Macro Themes for 2013 (part I)

1. Man vs. Machine
• Productivity gains will outstrip pace of consumption – technology such as automation, robotics and 3D printing will destroy jobs faster than it create jobs
• Up to 50 million current jobs could be automated in the future (and thus destroyed)
• How many jobs will be created through this automation? The answer is however many AI programmers you need (probably far less than 50 million)
• Firm's labor demand will be for a few skilled workers rather than many unskilled workers
• Hiring - firms are spending on capex instead of hiring; 75% of US manufacturing firms already employ <20 workers
2. US Manufacturing Renaissance
• Localization, or Anti-Globalization
• Production is being re-shored to be closer to the huge US consumer market and take advantage of local logistics
• EM (emerging market) are becoming less competitive
• EM currencies are appreciating such as CNY (Chinese Yuan)
• China could enter the "middle income trap"
• Overseas transportation are too high due to energy prices, incentivizing firms to repatriate
• Underinvestment and low capex spending in US means pent-up demand
• Theme 1 - automation and robotics override low labor costs
3. US Energy Boom
• EIA forecasts
• US will become energy independent by 2020
• Largest natural gas producer by 2015, surpassing Russia
• Oil output poised to surpass Saudi Arabia’s by 2019
• Consumption - 87% will be from domestic sources of energy by 2020, up from 79% today 
• Imports - 13% of consumption by 2020, will be primarily supplied by Canada & Mexico, increasing from 36% of imports today to 62% by 2020.
• Competitiveness
• EU suffers from expensive gas contracts with Russia
• Latam has moved plants to US due to low natural gas and electricity prices
• Electricity - prices are 50% cheaper in the US than in Europe
• Roughly 30% of US electricity is generated by burning cheap domestic natural gas
4. DM (Developed Markets) Aging Demographics
• Population - baby boomers outnumber millenials due to decreasing fertility rates
• Labor - baby boomers are retiring later due to recession, crowding out young from workforce
• Gov't debt - millenials inherit high gov't debt caused by spending on entitlements towards baby boomers
• Other - high student debt, tight credit, skills mismatch, high job turnover
• "Peter Pan" generation - millenials reliant on parents, delay adulthood, live at home
5. DM Big Gov't Socialism
• Political sentiment will lean towards fairness and equality
• Theme 1 - high unemployment and inequality will be balanced by redistribution through increased taxes and spending
• Theme 4 - baby boomers dominate gov't and are biased towards increasing gov't healthcare, pensions, social security, etc.
6. DM Central Bank Printing
• Currencies - race to the bottom means depreciation
• Inflation - will stay low due to tight lending and low velocity
• Financial repression - captive investors ensure low rates
7. "Peak Car"
• Urbanization, high fuel prices, increasing youth insurance premiums
• Car-sharing schemes - 1 rental equals 15 owned cars; e.g. 700k Zipcar members share only 9k cars
• Theme 4 - tight credit depresses auto-ownership

Rules

I'm a big fan of rule-based policy over discretion-based policy. This is especially important in areas which 1) inherently have a lot of uncertainty and 2) affect lots of people, such as fiscal, monetary, and regulatory policy.

Rules are a predetermined, objective and comprehensive set of responses to changes in inputs (e.g. changes in economic conditions). You should think of rules as computer-implementable replacements for human policymakers. This has advantages in reducing uncertainty, encouraging transparency to the public, enforcing government discipline, being resistant to time inconsistent behavior and providing optimal economic policy.

Rational Expectations vs. Uncertainty

One of the most important foundations of modern economics is that individual agents (me, you, workers, corporations, etc.) are rational and will discount future expectations. Thus, one of the most important channels in which government policy acts is through expectations management. If you expect interest rates to go up in the future, you will borrow more now. If you expect taxes to go down, you will defer consumption for later. And so on.

Uncertainty about future policy prevents these channels from working correctly. After all, in order to discount future expectations, you need to know what policy will look like in the future. Uncertainty, at best, undermines the public's confidence in politicians and at worst, can cause or deepen a recession (e.g. by essentially freezing consumers and producers in place). Furthermore, when a fundamental assumption of modern economics, rational expectations, is no longer true, most economic theories fall apart.

The advantage of rules is that it eliminates uncertainty. Furthermore, simply by doing this, it makes policy more effective, thus necessitating less drastic policy changes, making the policy path smoother and less volatile (no artificially induced fiscal cliffs here). Furthermore, rational expectations will be more applicable to the real world.

