverse influences. You might even want to occasionally allow members of the research team to give mini presentations about books they have read or topics that interest them. Afterwards there would be the option of a thirty minute nap which would allow for biphasic sleep patterns which help people recharge for the afternoon and also reduce people’s daily total sleep time.

The optimal pay structure is interesting I think. My initial gut reaction was to tie pay to the performance of the firm. So have a low minimal wage at say £30,000 a year with additional % of profit to all the employees. I think the problem with this is it incentivizes high sales not good research. So my initial idea would be to keep records of the Frodo risk rating and how well they correlate with actual events and then reward accordingly. This would create very long-term incentives tied to getting the answer right.

Finally, I think I would ultimately opt in favour of diverse influences over sectoral expertise. Therefore researchers would every six months be, probably randomly, allocated different clusters of potential systemic risks to work with the view that that would keep our thinking fresh and hopefully insightful. You might even offer each researcher, perhaps once or twice a decade, a chance to spend six months just reading, thinking and writing about whatever they want: a sabbatical in the office if you will.

Office

I think big financial organisations and universities make it harder for people to think creatively because they, through their big impressive buildings, implicitly intimidate their employees into accepting the status quo. This is to me very similar to how banks would try and give confidence to their customers by having big expensive buildings. Therefore I think the office should be in a non-financial district. My current thinking is a cool converted art studio in east London somewhere.

For the team lunch there would need to be a big open table to eat together and I also think it would be good to have an office library stocked with books and kindles.

Over time it might be beneficial to develop a suite of internal literature on what major schools of thought. Maybe even Munger-like checklists as a ward against human misjudgement. One of my favourites would be on any analysis a section on ‘what would convince me that I’m wrong?’ as well as internal quotas on criticisms of other peoples work and why they may be wrong.

Team

I am a big fan of Michael Lewis’ Moneyball which is a book about how the baseball team the Oakland A’s which had one of the lowest wage-bills in the MLB managed to compete with the big expensive teams like the New York Yankees by taking advantage of the mispricing of player value. I similarly believe that these same mispricings occur in the labour market for economics researchers. There are a number of biases I would try and take advantage of in my hiring decisions.

Firstly, there is a bias in favour of well-rounded, socialized and generally pleasant people. These are all great qualities in friends but not necessarily in out of the box researchers.

Secondly, I think there is bias discriminating against those who have had unconventional or volatile academic and professional careers. I think it makes more sense to judge a person’s ability to do good research not by their consistency but by their highs. As an example John Paulson who’s hedge fund, as profiled in Gregory Zuckerman’s ‘The Greatest Trade Ever’ made $20 billion dollars in the Great Recession, had an analyst on his team called Paolo Pelligrini. In fact it was Pelligrini who was responsible for making the shorting sub-prime trade recommendation. Pelligrini had an exceptional academic career where he came in the top 5% at Harvard and where one of his Maths professors said he was one of the most gifted students he had ever come across. His professional career, marred by poor client skills and disagreements with bosses, meant that I think he is a classic example of an undervalued asset. In fact, Ben Horowitz of venture capital firm Andreessen Horowitz talks about how Marc Andreessen is very difficult to work with and at times can be, frankly, a bit of a prick. Andreessen it is worth mentioning is a Silicon Valley legend who co-authored the first internet browser and was co-founder of Netscape. Horowitz’s point is that in normal working life you would not put up with these types of people as it would disrupt team culture but because creating disruptive companies is so hard what matters is exceptional genius and you should be willing to accept even very extreme personality flaws to get it.

‘I’ll take strength over lack of weakness every day… This isn’t WalMart or something; to do something new that is going to be the best in the world you need greatness.’ Ben Horowitz

Similarly, predicting economic recessions is probably the hardest thing you can do in economics so you should be willing to trade-off likeability for genius.

Thirdly, I think there should be an effort to employ a true diversity of people. Not just across different academic backgrounds and cultures but personality types as well. Despite the incredible (and commendable) racial diversity at most major corporations I still believe there is a striking monochromatic feel to modern corporate culture.

Fourthly, if every six months you had advisers come in on short-term contracts to offer their perspectives I think this would really help freshen up our thinking. You might eventually even want to have several small offices around the world and rotate staff to really mix up the influences on our thinking.

Fifth, have someone in the firm who regularly thinks about every person in the office and how they probably feel about their career. Are they excited? Do they feel listened to? Do they feel like they are important? Is there anything we can do to make their lives better? And then try and make office policies to improve things. I think this would be especially do-able if you have a small team of people.

I’ll finish with some parting words from Charlie Munger

It’s my opinion that anybody with a high I.Q. who graduated in economics ought to be able to sit down and write a ten page synthesis of all these ideas that’s quite persuasive. And I would bet a lot of money that I could give this test in practically every economics department in the country and get a perfectly lousy bunch or synthesis. They’d give me Ronald Coase. They’d talk about transactions costs. They’d click off a little something that their professors gave them and spit it back. But in terms of really understanding how it all fits together, I would confidently predict that most people couldn’t do it very well. By the way, if any of you want to try and do this, go ahead. I think you’ll find it hard. In this connection, one of the interesting things that I want to mention is that Max, Planck, the great Nobel laureate who found Planck’s constant, tried once to do economics. He gave it up. Now why did Max Planck, one of the smartest people who ever lived, give up economics? The answer, he said, “It’s too hard. The best solution you can get is messy and uncertain.” It didn’t satisfy Planck’s craving for order, so he gave it up. And if Max Planck early on realized he was never going to get perfect order, I will confidently predict that all of the rest of you are going to have the same result.

