The Green Gap


Wednesday, 20 February 2013

Predicting Future Economic Behaviour: The Price of Food Will Rise

Pretty lame, isn’t it? I mean, pretty much everyone knows that the price of food is already rising. It’s really quite a do-nothing hypothesis when you think about it. “The price of food will rise”. Is that it? Stating the obvious? Does that kind of statement make a guy some kind of economic wizard? No. But I must say this, on the anniversary of Copernicus’ birthday: stating the obvious worked for him.

The reason why the simple statement “the price of food will rise” is so important is not the statement itself. Saying “the earth rotates around the sun” is not, in itself, earthshaking. It’s what follows thereafter. All of a sudden the orbits of the inner and outer planets make sense. When you see the obvious, sometimes other facts that are difficult to reconcile become reconcilable.

The Price of Staples Will Rise

We all know that the price of food is rising, but we’re also hearing about droughts causing crop losses in the US and now Russia is feelingthe pinch, too. With the world’s biggest corn producer and the world’s biggest wheat producer putting out fewer crops, economists have already been able to project that beef, for example, will likely be more expensive toward the middle of this year due to the raising price of feed grain. With more droughts happening lately, the pressure on staples will be constant, and while we can’t necessarily say that the base price of staples will go up, it will fluctuate higher and, on average, be more expensive. When this happens, the meat downstream becomes more expensive by extension. Keep it in the back of your mind now that Russia has shut its doors to grain exports – likely until June – and many previously self-sufficient countries (I’m looking at you, China) are no longer self-sufficient. India is another case where, while they appear to have food under control, the per-person consumption of food calories is lower than in many other food-importing countries and I fear that lowering these calories-per-person is simply not something the Indian market can absorb. Americans can stand to eat fewer calories. Indians may not be able to. Will feed lots be profitable anymore if grain becomes too pricey? Perhaps there will be a rise in grass-fed cattle, which will increase demand for range land. Either way, the meat gets more costly and land gets more scarce. Mid-term result of grain no longer flowing from Russia? The Maghreb, one of the main importers of Russian grain, may have even more unrest to deal with. Watch Egypt.

Inflation Will Rise

The majority of the world spends the majority of its pay on food. North Americans and Europeans are something of an anomaly that way. I’ve already mentioned that inflation in China is on the rise, and when I left China, inflation was high – until they changed the proportions of goods in the grocery basket used to calculate inflation. In effect, inflation in China is a shell game: they don’t want the official number to be too high, so they change the make-up of the products it’s based on. The items they reduced in the basket: food. Sadly for the central government, the people know what’s going on, because they are spending most of their pay on just that. Salaries are going up to cover food price increases. Workers would not go back to the factories after the economic crisis for the same pay they worked for prior. Workers are desperate for enough cash to pay for food – and I’ve already argued that food determines the base price of the workforce. If the cost of food goes up, the cost of work goes up, and food-importing countries will be impacted more. This is one place where the First World worker has the advantage: we can absorb a price rise in food. Others cannot. In the long run, scarce food may start to make us more competitive than we currently are.

Trade Imbalances Will Shift and Potentially Reverse (eventually)

The Chinese have a long memory, and the Opium War is almost a current event on the time scale of that ancient civilization. To oversimplify the reasons China and England became embroiled in this one-sided conflict, we can say that there was a massive trade imbalance between the two countries. In effect, China grew tea and England bought it for gold. The natural problem being that tea can keep growing forever and gold is finite. In order to reverse the flow of bullion, England started assisting opium dealers in trading a different plant product for precious metals. This made the Chinese angry, and they started burning things. That gave the British the opportunity to go in and blow things up, and make the Chinese take the opium – illegal or no. To sum up, trade imbalances make people touchy. Currently, the Chinese hold a trade imbalance against the US which – to a degree – works in both nations’ favour. The Chinese are building an enormous pile of US dollars (not having learned anything from the Opium War, I suppose), and the US gets cheap goods and an endless supply of loans. Once food becomes more expensive, however, the flow of those dollars will slow. This will not require gunboat diplomacy, drug running, or any other kind of shenanigans. It will occur naturally as a consequence of more expensive staples. While there will be volatility in the staples market as the US and Russia have alternating bumper/poor crops (this hurts only the farmers, though – everyone else is more or less unscathed, but farmers start killing themselves when prices do this), eventually the average price of staples will rise. China will be unable to increase its own internal staple production to meet its needs due to overuse of chemicals, lack of groundwater, and desertification. With the relaxing of restrictions on domicile imposed by the hukou system, farmers will start moving to the city in droves. Who once were productive farmers will become consumers in the food system, and leaving large tracts of land to be turned into real estate deserts. I contend China’s food production will never rise in a meaningful way unless a miracle happens and they all of a sudden have a Green Leap Forward. Not bloody likely, but I remain open to serendipity.

