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The Problem With Economic Models

 4 min read / 

Economic models are everywhere. They’re used both implicitly and explicitly by politicians, economists, journalists and even the general public. These models somehow manage to wrap entire concepts in beautifully presented mathematics and graphs before presenting clear, concise conclusions. They provide a framework for digesting things such as how wages are determined, the effects of a living wage, how countries can grow after exhausting the gains from capital accumulation, the effects of certain policy decisions and many, many more key economic concepts. What could possibly go wrong when applying them to the real world? 

The Assumptions

Economic models become problematic when we attempt to take these models and their conclusions as facts and fall into the trap of thinking that things in the real world work as these models suggest. 

An economic model is defined as an interpretation and not a representation of reality. It is nothing more than a simplified interpretation of reality through the use of assumptions, most of which don’t hold in the real world. These assumptions are used to set up an economic reality – a scenario in which aims or questions can be addressed and answered. Once these assumptions have been established, some methodology will be applied to try and derive analytical conclusions. These conclusions are often interpreted as facts about how things work in the real world, leading to confusion about why the models don’t hold in reality.

If the assumptions of these economic models don’t hold in the real world, then why would their conclusions? To be clear, all economic models have assumptions. Every economic model has assumptions that may not hold in the real world; hence neither do the conclusions of these models. Some models and their assumptions have been stated below, and it is rather simple to identify those that may be unrealistic and may not actually hold in the real world

  • Mundell-Fleming Model (Imperfect capital mobility model, the most realistic)

    1. An open economy with constraints in physical movements and information
    2. The time period is short term (capital fixed, equilibrium reached within a year)
    3. Three markets: Goods Market, Money Market and Foreign Exchange market
    4. The country in question is small
    5. Domestic price level must be fixed
    6. Balance of payments consists of a current account and a capital account
    7. Exchange rate expectations are static
    8. Imports are competitive
  • Solow-Swan model

    1. Closed and private economy
    2. One sector producing a homogenous good
    3. Saving is a proportional function of income
    4. The labour force growth rate is constant (it is equal to the population growth rate)
    5. There is substitution between factors
    6. There are constant returns to scale
    7. There is no independent investment function, investment equals saving always
  • The Phillips Curve

    1. Short to medium term model
    2. Prices and Wages are slow to adjust to changes in aggregate demand
    3. There is an unemployment rate that doesn’t accelerate inflation (NAIRU)
    4. Workers are only concerned with their nominal wages
    5. Workers do not hold inflation expectations

So what does this all mean?

Final Word

Economic models should be used as a loose tool or framework for examining issues. These models are to be used not believed. Combined with real world testing using historical data, these models can be used to explain, in part, some phenomena. They should be used as part of an explanation, but shouldn’t be relied on solely. Reality checks with real world data are an absolute must. Unfortunately, it seems as though these models are often interpreted as how things work in the real world and that leads to a whole host of problems. It’s not just the average member of the public that falls into this trap either.

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  1. Kerk Phillips

    August 22, 2015 at 5:53 PM

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Global Affairs

Breakfast Briefing: SpaceX’s Used Rocket, Aliens and Bitcoin

David Cameron’s New Job

The former UK prime minister will head a $1bn China-focused fund.

Editor’s Remarks: Cameron has kept a low profile since resigning as prime minister in the immediate aftermath of the 2016 Brexit referendum, unlike his friend and former chancellor, George Osborne, who has taken on a number of highly publicised roles. Cameron is now set to take a senior role in a new investment fund aimed at backing China’s One Belt, One Road program. The fund is part of the UK’s wider strategy in developing closer relations with China as it transitions out of the EU and seeks new partnerships from around the globe.

Read more on the UK:

Sex Allegations at Google

A prominent AI researcher at Google has been accused of harassment by a former intern.

Editor’s Remarks: After a blog post by former Microsoft intern Kristian Lum revealed that she had been inappropriately touched by two men, one a successful academic and the other a data scientist at Google, the tech giant has suspended an employee. The individual in question, Steven Scott, is a senior researcher in Google’s AI team and had been a candidate for the company’s board but has since been removed from the ballot. Lum’s report has been corroborated by a number of employees also working in the AI space, who have witnessed Scott’s behaviour in the past.

Read more on Big Tech:

Bitcoin Nears $20,000

Since crossing the $10,000 barrier just a few weeks ago, bitcoin has nearly doubled.

Editor’s Remarks: Bitcoin’s enormous upward trend just keeps going, meaning that the total cryptocurrency market is now in excess of $500bn – well above the market capitalisations of many of the world’s leading multinationals. The latest surge in price coincided with Cboe Global Markets offering the world’s first tradable bitcoin futures last week, which have since outperformed the digital currency itself. However, bitcoin’s recent price movements have been eclipsed by Litecoin and Ripple each gaining around 400% in the last month. Ethereum has also had a good run and has settled into a new price point at around $700.

Read more on Cryptocurrencies:

SpaceX Launches Used Rocket

Elon Musk’s rocket company delivered NASA cargo via an already used rocket.

Editor’s Remarks: SpaceX launched a used two-stage Falcon 9 rocket on Friday that sent a used Dragon capsule on a resupply mission to the International Space Station. The rocket was previously launched in June 2017 when it took on a similar resupply mission, while the capsule was first sent into orbit back in April 2015. Friday’s launch was the first time that a used rocket had carried a used spacecraft and the first time that SpaceX had conducted a mission for NASA with a used rocket. SpaceX also launched yet another Dragon capsule to the ISS yesterday.

Read more on Aerospace:

The Pentagon UFO Programme

US media reported that the Pentagon ran a multi-million dollar programme to investigate aliens.

Editor’s Remarks: Between 2007 and 2012, the Pentagon ran the Advanced Aerospace Threat Identification Programme, which investigated UFO reports and sightings. The initiative was started by former Democratic Nevada senator Harry Reid, who commented that it was a serious initiative to answer questions about alien life that have dogged humans for decades. However, the $20m programme was not immune to cost-cutting and was eventually shut down by the Department of Defense. Speculators have also suggested that the entire effort might have been a facade for spying on the space technologies being developed by China and Russia.

Read more on the USA:

Keep reading |  4 min read

Global Affairs

Will Passive Investment Dominate the Future?

 8 min read / 

Passive investing has now become a phenomenon that is essential to both professional and retail players. Passive management is slowly, but surely, casting doubt over the relevance and success of active management.

Essentially, passive investing is modelled on the idea of mutual funds and ETFs – funds that track a specific market index. Market indexes can be traced back to the late 1800s to Charles Dow, founder of Dow Jones & Co., who wanted to create a means to track the overall direction of the market.

Passive funds are more than merely an accessible, digestible way of investing. Passive funds hold enormous stakes in public firms and if the three largest asset managers (BlackRock, Vanguard and State Street) were combined, they’d represent the main shareholder in over 40% of public American firms.

$600bn of US actively managed holdings have been sold since 2008 whereas flows into passive vehicles have surmounted
to $1trn which shows the divergence in growth rates of each strategy. It is estimated that passive vehicles bring in $3bn daily and 30% of assets are now allocated to passive instruments.

Poor Performance of Active Managers

The above graphic shows the inconsistency that often comes with active management investing. This inconsistency can be attributed to a number of reasons, one of which is the personalised style of active management. Active managers often favour a specific style of investment (e.g. value investing) but these styles often have a cyclical nature and what may perform and beat the benchmark one year may not necessarily be successful the following year.

Interestingly, the pitfalls of active investment do not purely lie in the personal mistakes of managers but can also be seen in the practicalities and efficiency of active management. Passive funds have the potential to benefit greatly from economies of scale and therefore can charge lower costs which accentuate their attractiveness to customers. However, active funds cannot benefit in the same way. As active funds outperform the benchmark, more capital is allocated to them and the managers will have to make more, new investments.

