The people who are supposed to be experts about the economy are often wrong. Here's why, and a trick to avoid making the same mistakes.
In investing there is sometimes talk of “first-level thinking”. The idea comes from Keynes’ beauty contest where Keynes says people who are tasked with predicting the winner of a beauty contest should not pick the person they themselves consider the most beautiful but rather the person they think others will think is the most beautiful. That is an example of first and second level thinking, i.e. thinking of primary and secondary effects. The concept is useful in investing as the price of a security is set by the market – which is analogous to the judges in the beauty contest – and if you are able to predict what the market will think about something you can make investments based on what you think the market will think about an underlying company rather than just the facts in front of you.
First, second, and nth level thinking is useful in plenty of other fields too of course, but today I want to discuss how the lack of second-level thinking often misinforms about the economy. Like any system made up by humans the economy is a reactive system. The level of reactivity depends on how regulated the market is, roughly on a scale from a Soviet economy on the more rigid end of the spectrum to an American-style liberal market economy on the flexible end of the spectrum. What I think often trips up forecasters, economists, and journalists reporting on the economy is the focus on first-level thinking, and neglecting the reactivity inherent to human-led systems.
For a practical example, consider the Russian economy after the extensive Western sanctions were implemented. There were scores of people claiming that the sanctions would inevitably lead to economic disaster for Russia with annual decreases in GDP in double digits. The reality has been that the effects have been rather small, and that Russia’s economy has been growing quickly recently. How come? Well, as mentioned the economy adapts. If the economy didn’t adapt I’m sure the experts would have been right, but people don’t blindly accept having a 30% decrease in their standard of living and a technological regression of 15 years overnight. They adapt and find new ways to do things, and when things which used to be imported are no longer sold they try to produce them domestically instead.
As discussed in a previous blog post necessity is the mother of invention, and an external shock creates a lot of new needs. By focusing on the present difficulties the future opportunities are missed. Another economic story which often gets misunderstood due to unimaginative first-level thinking is that of China’s shrinking population. More people die than are born in China so the population is both ageing and declining and the conventional story is that this is a recipe for disaster for China’s economy. In reality, I think this will prove to be one of the best things which could have happened to China.
China’s growth model has relied on cheap labour. Essentially China has been able to get capital and technologies from abroad to produce things in China because doing so was cheaper in China than where the companies which had the capital and tech were based. China was therefore able to build a giant industrial economy which lifted millions out of poverty and made it the biggest, but not richest economy in the world. The story is a familiar one and has often played out in a way which leaves the industrialising country in what is known as the ‘middle-income trap’. If you rely on cheap workforce to drive economic growth you will be able to build an export-oriented economy, but you will struggle to build an economy that consumes enough of what it produces to be stable in times when your trading partners are facing headwinds. China is currently in this trap where it is cheap to produce there due to the low wages paid to most workers, but those same low wages makes it consume less than the market needs, and if it were to artificially raise wage by for example setting a high minimum wage in order to boost consumption it would simultaneously hamper production by making it more expensive to produce things in China. A decreasing population might have very similar effects, but being a slow process gives more time to adapt than a change in laws.
The first-level takeaway from China’s shrinking population is that it can’t continue its current economic model when it can no longer have a very large and cheap work force. But the second-level takeaway from the same issue is that China’s current economic model is keeping it in the middle-income trap. By slowly and steadily decreasing the number of hours worked China will be forced to become more efficient per hour worked so as to avoid having to become poorer, and what China needs to escape the middle income-trap is to become more efficient.
Economies like the US, Japan, and Europe are rich because of much they produce per worker rather than because of how many workers they have; otherwise China and India would be more than ten times richer than say Germany. Being forced to face hardships which make efficiency more important than raw number of workers is exactly what China needs.
There are many more examples of this dynamic where the experts are fretting over a terrible risk to the economy which turns out to be far less dramatic than foretold like Brexit, oil shocks, stark immigration restrictions, and trade wars. The key to intelligently understanding and predicting what the economy will do, and what an external shock would do to the economy is to think of the second-order effects. So the next time you hear a gloomy prediction for the economy think of what the logical response to that event would be and mean instead of what the event itself would mean and you’ll be more prepared.
If you liked this post you can read a previous post about Trump here or the rest of my writings here. It'd mean a lot to me if you recommended the blog to a friend or coworker. Come back next Monday for a new post!
I've always been interested in politics, economics, and the interplay between. The blog is a place for me to explore different ideas and concepts relating to economics or politics, be that national or international. The goal for the blog is to make you think; to provide new perspectives.
Written by Karl Johansson
Cover photo by Leeloo The First from Pexels, edited by Karl Johansson