This means there are implications for Chinese productivity. Its growth once predicated on cheap unskilled labour, the cost of hiring in China will rise with the price of food. The same kind of production will become untenable in China. Foreign investment – already seeking alternative places to flow such as Vietnam and the Philippines – will threaten to dry up. What may this mean? It may make China blink on monetary policy. One option would be to allow the Yuan to float, the other option would be to unilaterally have the Yuan to rise in value against the dollar. Trade imbalance is going to force changes in monetary policy one way or the other, but this one thing I will say: do not underestimate the power of the US dollar. While its value is more or less based on the fact that it is the global fiat currency for petrol purchase (and the reserve currency for many other international transactions), even in an era of decreasing oil demand due to high price, the USD will retain value because we’ll be buying grain with it – or at least the Chinese will be.

Will there be a grain war? A more exciting reporter than I might say “maybe”. I say “no”. Will there be very boring high-level discussions about monetary policy amongst the grand high mucky-mucks of the Chinese Communist Party and Indian Cabinet? Yes. They may even get into heated arguments. I know. Perish the thought. We live in such turbulent times.

And then There’s the Death and Famine

Oh yes, I forgot. The over billion people that live on between one and two dollars a day will go hungry in droves. This will not have an economic impact on you. I guess you can decide for yourself whether this issue matters to you or not.

The Copernican Economic Shift

So once the economic shift begins, several bets are off. One may be the direction in which trade imbalances begin to flow. Another will be the ability of China to retain its growth in manufacturing centres. Will China shift its monetary policy? Will arable land become a highly desirable asset class? I think there are strong chances of these things happening, if only moderately, in the coming years. One thing I think is a certainty is the increase in the cost of arable land due to interest not only from investors but other states scrambling for the single most important strategic resource in any nation’s arsenal: food. As the old yarn goes, “buy land – they ain’t making any more of it”.

Saturday, 9 February 2013

Part 3: Irrationality does not exist because of data

Part 1 is here.
Part 2 is here.
A very strong contender for an actor most similar to the schizophrenic is an investment or venture capital firm (or trader). Both receive large amounts of potentially specious data and must interpret it in order to predict the future – a high-entropy proposition. All finance and investment relies on complex models and practices. All these models and practices are false: if one was true, there would be no such thing as a failed investment. All these same models are, to at least some degree, descriptive of what the market does, because they would not be used if they did not have some kind of predictive power. It remains to be seen whether this is because the models evolve with the market or the market evolves with the models. The issue here is data: I can’t guarantee you that my interpretation of market data will be accurate or not, but I can guarantee you that I have far less market data than an investment firm. Leaving entropy completely out of this, because we are all victims of high entropy when trying to predict the future: who will do better at reading the market, the person with less or the person with more data? In general, the odds would favour the person with more, and that is our last nail in the coffin of irrationality.