In fact, when Charlie Munger was asked in 2010, in a lecture at the University of Michigan, about his views on the economy the first thing he said was

Well let me start with a qualification. Warren and I have not made our way in life by making successful macroeconomic predictions and betting on our conclusions. Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us but by and large we don’t much bother with trying to predict the tides because we plan to play the game for a very long time. I recommend to all of you exactly the same attitude. It’s kind of a sneer and a delusion to outguess macroeconomic cycles. Very few people can do it successfully and some of them do it by accident. When the game is that tough why not adopt the other system of swimming as competently as you can and figure that over a long life you’ll have your share of good tides and bad tides.


FRODO RISK PART 3 – CATEGORIES OF RECESSION

Peter Thiel likes to ask the question ‘what valuable company is nobody building?’ and the more I think about the more I think this Frodo Risk company is one of them. It’s been less than a month since I wrote my first article about Frodo Risk as a concept and I can’t really remember where I got the idea from but already it just has that feeling of ‘this makes so much sense, why is nobody doing it?’ Part of the problem is that it’s very difficult to execute. In particular you are trying to be simultaneously systematic and comprehensive about ultimately unknowable future events. My initial best guesses on how to do this will be the focus of this article.

CATEGORIES OF RECESSION/SYSTEMIC RISK

Political Uncertainty – e.g. Eurozone crisis, Iranian Revolution 1980s, US September 11th, 1997 Asian Financial crisis

Asset price bubbles – e.g. 2008 US Housing crisis, dot-com bubble early 2000s, US 1857 railroads bubble

Fiscal tightening – e.g. US 1937-38

Monetary policy/Interest rate – e.g. 1980 US,

Market collapse – e.g. US 1836-38 Cotton market

Bank failures – e.g. US 1836-38

Cost-push (particularly energy) – e.g. 1973-74 US oil crisis, 2007-08 food prices

High leverage – e.g. 2008 US Housing crisis,

Post-war – e.g. US 1920-21

Lack of technological progress – e.g. Peter Thiel argument is bubbles form if no better alternative e.g. 2008 US Housing, Early 2000s tech bubble

Big company – e.g. 1926-27 Henry Ford switched production from Model T to Model A closing factories for 6 months, US 1873 – failure of Jay Cooke & Company, 1857 US Ohio Life Insurance & Trust company failure

Other country – e.g. 1980s Iranian Revolution, US 1847-48 because of British Financial Crisis

FINAL THOUGHTS

Even if you set a low bar of predicting 1 year in advance just 25% of the recessions that occur (according to IMF economist Prakash Loungani the market 1 year in advance predicts about 5% of the time), spotting recessions is an awesomely difficult task.

Clearly there are some shocks that are going to be beyond a few researchers in a room e.g. terrorism or natural disasters. Nonetheless I think comprehensive monitoring of asset price bubbles, government fiscal/monetary tightening and failure of one big company/market leading to general uncertainty are all situations that could be mapped out in advance with reasonable predictive power.

Of course the whole challenge is for any research firm trying to predict recessions crying wolf is just a big a sin as missing recessions. Ultimately the goal goes way beyond selling research to a few hedge funds, really you’d want the firm (or firms like it) to become so widely listened to that their research can move markets and recessions can not only be predicted but actually prevented. But that’s a dream for the future.

Returns To Capital And Labour Independent?

This essay is an attempt to explore the implications of human capital a little more deeply.

In Economics we are used to thinking about how market structure (competition vs monopoly) affects (supernormal) profit levels. What is left unexplained is what determines how much of that profit goes to labour and how much goes to capital – and in fact already our economic definitions are breaking down because profit is net of costs which includes labour. A naive first cut would suggest that surely returns to labour and capital are correlated and the real determining factor is how much pie (profits) there is to share around. Certainly, the technology industry with companies like Apple seem to have high returns to capital and labour and conversely the restaurant industry suffers from both minimum wage waiters and bankrupt restaurant owners.

However, just as Peter Thiel argues that the value that an industry gives to the world and the % of that value that a company captures are independent I would argue that return to capital and return to labour are also independent. Supermarkets are a good example of industries where the return to capital (e.g. the shareholders of Walmart) is high but where the return to labour (salary of Walmart employee) is low. Conversely, the airline industry is notorious for the tiny profit margins but airline pilots actually enjoy quite high salaries. Another example is the finance industry where I saw a lecture with the economist John Kay where he argued that investment banking CEOs were getting absurdly high bonuses despite delivering very low returns to shareholders.

The obvious economic explanation is that the labour market has its own demand and supply which is largely independent of the demand and supply for the product/service. At a simple level, industries that employ low-skilled labour pay that labour less regardless of how much profits the industry is making, similarly high skilled labour tends to be highly paid.

The implication of this analysis is that maybe the best industries for us to start the human capital idea in are those industries where equity investing isn’t attractive (because the companies don’t make much money) but the labour does.

