November 16, 2013

Watermelons, more watermelons

If we could plot "global anxiety over the end of times" (the end of human times, that is) on a time series graph, I would say that now we would be at --or close to-- an all-time high. Typhoon Yolanda's epic size and strength is indeed a reminder of how insignificant we are, which definitely does not help to calm that feeling of impending doom.

End-of-the-world anxiety takes different forms. Economically speaking, the specter deflation is one of them. The New Normal, or the idea that we have reached a point from whence we will never achieve the growth rates of yesteryear is another. This idea, defined as a statistical regime change, can also be described as an inflection point, or the point at which the speed of growth decelerates going forward. In other words, the point at which the second derivative of GDP turns negative.

The New Normal: The second derivative
(the slope's rate of change)
turns negative at L1
The reason this inflection point occurs is very intuitive. I remember vividly when my Introduction to Microeconomics professor back in the 90's made her case to explain this quirk in the graph: "Imagine you have a piece of land of 1 hectare dedicated to watermelons," she said in her annoying Fran Drescher voice, "the production growth of that land will increase very rapidly as you add the first farm workers, but it will increase less rapidly as you add more and more workers, to the point of saturation. Then, production will actually decrease," she said, drawing an impossibly large amount of stick figures inside the most irregular square that could pass for a piece of arable land on the blackboard. She was talking about the marginal product of labor and how it peaks (at L1 in the graph above) and then becomes negative (at L3).

Source: Wikipedia
At its most basic level, complex (civilized) human life on this planet can be defined as our quest to extract production from our one primordial resource (earth) to satisfy our immediate consumption needs. If we take the inverse of the marginal product mentioned above, then we are really talking about the amount of effort (labor) required to produce one additional unit --or marginal cost. The fact that each watermelon produced costs increasingly more is simply a consequence of using a real life, decaying natural resource (land).

We are nothing more than a very big group of farm workers exploiting a naturally decaying, finite piece of arable land. Luckily for us, several iterations of disruptive technology have allowed us to squeeze more watermelons out of our piece of land every time we've reached a saturation point in the past. But somehow, this time seems different. The generation currently graduating from college is being forced to put in more effort in exchange for the same (and sometimes, worse) entry-level jobs than earlier generations. Attaining the same standard of living as generations past is getting harder and harder for millenials around the world--narcissistic inclinations aside. This situation has unleashed an educational arms race, driving college students to accumulate staggering amounts of student loans with the hopes to gain a better life.

Source: Charles Hugh Smith

Source: Own calculations
Looking at this data in the same way as the marginal cost graph shown above, you see that each additional unit of production (measured as nominal GDP) takes an exponentially bigger amount of student debt to achieve. In other words, the piece of "arable land" that the US is using to produce its GDP is clearly becoming saturated, requiring more and more effort (money) to produce every additional unit of GDP. The millenial farm worker is definitely finding it more and more difficult to squeeze that extra watermelon out of an increasingly less fertile ground.

No wonder doom and gloom pervades. Maybe this saturation is the reason behind the economic paradox that turns population growth downwards precisely when you'd expect the opposite. Maybe this is the mystical inter-generational, self-correcting mechanism that keeps us in check. What is clear, is that the model of growth is becoming exhausted, and somehow we are in the middle of a transition period in which we will either redefine our conception of "prosperity" --a postulate that scares many people-- or find the next technology iteration that will deliver the next round of watermelons --until that round becomes consumed, starting the whole thing again.

I just hope it's not too late by then.

October 28, 2013

The Ranting Vulnerability

It seems these days that the United States is not living its best days as the world's sole hegemonic superpower. From the way the Syrian crisis has been dealt with, to the way the drone wars have changed the meaning of military conflict, to the embarrassing release of formerly secret espionage programs that force the president to apologize to foreign leaders. The reputation of the U.S. seems to be taking beating after beating.

Yet, despite all this, the role of the U.S. in the world is idealized by many in the U.S. as the paragon of collective virtue and liberty. American Exceptionalism still thrives. The society of the rule of law --the Land of The Free. Outside the U.S., humankind yearns for a leader. A nation to look up to for guidance and hope --a preserver or global stability.

The decades that followed the fall of the USSR have given way to the concoction of multiple purported superpowers that could, like Ivan Drago to our beloved Rocky, crush the U.S. as the sole hegemonic power over the world. The Chinese, with their meteoric economic rise during those decades, have been billed as the much-dreaded cut-throat competitor that will steal the U.S.'s baton.

The problem with this idea is that the Chinese are not really that obsessed with overcoming the U.S. as the world's superpower. They are preoccupied by other things. They seem to react more passionately to local geopolitical matters, are amusingly eager to emulate others in a distasteful effort to fit in, and are frankly much more preoccupied with a potential social uprising arising from their monumentally crushing pollution problems (or from their ruthless, medieval-like justice system). Of course, it is a healthy thing to feel threatened if you are number 1. In fact, the paranoia of losing your No.1 badge might actually be a good thing --if only it encourages you to try harder to be the best you can be.