Monetary Policy

Monetary policy refers to the central bank's actions of controlling the money supply, usually through targeting interest rates. Expansionary monetary policy refers to increasing money supply and lower interest rates, which leads to higher levels of economic growth at the cost of higher inflation. Contractionary policy refers to decreasing money supply and higher interest rates, which lead to lower economic growth with lower inflation (or deflation, negative inflation).

Currently, how monetary policy works is that Chairman Bernanke calls a closed-door meeting with the rest of the Federal Reserve Board of Governors. After the meeting, they issue a short one page press release immediately. Three weeks later, they release the more in-depth minutes. Scores of private economists and consultancies make their business forecasting Fed policy through official and unofficial statements by Fed officials. Even minor word changes between successive press releases, such as from "growth in business fixed investment appears to have slowed" and "growth in business fixed investment has slowed" are analyzed and interpreted.

In contrast, the Taylor rule replaces a discretionary interest rate regime with a simple three-variable equation (inflation, real rates, and GDP). In a Taylor rule regime, a computer collects data for the inputs, plugs it in, calculates the equation output, which is set as the new interest rate. The parameters and data are publicly available, so the people can easily follow along in real-time.

Nobel Prize-winner Milton Friedman also had an even simpler rule: you simply grow the money supply at k percent. If a rule is too complicated or has too many parameters, that just replaces the original source of uncertainty for new ones. Friedman understood this well with his simple k-percent rule.

Rules are especially applicable to monetary policy since the Fed is constantly playing a game of "expectations management" with the public. If you ever read Fed minutes or listen to Fed statements, you will know how often they emphasize maintaining credibility. This is how it works: monetary policy is credible because people believe it works because people believe monetary policy is credible because monetary works because...

The moment that the public stops believing in the Fed's promise to maintain its commitment to price stability is the moment that prices become unstable. Bernanke's claim that he will keep rates low until 2015 is not credible, simply because he will leave office in 2014. However, if a computer program were Chairman instead, its forecasts of its future actions would be credible (provided someone locked the computer and threw the password away to prevent tampering), because the public would know exactly what the computer program is likely do, since its programming would be transparent and open to the public. 

The main problem is that it's difficult to say what is the best rule. Should we follow Taylor or Friedman? Evan's rule? NGDP target? Or something completely different?

Fiscal Policy

Fiscal policy refers to government spending and (tax) revenue collection. Expansionary fiscal policy refers to increasing spending and/or decreasing taxes, which creates deficits, runs up debt and boost the economy. Contractionary policy refers to decreasing spending and/or increasing taxes, which creates surpluses, decreases debt and slows down the economy.

Deficits aren't bad in and of themselves, if they are balanced by surpluses in other years. Unfortunately, governments tend to have a bias towards deficits. One reason is that politicians like to boost the economy in order to ensure re-election. Another reason is because deficit spending is a transfer of wealth from young generations to old generations, and politicians tend to belong to the latter.

One way to think of debt is your present-self borrowing from your future-self. It might seem that your creditor is your direct lender (bondholder, credit card companies, mortgage banks, etc.). However, they are merely middlemen between your present-self and your present-self's ultimate creditor, your future-self. In developed nations, older demographics tend to see most of the immediate payoff of government spending (social security, medicare, etc.) and furthermore, they will unlikely be around when debts need to be paid off.

Thus, deficit spending is a transfer of wealth from the future (young) to the present (old). Older generations tend to be more politically established than younger generations (the average age of a US congressmen is around sixty). Of course, none of this is a problem when economies are developing and there are much more young than old (as in the leftmost pyramid). However, what happens when an economy stops being youthful (as in the rightmost pyramid)?

Fiscal rules can be thought of limits on either the spending side and/or the tax side. Some types of rules that you may already know about are 1) balanced budget amendments and 2) debt ceilings.

A balanced budget amendment would require non-negative deficits in every year. The problem with this type of policy is that it's inflexible and inherently pro-cyclical. Since in recessions, real incomes fall, tax revenues fall, which necessitates an increase in the tax rate in order to maintain tax revenues. Ideally, a rule should be counter-cyclical.

