Sunday, 29 November 2015

Why economists fail at foreign

One thing I've noticed about economic types over the past few years is that they really struggle to get their head around the interactions across the world. I've been trying to put my finger on why that is for a while now and I think I might have it. It's because they seem to be trained to operate from a single viewpoint. A single mental framework in which all the questions are asked and answered. And that mental framework is this.

Every analysis I've ever read from economic types seems to follows this mental model. It is always from the viewpoint of a particular country and the Rest of the World is abstracted to a single lump that is casually mentioned in passing. The lines are hard and rigid and follow the political boundaries of the country in question absolutely and without variation. The RoW is able to take action like a Deus Ex Machina without any effect on anywhere other than the Country in question.

It is precisely the same sort of mental trap as the 'government borrows' model. It leads to a particular type of behaviour, a particular set of analyses, and a particular set of conclusions - all incorrect.

So we end up with every country's financial system set up as though it was a net exporting nation, and loads of discussions about fixed exchange rate ideas as solutions to the issues this causes. It's like asking Lewis Hamilton to use dry tyres for a wet race and then the race engineer suggesting that the only solution to his predictable issues is that he slows down. Only to then to say he should have slowed down more when the car inevitably aquaplanes into the nearest crash barrier.

To get anywhere you have to shift viewpoint.
A currency zone world
Here the taegeuk represents the entire world and the colours each represent a different currency zone.  Currency zones consist of assets grouped by they primary denomination. The primary denomination is essentially the currency denomination in which the income/costs turns up. That's generally the same denomination as the primary capital value listing, but not always. Some assets have no primary denomination because they pay no income - Bitcoin for example. (Gold and other commodities tend to have an ongoing storage cost, and so effectively have negative income in a currency zone). 

So currency zones are conceptually separated by income flows and the stock of assets follows from that.

The dotted lines are the political boundaries of countries. The viewpoint is a view of a free capital floating currency world where the boundaries of countries are distinctly secondary - almost to the point of being irrelevant. You'll note that the currency zone division is by asset, not by entity. An entity can be in multiple currency zones and can have multiple physical domiciles with no necessary correlation between the two. 

Like all pictures it is a massive simplification of reality. Only three currency zones is unrealistic and there are unfortunate inverse relationships in the segment sizes (for example, red is the primary reserve currency in this model because the segment is the smallest. Chances are that segment is the most powerful country). 

The picture is akin to a mainstream economics - static, two dimensional and with no depth. So like mainstream economics use it only in toy situations where there is no risk of damage to real people. 

A more realistic visualisation would be dynamic, alive and moving.  The colours would shimmer and ripple as entities moved in and out of the zones - causing the zones to shrink and grow.  It would be multi-dimensional to represent the many more currencies and countries that there are. You would be able to zoom in and out and twirl the model around you. And it would have agents in there so you can understand how their motivations feedback into the aggregate and then back into altering their motivations.

But even the toy is useful in the way that it changes your thinking. For example
  • It's pretty clear that every entity in every country has the choice of ordering their goods and services from any of the countries and therefore has a choice of competitive supplier.
  • If a supplier chooses not to accept a particular colour of currency, then it has to have alternatives orders in one of the other colours or the supplier's sales shrink - and so does the world economy (the diameter of the taegeuk)
  • Growth in exports overall grows with world income (as the taegeuk increases in diameter), so if you're planning on growing faster than that then you're beggaring a neighbour somewhere.  
  • The whole focus on 'balance of payments' goes away because you're focussed upon assets and income flows, not the physical location of entities within rigid borders. In any case for anybody to have a deficit there has to be a surplus somewhere. It's all automatically balanced under the 'fair exchange is no robbery' principle. The surplus and the deficit arise at the same time and if they don't then neither can exist - as the transaction would simply fail due to lack of the right sort of money somewhere along the chain.  Attempts to reduce surpluses or deficits cause damaging feedback effects on all sides that will be resisted by the entities involved - particularly if there are economic policies in place. 
Just by linking the countries and the currencies in a simple mutual feedback model and by switching the viewpoint to a world view rather than a country view you get greater insight into what is going on.

So the next time you hear bizarrely one-sided ideas about how economic areas interact,  you'll know why.

They are just looking for a RoW.