Wednesday, October 17, 2012

Left vs. Right, Micro vs. Macro

As I watched the second round of the Presidential debates, it occurred to me that much of the disagreement is about the role of government in society. In general, the Right would prefer a less intrusive government and the Left would prefer a more interventionist government.

While the debate is all well and good in theory, I wonder how each side views the latest about-face by the IMF giving advice to governments to re-focus their policies away from austerity to growth. FT Alphaville has a great synopsis of how things have changed:
The main finding, based on data for 28 economies, is that the multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2, depending on the forecast source and the specifics of the estimation approach. Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7.

Translation: Government spending matters more than we originally thought. To explain, the multiplier effect is the effect an action, such as government spending has on the economy. If the forecast multiplier effect is 0.5, then $1 of spending has a $0.50 effect on output, or GDP, i.e. the other $0.50 is "wasted" and therefore inefficient. If it's 1.2, then spending $1 has a $1.20 on GDP and sparks more economic activity.

Ambrose Evans-Prichard, who would rather die than say anything positive about Europe, characterized the IMF change of heart this way:
Drastic fiscal tightening in a string of interlinked countries does two to three times more damage than assumed, especially if there is no offsetting monetary stimulus.

Pushed beyond the therapeutic dose, it is self-defeating. At a certain point it becomes pain for pain's sake.
More government is good under these circumstances then, right?

Micro vs. Macro
Contrast the IMF's macro-economic prescriptions to Mario Draghi's micro-economic approach of internal devaluation under his Grand Plan of structural reform. I wrote about how unit labor costs were converging in Europe, which is one step to solving the problem of North-South productivity gap (see An inflection point for Europe?).

Philosophically, the divide between the IMF and the Draghi ECB is not just an academic question about the proper estimator of the multiplier effect, which is a macro-economic question, but the difference between a macro-oriented solution and a micro oriented solution of getting the environment right to set the stage for sustainable growth.

Austrian vs. Keynesian macro-economics; micro vs. macro; who is right?    

Boundary problems in modeling
Economists all make certain assumptions with their models, but all models have problems at the "boundary" where the normal conventions of economics do not hold. Some investors, such as Ray Dalio, have openly wondered out loud whether European populations can stand the pain of the draconian solutions being proposed:
Frustrations increase, the established ways of doing things come under attack and frustrations over the ineffectiveness of government creates the perceived need for someone to gain control of the mess. Plato spoke of this dynamic. It was the reason Hitler was elected in 1933.
In modeling, these are known as boundary problems and we risk running into them. That's why Dylan Grice of Société Générale has produced a series of charts outlining this political problem of when Hitlers can arise.  

...and how economic stress can make people very, very cranky and start to blame others (via Also Sprach Analyst).    

I would characterize these issues of not just a simple philosophical problem of Left vs. Right or micro vs. macro-economics, but also a problem of the political constraints that we operate under. Be careful what you choose, economic solutions often have unintended consequences.      

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.  

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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