You may already be familiar with the US debt ceiling debacle of Summer 2011. The problems with this type of rule are that there has been no real consequences for missing it (not for the better part of the past century at least), and as a result, the debt ceiling has been raised 74 times. This is the equivalent of setting a clock alarm in order not to be late for work, but upon waking, hitting the snooze button about a dozen times. If your clock didn't have a snooze button, you wouldn't be so ready to fall back to sleep upon hearing the alarm go off. Ironically, the very existence of a snooze button decreases your willingness and ability to rise in the morning. Thus, in addition to being counter-cyclical, the ideal rule needs to be credible and thus, difficult to change.

Unfortunately, most of these rules are determined on an aggregate top-down level, and thus, have no meaning to individual lawmakers. Instead, spending increases and cuts can be (and frequently are) decided bill by bill. A lawmaker's immediate interests lie not in meeting some high-level target, but rather, in ensuring he gains federal funding for his pet projects. Thus, rules should instead target individual legislation rather than annual aggregates.

For example, one favorite idea of mine is that legislation needs to come in pairs: spending bills must be accompanied with revenue (tax, etc) bills. The exact proportion doesn't have to be dollar for dollar. In fact, you could have an independent board target the spending:revenue ratio, somewhat like a fiscal Fed. For example, a Keynesian board would dictate a spending:revenue ratio >1 during economic slowdowns and a ratio <1 during economic booms, in true counter-cyclical style.

Algo-Government

While the prospect of electing computers to presidential office may never come, there are places for strict but transparent algorithms in government. This reduces uncertainty about government policy, allowing rational expectations to work and making purchasing and investment decisions easier for both consumers and producers. As political gridlock is unlikely to go away for the foreseeable future, continuing uncertainty over fiscal issues (such as the fiscal cliff) and monetary policy (such as the end of Bernanke's term in 2014) shows that discretionary policy is mainly just terrible policy.

Automation and Labor

FT Alphaville recently had a thought experiment on how things would have gone if "the US, rather than taking advantage of cheap labour in China, had kept things at home and heavily invested in automation".

This is one of my favorite themes: the rise of automation in manufacturing and its effects on the global economic balances. Recently, over the past year or so, multiple research publications and journals (such as the FT, The Economist, GS, BofA, BCG, Gavekal, ISI) have featured this supposed inevitable renaissance as robotics and 3D printing revitalize manufacturing in the US.

It's an exciting and sexy theme I will probably cover in greater detail in the future. Today, however, I am interested in very specific component: labor.

Luddites

Low-cost production techniques could soon become so advanced and so low cost — thanks to developments like 3D printing — that even the tiniest salaries in Africa will not make it worthwhile to employ human beings at all.

In the 1800's, the Luddites were a group of disgruntled skilled weavers who displayed their discontent by destroying the automated looms that made it possible to hire unskilled (and cheaper) labor in their place. Of course, in hindsight, these productivity-enhancing machines were a good thing: it freed up future generations of educated men and women towards more interesting work, e.g. as innovators of new industries. In other words, would-be weavers became engineers, inventors, thinkers, etc. instead.

Are we falling prey to this Luddite fallacy today? It's clear that on its own, automation cannot be said to be a job-killer. Generally, as the prices of goods fall with the productivity gain made possible by automation, demand for goods increases, which results in increasing demand for labor. This gives us more employment, rather than less.

However, the current round of automation (the third industrial revolution, as The Economist likes to put it) is potentially different.

source:

This is unlike the job destruction and creation that has taken place continuously since the beginning of the Industrial Revolution, as machines gradually replaced the muscle-power of human labourers and horses. Today, automation is having an impact not just on routine work, but on cognitive and even creative tasks as well. A tipping point seems to have been reached, at which AI-based automation threatens to supplant the brain-power of large swathes of middle-income employees.

In previous industrial revolutions, machines replaced our "hardware", that is, our bodies and our physical labor (bad analogy, but let's roll with it). This was fine, because as long as our ideas added value and machines couldn't automate our thought processes, we could remain employed in an intellectual capacity. However, machines are now able to simulate many of our thought processes - and not just the purely computational ones - with the industrial implementation of artificial intelligence and machine learning techniques. Machines are now replacing our "software", that is, our minds and our intellectual labor.