The political blunders listed at the beginning of this piece do not threaten to plunge the world into disarray, notwithstanding how damaging they might seem for the reputation of the U.S. abroad. But when you witness the inexplicably irresponsible negotiating tactics of U.S. politicians to obtain concessions in their domestically-defined political agenda, you know that the political class does not conceive the U.S. as an hegemonic superpower whose potential default could sink the entire global economy into chaos and depression. When the political class does this, they are definitely not playing the "I am the leader of the world" part.

The fact that the U.S. dollar is the world's reserve currency is a serious matter. It means that the entire world's economic stability rests on the stability of a single currency that is supposed to be guarded by a stable political class --and equally important, a stable economy. There is a reason the Venezuelan bolivar is not the world's reserve currency, and that is because the world does not want to save their exporting proceeds in a currency whose value depends on a political leadership that could renege on its debt on a ranting whim. The U.S. politicians' dumbfounding perception that somehow, in their twisted, bizarro world, defaulting on the U.S. sovereign debt is not really that big a deal makes you question the stability of the world's reserve currency, and that is something that should make us shudder.

The financial world has a major flaw. Its fate overwhelmingly depends on the fate of its leader, exposing everyone to Dragon Kings. When a system is so dominated by a single entity, the weaknesses of the dominating entity become the weaknesses of the entire system, creating the risk of systemic failures every time the leading entity becomes unstable. Unfortunately, our dominating entity is bound to relive the political spasms we just witnessed with the debt ceiling negotiation. The parties have the incentives to repeat it again in February, and we'll be biting our nails again, hoping that they'll get an agreement at the last minute then.

The global markets can't function when what is supposed to be the safest asset in the world suddenly behaves like third-world debt. The consequences of the loss of confidence in the world's reserve currency cannot be overstated. The global financial system is showing structural cracks, and the most worrisome thing is that it seems we are one political rant away from catastrophe.

June 28, 2013

The Beginning of the End of Financial Totalitarianism?

The king of Qatar recently resigned from his post. According to the people with knowledge of the politics of the region, his health was in a very weak state, rendering the effectiveness of his actions meager. He declined in favor of his 33 year old son, who according to people in touch with the politics of the region has a very pro-western stance. Much like the abdication of the Qatari royal, the markets recently witnessed the initial steps leading up to the abdication of our monetary dictator. His actions were increasingly perceived as ineffective. Each decree carried less and less weight.

After our MIT-trained monetary autocrat came out with the latest decree --that the Fed will very likely begin to withdraw the cash injections into the economy-- the markets reacted, although not exactly in the way our beloved leader wished. The old status quo, whereby the movements in the financial world were a direct consequence of the latest ruling of the monetary dictator, was shattered. A new normal, one in which the fundamentals of supply and demand matter more in determining what has value and what does not has begun. It is a foreign feeling, really, to be forced to having to rely on such arcane skills such as fundamental analysis to be able to decide what to do with your money.

Of course this is not a binary world. The regime change from autocracy to democracy (or in the case of free markets, to the rule of supply and demand) does happen overnight. Just ask the Libyans. Kaddafi's departure marked the beginning of a convulsion-ridden, unstable stage in Libyia's search for an institutionalized democratic government. It is always better to hand over power peacefully, Qatari style. Like Bernanke, Sheik Hamad Bin Khalifa Al Thani saw that his powers where waning and declined in favor to his son, knowing that this was the smart thing to do. Clinging to power would have just exacerbated the fact that his actions were becoming less and less important. The decision to choose Sheik Tamim bin Hamad Al Thani --a westernized, pro-American royal-- as the new guy in charge of Qatar, has somewhat pleased the international community. But the most important thing is that the handover has been smooth.

Like Qatar's smooth transition, our monetary dictatorship succession is also in process. The absence of the current dictator in one of the most important monetary policy conferences (the Jackson Hole summit) was a delicately crafted signal of the disengagement of our autocrat. The hints given by president Obama confirmed the clear intention of our beloved monetary commander in chief to hand over the baton very soon. The likeliest successor? Janet Yellen, a revolutionary comrade with a proven pedigree, resolute steadfastness and the true traits of a leader. How revolutionary you may ask? Perhaps this anecdote (taken from the WSJ) might shed some light:
During the mid-1990s, then-Fed chairman Alan Greenspan asked her to take the lead in an internal Fed debate about whether to adopt a formal inflation target. Her preparation impressed others. "She does her homework," said Mr. Broaddus, her chief adversary in the debate.

During the discussion Ms. Yellen challenged Mr. Greenspan, who was rarely confronted, to define his views of price stability, according to Fed transcripts and people there. Later, as the economy strengthened, she worried about the booming stock market and also urged Mr. Greenspan to raise short-term interest rates to head off inflation—advice he declined, according to Mr. Meyer, her colleague at the time.
The question of what is the revolutionary style of Doctor Yellen is beyond the point. What is important here  is that the succession is in full gear and that there is so far evidence it will be smooth. Like Qatar's monarchy, it seems our monetary dictator will be removed without market coup, and that, is pretty good news.