November 4, 2015 2:40 pm JST
Paul Donovan

Taking a bigger bite of economics

Economists have had something of a tough decade. In 2008, Queen Elizabeth II famously asked economists at the London School of Economics about the financial crisis. "Why," she asked, "did no one notice it?" The economics profession collectively blushed with embarrassment -- although it is very difficult trying to predict what politicians will do when one is working with models that assume rationality.

     External shocks are always hard to predict, even when they are, to quote Donald Rumsfeld, "known unknowns." We know that we are entering an El Nino weather cycle. We know this is likely to be a significant cycle. What we do not know is how badly food production will be affected, what production turmoil will do to food prices, what food prices will do to policy, or what policy will do to the economy. We can model scenarios, but it is hard to be precise.

     There is nothing new in these challenges. However, in the past few years a new challenge has become apparent -- the rise of "sound-bite" economics. This increases the problem of "gut instinct" economics, which is an emotional rather than a rational reaction.

Sound-bite economics

Communication today is more varied than ever before. However, it favors brevity over comprehensive analysis. Economists often struggle with brevity. Business television shows often ask me to summarize a situation in 30 seconds. That limits the depth of the analysis. Newspaper and magazine articles (even this one) have word limits. Twitter has a character limit, and yet policy is conducted by tweets.

     This communication revolution is occurring alongside an increasingly involved world economy. Economists are being asked to explain something that is more and more complex with fewer and fewer words.     

     China is an excellent example. The growth of the Chinese economy over the past quarter century has been remarkable. From around 2% of the world economy in 1990, China now accounts for around 14% of the world economy. That increase is dramatic, and perhaps scary for some.

     One thing that is often heard is that global inflation has fallen because China flooded the world with cheap labor and through that process was able to supply cheap goods. This makes for good sound-bite economics -- "China causes low inflation" fits into a tweet. This ties in with "gut instinct" analysis -- China patently did provide cheap labor and did increase its share of global trade. However, this story is also not especially true -- China has probably been a force for higher inflation rates globally.

     Uncovering the reality of China's impact on overseas inflation rates is relatively complicated. Several factors come into play. China drove up commodity prices through its demand; China is an inefficient consumer of commodities, so that matters. Thus China created a relative price shift, raising commodity prices relative to manufacturing prices.

     But we also have to consider that China receives only a small fraction of the price that the consumer pays for a product. China rarely makes a complete product from start to finish; many components are imported from elsewhere. And once China has completed the process of manufacturing a product, there are costs for shipping, storing, advertising and selling the product. These costs are typically 70-80% of all costs and have nothing to do with China.

     Inflation did fall, for most countries, over the period of Chinese economic growth. However, other non-Chinese factors were at work. Independent central banks became pre-eminent over this period. Labor market reforms became more common, and since domestic labor costs are the single most important driver of inflation, this is potentially very powerful. Several governments deregulated industries and instituted price controls. None of this has anything to do with China.

     The problem for the economist is how to communicate all of that when "China causes low inflation" fits into a tweet. However succinct the economist is, he or she will never get the true explanation into 140 characters. In the world of sound-bite economics, the tweet tends to triumph.

More than a feeling 

I have recently been spending a lot of time reviewing the work of winners of the Nobel Memorial Prize in Economic Sciences. Two themes occur repeatedly. First, these economists used incredible focus to understand the detail of what they were studying; they got their hands dirty with data. And second, so many laureates defied the easy assumptions and conventions of their time; they had the courage to say, "Your gut instinct is wrong, this detailed analysis is what matters and I will prove it."

     As the world economy has become more integrated, more technologically driven and more complex, countless instances of this problem arise. Investors are increasingly driven by superficial analysis, not the in-depth analysis that is required.

     One of my favorite pieces of economic trivia comes from 1943. Ford Hinrichs, the head of the U.S. Bureau of Labor Statistics, hosted a series of prime time radio programs. He and his wife debated the composition of the consumer price basket before a (presumably fascinated) national audience. Perhaps today's economists should have their own reality television shows to replicate this. Investors would surely be better served if they were presented with a bigger bite of economics than sound-bite analysis can provide. 

Paul Donovan is a global economist at UBS Investment Bank and the author of "The Truth About Inflation," published by Routledge in April. More can be read at www.ubs.com/pauldonovan.

 

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