For the past month, I’ve been bouncing around Europe talking to a variety of people about primarily the Chinese economy but really about all about the global economy. In all the conversations I have had, there is one theme that comes through both implicitly and explicitly: people are scared because they do not understand what is going on throughout the global economy and everywhere they look are pockets of real risk. I had one very smart person works for a major asset manager look across the table and say to me: the problem is nobody knows what the _____ is going on right now. Many other people have expressed similar sentiments even if not quite so bluntly.
A lot of the markets are pricing in major adjustments even if there is little evidence that major dislocations are occurring. I want to differentiate here between a correction and a major dislocation or crisis. While it is undeniable that the global economy is in USD nominal terms contractionary, the sense of impending doom seems overblown. There are two important points here. First, major real economies are not strong by any means, but nor are they collapsing in free fall. Second, fear is a major driver of economic and financial events and the unknown is a major variable here that cannot be ignored.
Going off my usual topics, I want to ask in a very broad sense: what is happening to the global economy and by that I mean it in the broadest process oriented sense. I think there are factors and processes that we just do not understand at play here. Let me throw out some ideas but emphasize that these are just ideas that I have heard or seem to have some credence about a variety of factors. I’m not about to say they are all true or should be believed or are in any specific order but just to discuss ideas.
1.I am increasingly convinced there is an issue with the measurement of economic output, specifically with regards to economic output. This manifests itself in a couple of ways. First, quality (which is very hard to measure) and quantity (which is very easy to measure) are, I suspect, not being properly measured with regards to GDP. Let me give you a simple example. Assume there is a farmer who grows a vegetable, let us assume 100 units of lettuce or potatoes. I use agriculture because let’s also assume static output. Now let’s assume that the farmer plants a new variety of lettuce or potatoes that are maybe healthier for the consumer or don’t require any pesticide. For simplicity sake, let’s assume the farmer again produces 100 units and at the same price as before. Now the consumer is better off by consuming healthier food or requiring fewer inputs not to mention lower economic impact. Quantity, output is identical but quality has increased significantly. Though a distinction like this is typically cited for high tech products, I increasingly believe this to be true across a much wider variety of products. Second, historically, deflation has been the result of reduced money supply. Thinking simplistically, deflation has been thought of as driven by lower money supply or lower credit by tightening demand. Lower demand, lowers prices. However, I have become increasingly intrigued by the idea of supply side deflation, which central bankers are largely powerless to stop. While people frequently cite the Fed low interest rates as pushing down oil prices, this process strikes me as overly simplistic. With oil prices north of $100/barrel, it seems bankers would have signed on for most projects until interest rates were truly exorbitant. Interest rates even at 3% would likely have had little to no impact on the number of oil projects globally given their historical highs. This leads us to the supply focus on deflation. If we return to the example of the farmer, it seems in many cases that qualitative output productivity is going up more rapidly than we expect pushing down prices across a range of products and services. I was talking to a movie producer recently who was lamenting that in just a couple of years, animation work went from Los Angeles, to DMs looking to build animation industries, to emerging markets that can do high quality work. What used to take a team of animators now takes a couple people in India. Whether it is movie animation or rapid increases in organic non-GMO output, the growth in quality output is impacting prices. The reason that this matters is that we are using old tools to fight new problems and we likely aren’t even measuring the problems correctly.
2.One of the many assumptions made with increased prosperity is that as people grow increasingly prosperous, there will be an increasing diversity of products and services. What if this isn’t true though? The basic idea is that the more food people have, the greater variety of other products and services they will produce and consume. The more diversity of products and services, the more people will be employed in these new industries. However, what if there is some type of implicit limit on the heterogenous nature of products/services to absorb the decline in other employment? If you take a simple example of what I’m referring to, let’s assume there are two companies GM and Facebook. The decline in employment at GM is not made up for by the growth of Facebook and there is resulting mismatch in employment skills resulting in labor market pressure and wages. The only way this happens if there are numerous Facebooks to absorb the slack from lower employment at GM. What is the relationship between the implied growth of heterogeneity in products and services and employment with regards to the evolution away from more necessity products.
3.How many economic events are a result of increasingly perfect competition (and I don’t mean that as a bad thing)? It seems that everyday, we move closer to the economists idea of perfect competition. Trade has generally speaking never been freer, information for financial markets is nearly instantaneously distributed, capital markets are global, while large barriers to employment remain there is rapidly increasing internationalization even here, and various forms of trade reduce physical relocation. In short, global competition continues to increase, though yes this is not universal and there are areas where this is not true but the trend is clear. We can see this through significantly lower international income equality but higher internal income inequality. Virtually any consumer/producer/employee/capital is exposed to global price pressures. This has brought enormous benefits, but maybe that is also driving many of the processes that we do not understand with regards to prices. In essence, we may be in the middle of the great convergence of prices. I was recently in Thailand and after a local guide found out what I did for a living, he frustratedly noted that his business was down significantly and that Russians wouldn’t return until oil hit $80/barrel to strengthen the rouble increasing tourism. He gave another example of how the higher pound brought more Brits who could easily compare prices online with a higher pound. Perfect competition is impacting Thai tourism and movie production just to name a few. It is worth noting that the most rapidly rising incomes seem to accrue to those with some type of “monopoly” whether in industry, employment, or capital allocation. Increasingly perfect competition across borders impacting everything.
4.How much of current events are a redistribution of existing resources or remaking of existing resources? By that I mean, oil production used to be the Middle East was the dominant producer of oil. Now, while still significant, enough has been distributed throughout the world that they are effectively politically irrelevant. OPEC can’t even agree to a meeting. Between energy efficiency gains (*real*energy efficiency gains) in China and increased solar adaption at economical rates, it cannot be ruled out that China won’t need to build a coal generation plant or increase coal consumption ever again which has likely entered a long term decline. These are just a couple of examples where it seems very likely that we are in the middle of incredibly disruptive periods of economic production redistribution between what types of products are made and where they are made. We do not need or want the same basket of products and the products is being made by different people in different ways than before.
5.How much do structural factors impact the global economy and economies? Demographics not just within a country but across the world are enormously important but I think poorly understood. How much of a shock China had on the global economy for instance in areas like commodity consumption is well understood but what about other areas where it seems less well understood. I don’t think we understand the increased influence of China well on what is driving global economic events, and the same is true increasingly of India. These structural factors and shocks have been enormous and I would say generally, I think poorly understood even by myself. As one example, you have every major economy, let’s even include BRIC type economies, either in deflation or with extremely low inflation. Can anyone say we really understand what is driving this across such a diverse range of economies?
I am not claiming to have answers here but rather things I have heard from people or ideas that have struck me. One thing I can say, I think many very smart people are left grasping for answers, not really understanding what is going on the global economy right now.