Hindsight is 20/20 they say, and failed investments eventually make sense when fully analysed. The problem is that they have to fail in order to determine holes in the model. The humans who developed the model have to have the humility to make necessary changes to the model to preclude such failures in the future. The model must be disseminated accurately and applied appropriately to have a chance of improving its predictive capability. Do these things happen? Occasionally. Normally, the same well-worn model tends to go back out into the field; its shortcomings described as a 1-in-100-year anomaly or a failure of interpretation. Is this rational? Depends on the environment – how many times had the model succeeded before? Depends on the entropy – was bad data entered into the model? Depends on the data – was there enough to give the model a chance of success? Indeed, hindsight is 20/20, and what was a rational investment choice is now seen, in the light of new data, to have been “irrational”. But was it? With just a little more data, the benefit of hindsight (low entropy), and the ability to understand the whole environment, we can certainly say the decision was wrong, but was it irrational? Not at all.

Environment, entropy, and data can actually be boiled down into one simple concept: information. Environment is the source of all data; entropy is the factor that affects an actor’s interpretation of data; the concepts of data and information are more or less the same. We can truthfully say that “all actors are rational depending on their information”. As an illustration, consider what happens to you after you die. In reality, it doesn't matter what you think, what matters is that you realise you are dealing with a situation in which the information has high entropy. You can easily agree that many people who see these words will believe something different than you about the topic. They will, if they disagree with you, consider your views irrational, and you theirs. If you reflect back on the reasons for which your views are rational, you can see the environment in which you were brought up, the experiences that reinforced the ideas you hold, and the data that you inserted into your mental model of how the world works in order to come to your rational conclusion. You can also transpose that experience directly to all the other people who come to this page and disagree with you. While the result is different, the information was not; while the end decision is rational to everyone who reads these words, it is not, necessarily, right.

Part 2: Irrationality does not exist because of entropy

Part 1 is here.
Another actor who often finds themselves tarred with the classical epithet of irrationality is the schizophrenic. The condition of schizophrenia gives a person access to a new source or sources of data to which others may not have access. This data may or may not be perceived as “real” by the schizophrenic. The condition of schizophrenia may, over time, make the sufferer so suspicious of all data that they become less capable of separating accurate data from the physical world and the data derived from other sources. Information Theory, which considers data not by its content, but by its simple existence as a quantum of communicable information, is the best lens to view this type of “irrationality”. Specifically, the concept of entropy in Information Theory provides a key to one part of the puzzle.

Entropy is the probability of being able to predict the content of a piece of data. It is less probable for me to predict the winning lottery numbers than it is to predict the outcome of a coin-flip. The result of a coin flip is a piece of data. The winning lottery numbers are also, taken together, a piece of data. Entropy tells us that one is easier to predict than the other because there are more potential results for one piece of data than another. While this sounds like straight probability, be warned: Information Theory started in the 1920s and gave you such wondrous toys as the Voyager space probe and the CD. We’ve only just come to the mouth of the rabbit hole on this topic, and this paper isn’t long enough to go too deep.

Experiences that are a product of a schizophrenic’s environment produce interesting results. When a person hears voices or sees things that he is unable to differentiate from the simple physical reality others perceive, his world is no longer bounded by the same rules. Some of the data he receives is unbounded by physical laws. This may or may not help him in trying to sort the physical from the perceived. If a vision or sound accords with the laws of physics, a schizophrenic may be forced to determine whether or not this seemingly real data is truly real. This is akin to flipping a coin and seeing a heads – but not knowing whether the result is due to the actual coin toss or simply due to one’s own perception. There is greater entropy in a schizophrenic’s life because even if he receives data, he must still determine whether it is “real”. In such a high-entropy environment, it is very difficult to discuss rationality simply based on environment. Whereas the environment is the source of sensory input to the actor, the high entropy of the data received from the environment changes the very nature of that data. Environment plus entropy yields potential uncertainty, and that uncertainty can lead to what might be called “irrationality”. Still, if a person is schizophrenic and is acting in a high entropy environment, they are simply making the best choice available to themselves under the circumstances. That is a perfectly rational action, and while the schizophrenic deals with high entropy all the time, everyone experiences a moderate level of entropy because our perception is imperfect.

Part 3 here.