Modern Luddites like to point at today's unprecedented levels of long term unemployment as evidence for this. However, if this were true, why is there continuing high demand for skilled workers?

source:

Nearly 60 percent of survey participants expect to increase their workforce (compared to 50 percent in the fall), but finding qualified workers to fill open positions continues to be a concern for the industry – an unusual dichotomy, given that national unemployment rate remains high," said Kurek. "The need for a skilled workforce could be one of the greatest impediments to growth for U.S. manufacturers and distributors, and makes it difficult to compete in the global market."

source: 

For many manufacturers, finding the best people to fill these new positions is far from assured. Respondents to ThomasNet.com's IMB lament the skilled labor shortage, and are vocal about what needs to be done to fill the gap. One noted that we need to "improve the attitude within the U.S. regarding the desirability of manufacturing for the next generation." And many respondents want to see education reform with the aim of giving America's youth the skills needed to join the manufacturing workforce.

Usually, automation draws labor demand away from the high-skilled towards the low-skilled. So what is going on here?

Perhaps it's simply a matter of perspective.

Skills and Training

In the long term, it may be true that we are on the cusp of a post-scarcity world of maximal leisure and obsolete labor thanks to the ever increasing intelligence of machines. In the short term, however, human intellectual capital is very much in demand.

[In the 1990s] the US went for massive outsourcing. However, Germany and Northern Europe in general went for automation. The reason why the latter region went for automation is that they were already fighting high labour costs as early as 1980, so they already were well on the path to automation.

At least in Northern Europe, the big automation revolution that we saw starting around 1980 seems to be coming to an end. The reason is the full exhaustion of engineers/skilled technical workers.

This is why some have proposed working hour limits, e.g. instead of a few investment bankers working 100 hour weeks, twice as many bankers working 50 hour weeks are hired. Of course, the policy's track record isn't that great (consider France's 35 hour/week limit and look at their economy) and furthermore, it falls victim to the lump of labor fallacy. However, this perhaps helps us in understanding the liberal's curious characterization of an ambitious overachiever taking excessive overtime for himself as somehow "greedy" due to his theft of his fellow man's labor hours. Compare with a conservative's view that all hard work is deserved and efficiently allocated to those who are most deserving.

However, considering the theory that we are on the cusp of a post-scarcity world, perhaps the liberal is right.

We live in a world were there is too much work for highly educated workers and not enough work for low educated ones. This at a time of general decline in education standards as demonstrated by many PISA studies. The forces of the market would have it that wages of the educated will rise and wages of the non-educated will fall.

This is why we need cheap, effective and widely available STEM (science, tech, engineering, mathematics) training (and retraining) opportunities in the US. This is both for new entrants to the labor force as well as for existing workers who have been displaced. A "liberal arts" education may be more intellectually pure, but for the majority of the population, it's simply irresponsible. The German education system, which emphasizes vocational schools alongside industry apprenticeships, is a good model (already these are starting to pop up in the US). This would also serve to help students avoid taking on excessive student debt as costs are lower than traditional research universities, and full time offers are often made by the employer to their apprentices upon graduation. Businesses would also be more willing to hire new graduates (as opposed to experienced hires) as job-specific training has already been completed (avoiding expensive on-the-job training programs as in the US).

However, the fundamental problem remains that the exponential pace of technological progress may simply be too fast for the skills mismatch gap to close. This is why I am optimistic about online education opportunities such as Udacity, Coursera, Codecademy, iTunes U, which meet many of the above requirements for good STEM training: cheap (it's free), effective (taught by professors, some of whom are at Ivy League universities) and widely available (anyone with internet). Recently, Udacity announced that they will offering certification exams in Pearson testing centers in conjunction with their job placement program. Unlike inflexible bureaucratic universities, online education is subject to the free markets: courses are offered in the subjects where the demand is, course demand goes where the opportunities are. This should go a long way towards minimizing the skills mismatch gap.

Future

Demand for unskilled labor will disappear or at least be significantly diminished. Although AI, robotics and 3D printing may have the potential to completely eliminate labor as a factor of production, as some modern Luddites claim, in the short term, the modern day equivalents of machine-operators (programmers, engineers, technicians) will be in high (and probably increasing) demand.

As the ultra-low labor costs in emerging markets no longer matter, jobs may initially come back to the the developed world. However, this job reshoring may be limited in impact as the emerging markets will seek to rapidly catch up (look at the growth of India's IT talent), especially as knowledge becomes freer and more easily available (such as through online courses). Thus, the most sustainable way for developed markets to compete will probably be through superior education and training.