The Problem With Comparative Advantage And Justin Yifu Lin's CAF Strategy of Economic Development

My friend recently posted on my Facebook an article which quoted Bill Gates saying that people don’t realise how many jobs are going to be automated in the near future. The implication being that my previous essay ‘Technology growth will lead to mass unemployment’ was correct. However, I’ve been spending a lot of time thinking about the idea of ‘what would convince me that I’m wrong?’ as a way to stay open-minded and avoiding being emotionally attached to my ideas, something that Michael Burry, of Michael Lewis’ ‘The Big Short’ impressed on me. Apparently he hated writing quarterly letters to investors for exactly this reason because in defending his ideas he would become attached to them and may not be able to leave them even if they were wrong. One unexpected fallout of this way of thinking is that an expert, someone you respect or even the person paying your cheques saying your wrong (or right!) does not qualify as a legitimate reason for changing your mind. Of course, if they present good arguments then that’s fine but just trusting in another persons intelligence or superior understanding is unfortunately not allowed. So although, I have to admit the absurdity of me critiquing an economist of Justin Yifu Lin’s reputation I nonetheless I have to persist until someone can convince me that my arguments are wrong. Having said that, to test my own understanding of his theory of Comparative Advantage Following (CAF) Economic Development the first part of this essay will simply be an attempt to relate an unadultered narrative of his theories and ideas. This may also serve as a way to get you up to speed on his ideas in case you are not familiar with them. The second part of the essay will be when I share some of my own ideas and critiques.

PART ONE – JUSTIN YIFU LIN’S CAF DEVELOPMENT STRATEGY

So here is the problem. You’re a poor, largely agricultural developing economy and you want to grow. Fast. What should you do? Well the obvious thing would be to look and see what your most successful neighbours have that you don’t. What you would find is they tend to have well-developed capital-intensive manufacturing industries. Therefore much of economic theory is built upon the idea that poor countries need to build up their industrial base. However, this won’t just happen on its own and so requires government policy to incentivise capital accumulation. Justin Yifu Lin argues that this can have the opposite of the desired effect crippling the poor country for decades just like we saw with China in the 1950s and 60s. In Yifu Lin’s view prematurely developing capital intensive manufacturing industries is like trying to walk before you can crawl. Instead countries should focus on industries in which they have a comparative advantage and can develop a surplus in. These industries he describes as viable because they can compete and survive without government support. Over time the developing country can invest its economic surplus in capital and gradually become more capital intensive. As the economy changes so will the industries in which the country has a comparative advantage in and thus you will have economic development smoothly transitioning to increasingly capital intensive industries. In ‘Part One – Justin Yifu Lin’s CAF Development Strategy’ I shall first outline more specifically the pitfalls of artificially developing a manufacturing base or what Justin Yifu Lin calls ‘Comparative Advantage Defying’ theory of economic development with specific reference to China’s economic story. Then, I will describe Yifu Lin’s ‘Comparative Advantage Following’ economic theory .

YIFU LIN ON WHY ‘CAD’ STRATEGIES DON’T WORK

As previously described poor countries that want to quickly develop an industrial base need to intervene in the market because otherwise heavy industry capital investment will not naturally occur. This is for three reasons in particular.

  1. Capital intensive heavy industries require long construction periods and this in turns means large interest rate costs. To counteract this the government needs to artificially lower the interest rate.
  2. Key technology and capital needs to be imported but as we’re talking about poor countries with limited exports they do not have enough FX to buy the capital required. Therefore governments need to intervene in the exchange rates to make imports cheaper.
  3. Huge barriers to entry because of large initial capital outlays make investing in capital intensive heavy industry very expensive. For agragrian economies with limited surplus this is a particularly serious problem. Therefore to help incentivize capital accumulation by increasing expected profits need to grant monopoly status to firms as well as lower productive input costs namely lowering wages.

Such policies however lead to many unintended consequences which ultimately make the efforts counter-productive. Taking China as an example although there was remarkable capital accumulation: 24.2% of GDP in the 1st Five Year Plan and 30.8% in the 2nd economic growth in the period of 1952 to 1981 was a pitiful 0.5% a year at best. This is because although China had developed capital intensive manufacturing industries they were terribly inefficient and uncompetitive, only kept alive by government support. Support that was funded by the already poor Chinese farmers.

The reason why this happens gets a little messy but the key thing to keep in mind is that the government is trying to push the economy into industries its not naturally suited for, the market however pushes back which leads to lots of problems. Specifically

  1. The aforementioned strategy of lowering interest rates also lowers savings and as the level of savings help determine the investment level it results in a short-run shortage of capital.
  2. In manipulating the exchange rate although imports become cheaper exports simultaneously become more expensive which lowers foreign exchange reserves, which means less capital.
  3. For a country that is already poor paying for the huge capital costs becomes prohibitively expensive. Essentially you end up taxing poor farmers to subsidize inefficient manufacturing. In particular, the policy of lowering wages in turn reqruires lowering the prices of daily necessities which leads to shortages. In the China story the government therefore had to intervene in the agricultural products markets with disastrous effect. In fact the China’s effort to control the agricultural markets through the Peoples’ Commune suffered a 15% reduction in grain production both in 1959 and 1960 and the deaths of more than 30 million people.