R.A.M.ifications: the Failure of the Rational Actor Model

The Rational Actor Model (RAM) is one of the principal foundations of Game Theory. It assumes that an actor, be it individual or corporate, will always act in its own self-interest when faced with a decision. Self-interest is taken to be objectively interpreted: there is a “best choice” in any situation that can be mathematically proven. Suboptimal choices are considered irrational. The concept of rationality itself is the very first problem with the RAM, as I will argue that there is no such thing as irrationality, and therefore rationality is a red herring. RAM tends to place all actors in the model on the same level in terms of environment, entropy, and data. This renders the model nondescriptive, as RAM cannot apply when actors come from different environments, have different weights assigned to their experiences (entropy), and have different levels of data about a situation. Data gaps are a fact of life and “perfect” data is an anomaly. These three ideas spell the death knell of the current RAM as a descriptive assumption. The only way to save RAM is to rid ourselves of the concept that there is such a thing as “irrationality”.

Irrationality does not exist because of environment
A poster child for the classical concept of irrationality is North Korea. Of the states in the world, few are more erratic, and none so erratic are so disruptive. The problem with analysing North Korea is that it can be seen through numerous lenses, and many of those lenses are not objective, but based on values judgements. Anyone who asks a question of Korea that starts with the words “why don’t they just…” and then recommends a course of action simply hasn’t put the time in to understanding North Korea as a rational actor. If anything other than the perpetuation of the regime was North Korea’s sole interest, such speculation would be potentially instructive. As it stands, we have a nation of some 20 million people which supports a tiny oligarchy – the only people who truly have “skin in the game” – in their chessboard of internal politicking. Internally, the Kim clan must assure dominance over the other petty power brokers, and externally, North Korea must milk the international community for aid while never truly allowing one state to become their sole interlocutor. Erratic acts – such as powering down the Yongbyon reactor only to power it up again secretly, kidnapping Japanese citizens and then releasing them some decades later, and sinking the occasional South Korean patrol ship then denying such activity on the world stage – serve to draw close and then alienate states each in their turn. So long as one state can give it aid and begin to make headway in the Hermit Kingdom, North Korea can afford to push away another for its own internal ends.

North Korea acts erratically, but not irrationally. Time and time again, results have proven to North Korea that such continuous games of “he loves me, he loves me not” get it the results it desires. Like a spoilt child, rewarded for his tantrums, so is North Korea a classic enfant terrible of the global stage. If such action is calculated to produce a desired result, and if such action is based on previous experiences of success, then how can it be called irrational? The best way to understand an actor like North Korea is not to ask “will North Korea react rationally to this offer”, but “what is the environment in which this action could be considered rational?” In the case of Korea, its experiences dictate that these actions will produce a desired result. The actions taken are erratic, but calculated; to consider North Korea anything but a rational actor in such a situation likely betrays an ideological presupposition on behalf of the interpreter.

In order to understand North Korea’s actions, we require access to data regarding its previous decisions and the results thereof. Environment is key – even applied Game Theory teaches us this. For example, in a 2005 paper (“Investigation of Context Effects in Iterated Prisoner’s Dilemma Game”), Evgenia Hristova and Maurice Grinberg detailed predictive strategies for cooperation in iterated Prisoner’s Dilemma games, finding that cooperation was not simply based on the games being played with the current opponent/partner, but all previous partners. Based on reading I had done in University, I determined that I would attempt an experiment myself that came out of Post-Modernist critique of the RAM through discourse analysis. I had a class of MBA students in a Business Strategy course divide into two teams. The professor of the course explained the rules for iterated Prisoner’s Dilemma in extremely competitive terms. For example, we made certain he said “opponent”, “beat”, “compete”, and “win”.  When I explained the rules, I used extremely cooperative terminology: “partner”, “resolve”, “cooperate”, and “participate”. The results were definitive, at least to me: In one-off games, the competitors always won. In iterated games, when cooperators were paired with cooperators, they by far scored highest. Any other pairing was so affected by the existing discourse – or became so disenchanted by their “partner’s” lack of cooperation – that they were dominated by defections. The history, the environment of each player, was a factor in their strategic choices. Those strategic choices were preordained by our simple choice of words. Were those choices irrational? No. They were purely environmental.
Notes on Game Theory and human choices: