A Mechanical Economic Model; a review on Ray Dalio’s principles

 By: Shahab Sabahi, Policy Analyst in Energy Security and Policy Research Group

Ray Dalio articulates dynamics of economic growth in three principles; perpetual productivity growth, short time business cycle, and long term cycle. In this sense, he portrays the economics as machines, whose elements mechanically respond and interact to / with each other. His principles appear on two videos, which I checked out; they are reachable at http://www.youtube.com/watch?v=PHe0bXAIuk0 and http://www.youtube.com/watch?v=SFaRazMpxcM . The former has been prepared in an educational format with clear explanations and referred by New York Time. The latter presents Ray’s talks in the “Council of the Foreign Relations”, which is hard to stay with since Ray is a businessman, so he hardly puts his ideas in words, the job that professors/teachers do very well. I recommend watching the former video.

 

What I took away from his principles!

Alike economists who practice business, he tries to generalize the replication of some historical events in a single mental model. He develops the mental model to understand interlinks of historical events and in order to predict futures. His model simplifies a complex system which is inherent with social, political and technical elements, while in effect each element by itself is a complex system. From this sense, one should appreciate his efforts because his simplified model is easy to grasp for non-technical people and even technical persons encourage revisiting their views on economic systems.

Ray in his model takes “the existence of a perpetual productivity growth” for granted!!! He assumes a few small independent markets interact with each other at a higher level (aggregated), the level in which governments / central banks influence the trend of the “market interactions”. Furthermore from his point of view, economies experience two cyclic moves; namely short term and long run; which take place due to governments/central banks influences on credit/money markets by imposing fiscal/monetary policies. 

 

In short, he puts up his economic growth model upon these fundamental assumptions and he concludes such ups-downs is a nature of economic system and he predicts more financial crisis /recovery in the years to come.

 Critique of perpetual productivity growth

Advocators of technology growth may praise Ray’s idea. In his talk, like technologists Ray took the “perpetual productivity growth” for granted (Schumpeter, J., The notion of Destructive Innovation). Despite he gives a description at length about the source of business cycles (cyclic moves) before taking them as assumption, in his simplified model he fails to link business cycle with the productivity growth and does not explain “how to sustain productivity growth in long term”.  One with a background in industrial economics may think of “investments in R&D (research and Development)” as the source of productivity growth which has been theoretically proven (Endogenous Growth Theory; Arrows, K.; Uzawa, H.; Romer, R.). But one may fail to see the underlying principle of the endogenous growth theory which is POLICY measures such as subsidy which has financial consequences on country’s balance sheet. In fact there is a threefold reason that “I do not believe to the notion of the perpetual productivity growth”.

First, theoretically it depends on investment which in turn is subject to business cycle (cyclic moves). It means the productivity growth contributes in both causes and effects of business cycle.

So Ray’s straight line for productivity growth should be teeth-shaped or cyclic-waved.

Second, the empirical data from the “DOT COM” era shows the “effectiveness of investment” in R&D is also matter. Even DOT COM market failed to effectively allocate the investment resources to high-tech activities which rely heavily on R&D activities (same is true in pharmaceutical industries.) It partly stems from the phenomenon of “emergence of asset bubble.”

Third, from an energetic analysis perspective (from the book “biofuels an illusion”), productivity cannot infinitely grow at least in a constant pace. Inter and intra human, capital, and energy replacement are constrained with the capacity of system which means a nonlinear productivity growth trend.

Having the above mentioned arguments, I beef with Ray’s idea of perpetual growth (a British expression of disagreement.)

 

Critique of Ray’s notion of money and credit

True. Changes in the volume of credit and money in the market lead to cyclic moves of the economic growth. Also true where Ray said government’s income sourced from taxes and selling governmental bonds and a central banks was independent from government for controlling the value of currency. But Ray’s model falls short to define three important phenomena:

 

·         Government investments; their needs and effects. Think about them in lights of the fact that private businesses are much capable than governments to allocate investment resources effectively by tracking the market forces (please assume for a moment that there is no market failures; in financial downturns, private businesses are reluctant to invest, even price signals tell the private businesses “Go Ahead” WHY?)

·         Whether short business cycle causes a long business cycles or vice versa or there is no fundamental link between two (Ray jumps over this topic)

·         Consumer saving behavior and its effect on the credit and money markets (Ray’s model cannot capture this non-mechanical phenomenon however Ray talks about only borrowing but not saving.)

 With reducing social systems in general and economic systems in particular to the mechanical systems (as economic modelers do, not econometricians) many phenomena are either excluded from models or their causes/effects are not fully captured. Economic models; from simple to complex ones; tend to be calibrated based on a benchmark. In other words, they are forced to look like the true models. These economic models simplify many behavioral or institutional phenomena to single parameters which in reality are nonlinear variables.