As 1. changing the exchange and 2. the interest rates mean that not only are heavy industry capital costs cheaper but so are light industry and agricultural costs there is a danger that the already limited capital is diverted away from heavy industries to the less expensive light and agricultural industries. Therefore the government in pursuit of its policy of prioritizing heavy industries is forced to nationalize. But in doing so suffers from all the negative incentive effects of government control with the potential for corruption and poor management and ultimately inefficient uncompetitive manufacturing.

YIFU LIN ON WHY ‘CAF’ STRATEGIES DO WORK

Instead of trying to artificially upgrade the industrial and technological structure Yifu Lin argues that countries should seek to upgrade the underlying endowment structure. With this successfully done the desried industrial and technological structure will naturally arise. As land and natural resources cannot be changed and labour growth differences between countries are minimal the key thing is to focus on capital acccumulation. This you will recognise is the same goal as the ‘CAD’ strategies. What Yifu Lin disagrees with though is the not the aim but the method. In particular he argues the best way to accumulate capital is to increase the economic surplus or profit that is made in each period as well as increase the percentage of that surplus that is invested in capital.

At the heart of ‘CAF’ strategies is by definition the concept of comparative advantage. Ever since its conception in 1817 by David Ricardo comparative advantage has been the bedrock of international trade. What comparative advantage says is that even if one country, let’s say America, is more efficient at producing goods than another country, let’s say Russia there can still be gains from trade. If you imagine a two good world of grain and ipods. In this world America produces both grain and ipods cheaper than Russia. However America is excellent at producing ipods but only very good at producing grain, in other words its relatively better at producing ipods. Russia in turn although it’s worse than America at producing everything it is good at producing grain but bad at producing ipods thus it is relatively better at producing grain. Therefore if America focuses all its effort on producing ipods and Russia all its effort on producing grain world output increases because each countries’ factors of production have been utilized doing what they are relatively best at doing.

A developing country following ‘CAF’ strategy essentially is picking its battles. Rather than trying to go up against the developed countries in industries they have huge advantages in, by following comparative advantage developing countries can pick industries in which they don’t have to compete against developed countries. CAF strategy in contrast involves competing against developed countries companies in industries they are more efficient in. Of course developing countries can try and support their companies through subsidies etc but an inefficient company backed by a poor country is still going to lose against a developed countries efficient and more technologically advanced companies. Even though for a developing country, focusing on its comparative advantage industries, the spoils of victory might not be as great companies competing in these industries will be what Yifu Lin calls ‘viable.’ Which he defines as companies that are normally managed with no government support that can achieve a normal profit in an open, free and competitive markets. Then over time countries will shift from the labour intensive industries to the more capital intensive ones as companies invest their profits competing in their comparative advantage industries into accumulating capital.

PART TWO – THE PROBLEM WITH ‘CAF’ AND COMPARATIVE ADVANTAGE

There I think three primary problems with comparative advantage and therefore Yifu Lin’s ‘CAF’ strategy.

COMPARATIVE ADVANTAGE DOESN’T MEAN NO COMPETITION

The first problem I think is that although through ‘CAF’ strategies countries can avoid competing with more developed countries in industries they are inherently inefficient at unfortunately there are still lots of poor countries whose comparative advantage is in labour intensive industries left to compete with. Countries in an effort to support their domestic industries may employ protectionist measures or risk having them out-competed. Even if a country’s countries are able to survive the competition between so many companies operating in the same industry inevitably erodes the profit margins. This is crucial because it is exactly this economic surplus from which future capital accumulation is supposed to arise. This competition not only occurs between poor developing countries but also developed countries because as the cost of copying technology is lower than the cost of innovating countries – at least to some extent – can converge. This is usually viewed as a good thing but it has the unwanted by product of resulting in economies with similar economic structures and therefore increased competition.

CONTINUOUS CAPITAL ACCUMULATION? OR DISCRETE?

Yifu Lin assumes that through focusing on the industries in which countries have a comparative advantage countries can gradually shift the isocost line and move away from labour intensive industries towards more capital intensive industries. This picture however is too simplistic because capital cannot be viewed as a continuous line. The reality is that accumulating capital in car manufacturing doesn’t mean that you can then smoothly jump to accumulating capital in ship manufacture. They don’t transfer that easily. This is also true of expertise and human capital. In reality each industry is relatively discrete. This means that countries can get trapped in a specific set of industries which they are viable at but cannot switch to different and perhaps more capital intensive industries without huge investment. Which of course leads us to exactly the same problem we were hoping ‘CAF’ would solve; that of a poor country trying to transition to a more capital intensive industrial structure but not having the capital to do it. Yifu Lin argues that because China enjoyed little economic growth in the 20 years until 1978 therefore China’s plan of transitioning to heavy industry was a failure, despite the incredible capital accumulation numbers. I would argue that perhaps China just showed an incredible resolve for a poor country to make itself poorer in the short-run so that in the long-run it can fundamentally shift its industrial structure and build the foundation for future runaway economic growth. For countries not willing to take this Faustian bargain the future may be bleak as the country gets trapped specializing in labour intensive industries and other countries become more and more efficient in the capital intensive industries.

COMPARATIVE ADVANTAGE ASSUMES FULL EMPLOYMENT

This last critique is perhaps the most controversial. To take the previous example of Russia and the United States even though America enjoys an absolute advantage over Russia in the production of both ipods and grain America specializes in its comparative advantage ipods and Russia in its comparative advantage grain. At the heart of comparative advantage though is the assumption that America doesn’t produce grain because its limited factors of production would be better spent producing ipods. However if America had sufficient factors of production to produce enough ipods and grain to satisfy world demand then the United States with its absolute advantage in both industries would out-compete Russia and Russian workers and capital would be left unemployed. It sounds of course implausible because surely the Russian factors of production would be employed doing something else but as we have seen in the Great Depression it is possible for economies to last long periods without fully utilizing all its factors of production. In fact it could be argued that most of economic theory is about jump-starting economies out of low employment equilibriums into high employment equilibriums. I think this critique is particularly significant because as I argued in another essay titled ‘Technology growth leads to mass unemployment’ I think there are compelling arguments to believe that unemployment of factors of production and in particular labour could soon be a widespread problem. Of course, this is against our economic intuition because our economic history is one of our economies and labour forces shifting from labour intensive agriculture to labour intensive manufacturing to labour intensive services. Thus although much of our economic growth has been fuelled by the automatization of the efforts of labour there have always been new industries to soak up the unemployed workers. I think now for the first time in human history that is potentially not going to be the case. In particular this oncoming robotization points to a fundamental decoupling of labour and capital such that in many manufacturing processes the concept of a diminishing return to capital because of limited labour to work that capital will become meaningless.

China's Democratic Future

The most pressing question about China in the 21st century is what is China’s long-run political system?  There seem to be two distinct futures.

  1. China moves to some version of Western democracy
  2. It does not.

This is a significant question because if it is the former the question then becomes will the transition to a Western democratic political system be through gradual change or through disruptive revolution? Which of these paths is taken hangs over China with great uncertainty and China’s central role in the global economy makes it impactful to all investors whether invested in China directly or not. Of course against the backdrop of short-term market movements such long-term concerns may seem unimportant and faraway but as the sub-prime mortgage crisis and the Grexit situation have shown these long-term build ups of systematic risks are worth keeping half an eye on.

‘It might seem unfair to concentrate on the ability to anticipate recessions, given that they are (thankfully) unusual events. But it is only sharp discontinuities in economic conditions that we want to know about in advance. To be informed that trade will grow roughly as it did last year is valueless as professional advice, given that our own intuition will tend to tell us that anyway.’ Dominic Lawson

This essay aims to give a tangible example of a framework (my Frodo risk idea for predicting recessions) for tracking potential long-term systemic risks against the stream of new data and events.

The widely held view on China, of course, is that it will gradually progress to a democracy with ‘Chinese characteristics’ where China’s sheer size, culture, and historical preference for ‘stability’ account for some non-democratic components of its future political structure. This view, although it may prove right, suffers from a) being very simplified and b) offers no systematic way to track this narrative against what is actually happening in China and whether events are aligning with the hypothesised future and c) perhaps most dangerously a sufficiently compelling explanation of what is going to happen that a market participant may not make the effort to dig deeper until it’s too late.

Regarding a transition to a Western-style democracy there are four scenarios that we are going to consider:

  1. Scenario 1 – Government led smooth transition
  2. Scenario 2 – Chinese middle class revolution
    • 5 worsening, 2 stable, 2 improving
  3. Scenario 3 – Chinese rural working class revolution
    • 2 worsening, 2 stable
  4. Scenario 4 – Chinese urban working class revolution
    • 1 worsening, 3 stable, 3 improving

TRANSITION TO WESTERN-STYLE DEMOCRACY

Scenario 1 – Government led smooth transition

If the Chinese government is to provide a smooth path to Western style democracy you would expect to see

1. A gradual introduction of the democratic process and a reduction in government autocracy.

2. Chinese government rhetoric around political reform.

TRANSITION TO WESTERN-STYLE DEMOCRACY

Scenario 2 – Chinese middle class revolution

There are a number of early warning signs that you might expect to see in the event of a Chinese middle class led change in government.

1. Increasing numbers of protests for democracy. ~ worsening

The 2014 student-led Hong Kong Protests, or so called Umbrella Revolution, were a reaction to the NPCSC’s proposed reforms to the Hong Kong electoral system which are widely perceived to be very restrictive in terms of the candidates that present themselves to the Hong Kong electorate. Police tactics (including the use of tear gas) triggered yet more protests. Despite this, the protests were ended without any political concessions from the government. Going forward, Hong Kong’s Western ties (with its British history) and non-Mandarin languages (English & Cantonese) may mean that it is a likely seed of future political dissension that could spread to the rest of the Mainland.

2. High government corruption ~ worsening

One of General Secretary Xi Jin Ping’s signature policies since taking power in 2012 is his anti-corruption campaign and his so-called crackdown on ‘tigers and flies’ (high level officials and civil servants respectively). There was initially much skepticism from the Chinese public however the extent and reach of the campaign has beaten expectations where there have been more than 70 provincial (or above) officials including four National Leaders including most notably Zhou Yongkang. Having said that, critics argue that the crackdown is politically rather than corruption prevention motivated. Alarmingly the 2014 Corruption Perceptions Index has found that, despite the crackdown, China’s corruption has worsened (40 in 2013 to 36 in 2014) not improved. The primary issue seems to be a lack of transparency and the ease with which officials can launder bribes offshore. If this downward trend continues this could be a potential seed for future unrest.

3. Difficult business conditions ~ stable

Chinese business sentiment has remained relatively stable over the past decade.

Future business conditions however look very uncertain with potential continuation of the recent decline. 

4. Lower economic growth rate ~ worsening

Of course a 7% growth rate is still extremely high but China’s history of decades worth of unprecedented growth rates has led to the narrative that the Chinese people will only compromise on democracy and human rights if the Chinese government continues to deliver continued economic development. For a long time growth rates of less than 8% was considered the crucial threshold but so far the Chinese government countered that perception with a ‘new normal’ rhetoric of sustainable growth.

5. Urban city problems ~  improving

There are many severe urban city problems in China and according to numbeo China has one of the lowest quality of life indexes in the world (where factors includng purchasing powers, safety, health care, consumer price, property price to income, traffic commute and pollution at just 15.99 in 2015 compared to  192.49 for the United States and 78.60 for India. However, this still makes for a significant improvement on China’s 2012 score of just -49.55.

On the pollution front in particular, in 2014 Xi Jinping has ‘declared war’ on pollution in China where new environmental laws past in April enabled environmental enforcement agencies with significant punitive powers. This law is coupled with a massive US$277 billion package with the goal to reduced air emissions by 25% by 2017(compared to 2012 levels).

Even more remarkably this March China Academy of Space Technology’s vice president Li Ming ‘China will build a space station in around 2020 which will open an opportunity to develop space solar power technology’ with the long-term view of having a commercially viable space power station by 2050. The plan would involve building a station with five to six square kilometres of solar panels (twice the size of the New York’s Central Park) and then beaming the energy back to Earth by microwaves or lasers.

Coming back down to Earth (literally), there is a worrying trend in China’s urban cities with the rise of the so called Diaosi or so called self-proclaimed ‘losers’ which a sociologist at the Chinese Academy of Social Sciences has attributed to a ‘feeling of relative deprivation is a troubling consequence of China’s growing wealth gap.’

It is also worth emphasising China’s cities suffer from a number of very significant challenges including the migrant underclass who toil in factories and menail jobs but are denied public services because of internal migration restrictions (from the household registration or hukou system). It is also concerning that farmers in China have no property rights which has left them open to exploitation by urban officials who are looking to make money through land grabs and selling the land onto developers.

6. Middle class emigrating abroad ~ worsening

According to a 2014 Barclays report which surveyed more than 2,000 wealthy individuals (>$1.5m) around the world showed that the Chinese want to emigrate more than any other any other region. The survey found 47% of rich Chinese planned to move abroad in the next half-decade compared with just 23% in Singapore, 16% in Hong Kong and only 6% of Americans and 5% of Indians.

The primary reasons cited were better children’s education and future job prospects were named as the main reason to emigrate by 78% of respondents. A better economic situation by 73%. The US and Europe were the favoured destinations.

7. Academia/public intellectuals criticizing government ~ stable

In 2008, 60 years after the UN’s original ‘Declaration of Human Rights’ 350 intellectuals and human rights activists signed ‘Charter 08’ (so named because of Czechoslovakia’s famous Charter 77). It has now has more than 10,000 signatures.

At least 70 of the original signatories have been summoned by the police and in December 2008 Charter 08’s leader Liu Xiaobo was sentenced to 11 years in prison for ‘inciting subversion of state power.’ In October 2010 he would be awarded the Nobel Peace Prize

8. Government finances are weak ~ improving

After the Financial Crisis most countries suffered a massive increase in public debt and China with it’s gargantuan stimulus package in 2009 was no different. The government since then has shown an impressive ability to bring that debt back under control.

Recent policies include this year a debt relief programme for local governments where they will be able to swap $160 billion of their high interest debts for lower costs bonds, according to the Economic Observer, a local newspaper, this may just be the first tranche with total refinancing being three times that amount.

9. Increase in Human rights/freedom of speech restrictions/violations ~ worsening

According to the Dui Hua Foundation China executed 2,400 peoplelast year this is compared to just 778 in the rest of the world combined. Nonetheless compared to in 2002 the 12,000 executions. According to Dui Hua China ‘has executed far fewer people since the power of final review of death sentences was returned to the Supreme People’s Court in 2007’, Dui Hua’s executive Director John Kamm told the Telegraph the decline was ‘the single most positive development in the field of human rights in China in decades.’

However general human rights abuses are worsening. According to a Hubei based Civil Rights and Livelihood Watch China is ‘worsening and regressive human rights situation… the stability maintenance regime is getting stricter and stricter, you could say it’s getting more and more brutal and more inhuman….[Last year – 2014] was the cruelest we have [seen] since 1989 which is cause for extreme concern.’

TRANSITION TO WESTERN-STYLE DEMOCRACY

Scenario 3 – Chinese rural working class revolution

1. Increasing urban-rural inequality ~ stable

Urban rural inequality has been fairly stable over the past decade although the residency permit or hukou system which prevents rural Chinese moving to the more prosperous cities may be an eventual seed of future dissension.

2. Cost of living/food/fuel rising ~ stable

According to Brien Chua a Singaporean job recruiter rural people in modern China told the Strait Times ‘With lodging expensive and food costing more than double the price than back home, no one wants to move to the big cities anymore.’

3. Rural unemployment ~ worsening

According to a 2014 report from the Chinese Academy of Social Sciences estimated that the rural area unemployment rate among college graduates could be as high as 30.5% which when coupled with the strict rural-urban migration laws would suggest a worsening situation. Unemployment statistics in China however are notoriously bad especially as the 274m migrant workers are completely ignored in the datasets.

Thus the implausibly stable official unemployment figures (in a range from 4.0% to 4.3% over thirteen years) despite drastic fluctuations in GDP/growth rate over that same period are given very little credence by most economic observers.

4. Increased rural-urban migration ~ worsening

China has a strict household registration system which is meant to limit internal migration (particularly rural to urban) within the country. Nonetheless there is a huge migration population of workers, estimates number at more than 250 million with that number expected to double by 2025.

TRANSITION TO WESTERN-STYLE DEMOCRACY

Scenario 4 – Chinese urban working class revolution

1. Increasing inequality ~ stable

Inequality in China increased significantly throughout the 90’s although it has stabilized since at a high Gini coefficient of ~0.47. In urban areas specifically Gini has risen significantly from 0.15 (1981) to 0.36 (2011).

2. Increased cost of living/food/fuel ~ stable

Against a back drop of a decade worth of 7%+ growth cost of living has remained relatively stable where according to numbeo data China’s cost of living index was 43.47 in 2009 and just 48.89 in 2015 still well below advanced developed Europe countries who are in the 90s and the United States which is in the mid-70s.

3. Increased housing costs ~ improving

In 2014 the Chinese government has cooled its effort to tighten lending and cool the housing market through a rate reduction on loans longer than five years by 40 basis points in November and 25 basis points in the following February. This explains the spike in real house prices in 2014 you can see below. However, since then the market has remained bearish where the latest tally by the Survey and Research Centre for China Household Finance of 28,000 households in 29 provinces indicated 22% of urban homes were vacant in 2013.

Generally, the interpretation is of the oversupply of housing and weak demand has been negative but for our purposes this is unequivocally good thing as it only makes housing more affordable for the urban working class.

4. Urban unemployment ~ stable

China’s economy job creation numbers remain strong such that rather incredibly there are more job offers than seekers.

Whilst unemployment number have stayed relatively stable.

There is much concern about the reliability of the data however.

5. Increased urban protests/meetings ~ improving

As you can see this is a definite uptick in strikes since 2011 although recently they have fallen dramatically in line with Xi Jin Ping’s recent crackdowns.

Of course it is worth noting that the crackdowns may have exactly the opposite effect, denying people a channel to express their views and led to a bubbling of dissent that may burst. This issue is worth watching very closely.

6. Worsening social mobility ~ worsening

Social mobility in China is very low where if one father earns 2x that of another than how much more on average will his children earn relative to the other father’s children (this is a calculation of the elasticity of inter-generational income) is 60%. This is in comparison to 47% in the US and just 15% in Denmark.

However, research from Yi Chen of Nanjing Audit University and Frank Cowell of the London School of Economics have found that since 2000 people at the bottom of society are more likely to stay there then in the 1990s ‘China has become more rigid.’

7. Culture ~ improving

Despite all the problems, China’s return to an elite place in global politics and the rise of Chinese both culturally with an increasing number of Chinese actors in Hollywood (e.g. Fan Bingbing) and the prominence of its business leaders, most notably Jack Ma of Alibaba. Jack Ma, the second richest man in China, has inspired an almost cult like following where he tours the country giving inspirational speeches saying that ‘if Jack Ma can be successful 90% of Chinese people can be successful.’ This could be dismissed as mere rhetoric but even the most cynical would have to admit that Jack Ma has succeeded against all the odds. For the young Chinese the most important thing is passing the gaokao (or university entrance exams) – Jack Ma failed three times. In China the ideal man is ‘Gao Fu Shuai’ (literally tall, rich and handsome) and the overwhelming profile of most romantic tv drama leads, is a cold, efficient Fu Er Dai (literally second-generation rich) or Guan Er Dai (son of a senior government official) who treats the poor, plain looking but positive female lead badly before slowly warming to her. The importance of a powerful father is especially true because of the importance of guanxi (or connections) in China. Jack Ma has succeeded (sensationally) despite none of these advantages which has only endeared him more to the Chinese people.

OR SOMETHING ELSE

Many of the indicators point to the fact that China requires drastic change. Interestingly though, according to a fascinating study by the Chinese Academy of Social Sciences found that there is a startling trend that young people in China are much less in favour of democracy than older generations.

Anecdotally, one of my teachers at Tsinghua University explained her indifference to the Government, ‘politics is like celebrities relationships, it’s got no impact on how I live my life.’ The best analogy I can come up with for a Western person to understand the Chinese mindsight is how for a European who the President of the United States is and which political party he belongs to actually has a significant impact on their lives but of course despite this no one in Europe is protesting for the right to vote in American elections. It is worth remembering of course that the combined populations of Europe and China is still several hundred million short of China’s which speaks to just how massive China really is and maybe explains the feeling that most Chinese people have which is of great distance and disconnect to government that most Europeans in states of just tens of millions can find it hard to relate to.

Finally, I think it is worth pointing out that post the Financial Crisis there has been more soul-searching in Western politics about the form and structure of government than in China.

And he [Lee Kuan Yew] was not only just thoughtful, just the very idea that he would take parts of the Western system and say ‘Oh this part is good, this part may not apply everywhere,’ this part he disagreed with. It was kind of bold because of course the Western system was succeeding, you know, basically all the rich countries in the world had followed the Western system, and so the idea that he thought he would do it slightly differently was a huge contribution. And so Singapore’s a city state, so you do things in terms of paying government salaries and excellence there that may not scale up but what he did was very incredible. What we really want is this mix of democracy and expertise and no country has that balance right. If you err on the side of democracy there are certain extreme thing about the wrong person getting in power and if you kick them out then how do you get new people? So a democracy they have some huge advantages that helped the US quite a bit. It is a little scary now when we have complex problems like how do you run a healthcare system efficiently. Why is the US paying so much? And there really isn’t at this time any elected representative who can have a good discussion about the dynamics of the system and why it’s different from other countries and how we might change that. So government has to deal with very complex issues and the Chinese government although I’d say the trend is a tiny bit away from it has had engineers and scientists in a lot of key positions and a willingness to look at what other countries do and also this notion that if you’re going to have a new policy you can often try it out in part of the country see if it works and tune the policy before you try to scale it up in a really broad way. So the Chinese government is a student of policy more than just a, say, the UK Parliament or the US Congress where people are kind of yelling at each other like ‘I’m right’, ‘No you’re right’ It’s not like ‘oh we’re going to do an experiment.’ I’ve never sat in the US Congress and had them say ‘Oh let’s try yours out in one state and we’ll try out mine and we’ll come together and let’s combine the best features.’ That’s not a typical electoral dialogue that we’re having right now. So it’s a work in progress. There are things like how you run your universities where the US model – you know other people should just adopt it. Then there’s things like health systems and governance where they should take some aspects that try out variation. So we get the benefit of 192 countries slightly different experience including at the sub-national level.’ Bill Gates

‘We have a very strong government and they have very strong execution capabilities when it comes to infrastructure, like high-speed rail or highways. We have massive constructions and now is probably the largest infrastructure in terms of transportation in the world. But when you have a strong government are you concerned about innovation?’ Robin Li, Baidu

‘…in terms of things like, how do you make energy the state policy’s not holding back somebody figuring out some big invention. In fact, I have a nuclear power company called Terra Power. That really, China’s the most natural partner for us with the breakthrough generation of nuclear. Because China’s a lot like the United States was in the 1960s, where the idea you want to go forward and do new things, it’s very clear. The idea that the status quo isn’t where you want to be. The US today is very careful that they were pretty happy with the current conditions, so if somebody wants to build a new building or take some new approach, there’s a lot of ‘Hmm, maybe no.’ There’s like five levels you go through, maybe no, maybe no. Whereas the bias towards moving and doing new things which has a small downside but a huge upside as well. I’d say in terms of breakthroughs in some areas, like nuclear, it’s more likely to come out of China than almost any other place because of this bias towards doing big projects. And 1950s, 1960s that was the US and the 70s it started to be Japan. Korea took on that role, that big engineering bias is great for the world.’ Bill Gates

‘It’s a very interesting problem, that our founders coped with which is just how democratic you wanted the system… I don’t think it is a pure democracy… I took political science… and everybody teaches the more people that vote the better systems will work and having a contrarian streak I am not so damn sure! That the civilization doesn’t work better when a lot of people don’t vote.’ Charlie Munger

‘I think the biggest blow to our relationships is the Chinese interpretation of the financial crisis. That we did not look at political matters in an identical way that was apparent after years of the relationship. And they sort of understood that this was the case but they did think that we had a magic formula for economic progress from which they could learn. (And they had in fact with Deng Xiao Ping). That’s right and basically when Deng Xiao Ping said reform which was his basic slogan he really meant learn from the Americans. And he sent tens of thousands of students abroad. And it suddenly turns out that the American financial model that they had really tried to copy in some respects started disintegrating in some of its assumptions and that has not only made them lose confidence that we knew what we were doing but those people inside the Chinese system who leaned towards the United States had a lot of explaining to do. And we still suffer from it, I saw some Chinese commentary on the Chinese 5 year plan, and I don’t pretend to be an economist but that commentary said ‘Don’t let the Americans seeming recovery fool you because the West is trying to solve the current Economic crisis by exactly the same methods that got them into the crisis. Although I’m not saying that they’re right there is some merit in it.’ Henry Kissinger

CONCLUSION

This piece represents my first serious attempt to flesh out my ‘Frodo Risk’ approach to systematic risks with respect to a specific problem. It is truly unbelievable the extent to which financial market participants are overwhelmed with information and having now seen it up front I’m starting to understand why even the smartest people can fold under the sheer weight of information overload. What I hope this approach represents is a structured filter for monitoring information about long-term threats/risks. Any one of the news stories above e.g. a 5% decrease in business confidence taken in isolation would justifiably be considered insignificant but if that 5% decrease coincided with all the other potential revolutionary factors moving in the same negative direction it might speak to a much larger truth.

Most market participants have a short-term focus of, at most, just a couple of years but having reports like this around specific systemic threats might be a useful and time efficient way to keep an eye on these long-build ups so that situations like in Greece and the housing market in the United States don’t come as such a surprise.

Feedback on the report and structure is, as always, most welcome especially as in writing this I have wrestled with how much information should be included. Should it be primarily links to other peoples research and datasets with just one sentence summaries or should the report (if it’s only going to be read once a quarter/half year say) be more comprehensive?