Government bonds, for example, and their effects on the central bank’s balance sheet when the bonds are purchased back by the central bank is a delicate institutional variable which is ignored in Ray’s model and many other models. It could explain why government investments are needed and how far these investments can go.

It also explains the phenomenon of money printing (please note that, there are four monies in economies, printing money DOES not mean increasing the money base). Again it is about balance between spending, earning and value of creating outcome.

 In Ray’s model, it seems that the accumulation of short term business cycles leads to the long term cycle. We should take it with the grain of salt. The latter cycle, if I may use Hegel’s dialectic approach, is a synthesized product of lifestyle changes, political & ideological shifts, markets integration, and evolution of inter and intra society’s relations. Doubtless, the long term cycle is indirectly affected by the short business cycle. In my opinion there is no general pattern for long term cycle as our observation through history goes back only 200 years. But I agree with Ray’s model for the short term cycle and its causes by credit expansion / contraction.

Undoubtedly the saving behavior correlates with fiscal and monetary policies. Increasing tax will reduce the saving level as households’ disposable income slashed and price levels shift upward. A downward move for interest rates would cut the desire for short term saving too as yields are not significant in comparison to alternative investments. But the saving behavior strongly links to the societal demography and institutions.  An aging society with well-structured pension funds tends to buy safe government bonds regardless the movement of fiscal or monetary policies. Such a behavior is hard to be abstracted within a parameter as it varies over time and space.

In addition, the long term behavior of saving / investment links to the prospect of inflation trend which is function of many parameters and hardly influenced by short term fiscal and monetary policies. 

 Conclusion       

Ray Dalio’s principles and idea on the economic system provides an abstract, simple, mechanical and illustrative model. The model introduces very fundamental dynamics of the economic system in very simple language. However it falls short to dig out the realities behinds the evolution of the economic system as a mechanical economic model is far weak to capture underlying socio-political forces.

The linear perpetual growth is a notion that being supported with no empirical evidence. 

Printing money is an abstract and vague term. There are at least four types of money, and in the last three decades no hard currency has be printed in excess in the sense of printing paper.

The Ray’s model provides a nice simplified definition for short business cycle. However it looks over the role of saving behavior and institutions in shaping, intensifying the cycle. The model also mechanically and linearly links the long cycle with short business cycle, which is half true.  The long cycle is a complex phenomenon and with a handful historical data, it is hard to offer a generalized model for them.

Conservatism: Role of mental models, a quick look

By: Shahab Sabahi, Policy analyst in Energy Security and Policy Research Group

Conservatism is an ideology which values the status quo and accepts change only reluctantly and at a very slow pace [Adana, J.]. It is based upon the premise that human institutions are the product of a gradual process of experience or intrinsically existed, and that they have endured because they have proven to be effective over a long period of time. It follows that it would be most irresponsible to change these institutions and practices in any fundamental way [West, N.]. From conservatism’s view, it is not realistic to expect that workable new institutions and practices can be introduced to replace existing ones except through a long gradual process of experimentation. To do otherwise is to invite chaos. Where does this idea come from?

To answer the question above, I attempt to examine conservatism based on the human mental idea creation mechanism. People in all human societies create mental models of reality. The mental models attribute causality to factors; sometimes invisible ones; which make the world affairs more predictable and easy to understand. In earlier societies, these invisible forces were spirits and nature; today they are abstraction like scientific theories, socio-economic hypothesis. All world views and beliefs constitute a metal model of reality, in which observable events are attributed to either nonvisible or visible forces. Shared mental models are critical in facilitating large scale collective actions by setting common goals. Shared mental models are bases for social rules and shaping institutions, since the models often suggest clear rules for societies to follow. Oftentimes rules and institutions are enforced in the form of beliefs. They contain with considerable emotional elements and therefore are believed for intrinsic reasons and not simply because they are context related and accurate for just specific times. Intrinsic values are unchallengeable and thus become foundations for other sub-rules and institutions. Rules and institutions with intrinsic values are heritable, so they should be saved generation through generation by right people who understand the intrinsic values. They are always interpreted as effective rules as they continuously set parallel common goals, failure to one give a success for other one.    

All of this reinforces the fundamental conservatism, because with presence of beliefs and emotion, mental models of reality once adopted are hard to change in the light of new evidence that prove they are not working. 

 

 

“There is no way out of crude oil dependency”.

A review on the article :“Does biodiesel demand affect palm oil prices in Thailand?”

By: Shahab Sabahi, Policy analyst in Energy Security and Policy Research Group

In an article in the Journal of Energy for Sustainable Development, 2013; Chongprode Kochaphum et al examine the biodiesel development policy in Thailand. Through a lucid analysis, they caution few socio-economic impacts that the Thai biodiesel development plan would bring about. By employing demand-supply functions and analyzing the datasets of Thailand’s economy over the period 2006 and 2011, even if a short time span, they reveal that potential increases in the palm oil products would burden a net negative impact on the Thailand economy and society. However their findings show a reduction in crude oil import and a rise in farmer’s income as the positive impact of the biodiesel development policy. They, furthermore, highlight the degree to which net negative impacts are exacerbated when the crude oil price and demand for biodiesel increase with carrying out a sensitivity analysis.

The scope of Chongprode Kochaphum et al’s analysis was confined to the Thailand biodiesel domestic market and the import and export and related international trade variables were excluded [The article Page 2; Methodology, Price estimation]. This scope was implicitly disclosed a fact that a partial equilibrium and a static demand-supply analysis was employed by the article. Moreover this scope was formed an assumption which led to unrealistically calculation of average price. 

For the purpose of encouraging and opening fronts for future researches,  I would like to make few remarks on some of the article’s assumptions / views /conclusion statements as follows:

1.       The article introduced a term so-called “currency saving”. It appeared first in the article’s abstract without a definite definition. Readers might confuse the term with “balance of payment savings” which refers to national’s foreign current account. However the article clearly termed “currency saving” as “oil import reduction” [Page 2; Goal and scope of study]. With this definition, my perception from the article’s findings is that  

·         Biodiesel development will replace some “Volume” of the imported crude oil and does not necessarily translate to a “Surplus in balance of payment” by saving the “Monetary Value” of the imported crude oil. The article calculated its so-called “currency saving” with simply multiplying the average diesel price of the domestic  market by the replacement volume of diesel producing by palm oil instead of crude oil. The view failed to consider the facts firstly the Thai government pays “foreign hard currency” NOT “Thai Baht” to acquire “crude oil”  and the and secondly Thailand is a net imported crude oil commodity and the “Thailand balance of payment” whose status show “currency surplus” or “currency deficit” significantly links to the value of Thai Baht-US Dollar exchange rate. Make any judgment about “money currency saving” requires a broader international trade and finance consideration that the article’s scope falls short for taking them into the account. 

·         The value of Thai Baht had been appreciating about 26 percent during the period 2006 to 2011 [the Bank of Thailand statistics]. This development made importing crude oil would be cheaper than producing indigenous fuels production as the domestic business costs soared (Long Range Aggregated Supply LRAS)  and became more expensive, even with the presence of subsidy, to produce biodiesel and even cooking oil [the Bank of Thailand CPI and Total Factor Productivity report]. Indeed the Thailand economic growth and Direct Foreign Investment caused to boost upper the value of the Baht (an analysis on the Long Range Aggregated Supply can reveal the drivers of growth and price shift).  To consider effects of this development an “adjusting prices” mechanism is required. The effects of this development should be implicit in every “calculated average prices”. For the sake of estimating an “adjusted average diesel price” considering this mechanism, my rough calculation shows an “adjusted average diesel price” of between 4 to 7 Baht / liter instead of 16 Baht/liter that the article calculation assumed the latter one. Thus the positive contribution that the article called “currency saving” should be roughly halved (far less than half) than the article’s calculated figure which would shift the net cost-benefit balance in favor of more costs.    

2.       The article found that the price of cooking oil would increase in the Thailand domestic market. Since the article had excluded any impacts from importing cooking oil, they concluded a reduction in the net income of farmer.  If the exclusion assumption would be relaxed, a new conclusion might emerge which would be close to reality. In theory it is arguable. As the article calculated an increase of farmer income and a rise in the cooking oil price in domestic market, there would be a point in the time that imported cooking oil would be cheaper than the domestic one. This would create a dynamic to shift from consuming local cooking oil to imported one. This dynamic would play a trade-off between disposable income- consumption of farmers to a new improved balance status.

Therefore a reduction in net income of farmer may not be a conclusion. It depends on the value of the marginal propensity to consume and other socio-economic factors. The figures in an article “Wealth effects and Consumption in Thailand” in 2011 by Phurichai Rungcharoenkitkul -The Bank of Thailand, support this argument. 

However I would like draw my own conclusion from the article’s analysis:

 “There is no way out of crude oil dependency”.  

True, this is what the article’s findings revealed to me. The article sensitivity analysis has more stories to tell. The sensitivity analysis shows changes in crude oil prices will considerably shift the price of biodiesel which in its own determines that biodiesel production would be economically feasible or not.  Even demand of energy plays its role to make this new creature; biodiesel; being viable in an economy or not.

No matter if a nation is able to produce biodiesel and consequently, likely, cut its crude oil imports, the inconvenience truth is that  movements in crude oil market, determinants of monetary and foreign policies shape the nation’s energy security policy formulation [energy security which is defined “accessible, affordable and sustainable supply of energy”]

As long as this conventional source of “easy” energy is at hand and in part monetary policies pegs to this source of energy, indigenous biodiesel development remains a shadow in the economic system.