The problem with active managers receiving more funds and increasing their exposure to markets is that these new investments have the potential to dilute their best-performing ideas, thereby suggesting that active management actively experiences diseconomies of scale. Having the misfortune of experiencing diseconomies of scale is an extremely debilitating factor for money managers in an environment where an increasing number of people want to invest their money due to digitalisation and simple internet access to markets.

The Benefits of Passive Strategies

There are multiple technical reasons why passive investment strategies are becoming more popular than active strategies.
Firstly, the fees accumulated from passive investment are significantly smaller than active: one can expect to be charged roughly 0.20% annually for passive funds whereas fees for active management are usually around 1.35% per annum.

Secondly, passive strategies allow for tax minimisation. A key feature of passive investing is that the levels of buying and selling are kept to a minimum which therefore allows for the reduction of investment-related taxation. Thirdly, a vital component of successful trading and investment is psychological discipline and self-control. One of the benefits of passive investing is that it distances the individual from decisions about what to buy/sell so, therefore, it is easier to endure the volatility and gyrations of the market.

Furthermore, investing in a passive index of a particular market will allow the investor to diversify their equity holdings
each year as firms enter or leave the index. Allowing for diversification in equity holdings is especially useful for retail investors who do not have the skill or knowledge to analyse and value equities.

Passive-Related Trepidation

One issue with a world that focuses the majority of its investment activity on passive strategies is that capital cannot be allocated efficiently, which will, in turn, lead to market failure. One of the most important roles of financial markets is to allocate capital to firms based on their efficiency however if one is to invest via index funds then the capital to be invested is allocated to all of the firms in the benchmark, not the most efficient ones.

The problem of inefficient capital allocation is even further accentuated as active managers often stay close to the benchmark index due to fear of underperforming which depletes the number of ‘activist investors’ who often take on the role of monitoring and restructuring corporate strategy.  Furthermore, investors that purchase an index fund do not have the ability to sell the stocks of a particular firm that may be exhibiting poor management practices. Overall, the power of capitalism could be eroded due to funds following a more passive route.

Index funds are also the source of competition problems in the asset management industry. Previously, the asset management
industry was extremely dynamic and competitive due to the difficulty of constantly increasing market share: it was rare to not experience a period of poor performance where capital would flow out. However, when deploying passive strategies an asset management firm will never fail to perform worse than the benchmark and, more importantly, the economies of scale experienced will allow the behemoths of the industry to decrease fees to a level that prices many other firms out of the market.

Another worry emanates from the possible losses that could be incurred from passive strategies in times of severe market
distress. Many current and popular passive funds have not yet been subjected to a period of severe market turmoil. However, due to the extreme exposure that owning all of the products in a particular market brings, the losses than at investor may face could be significantly worse. The specific design of some passive products also leaves a worryingly large amount of scope for investors
to be hurt in a market downturn; bond indices are usually weighted by volume which means that investors end up exposed to borrowers that have the most debt – who are often the ones to suffer most in a period of downturn.

Finally, the rapidly growing popularity of passive investment strategies has led to the intense growth of index providers such as MSCI, FTSE Russell and S&P. These major index providers can control an enormous amount of investment flows by simply adding or subtracting a firm/country from the index- this level of control and influence has historically never been healthy for markets and institutions.

In Conclusion

As is the case with many of the revolutionary developments of the modern age, regardless of whether you are comfortable with
them or not there is scant alternative other than to accept and embrace them. It is often the case that even the staunchest opponents are convinced of the benefits of a process when they are forcibly exposed to the thing in question. The only thing left to do is enjoy the benefits that come with innovation.

Admittedly, there is still strong demand for active managers in fixed income however as time goes on many believe that the
specifics of passive investment can be readily applied to the bond market and be as effective as they are within equity markets. Interestingly, the rapid growth in passive investment actually provides the opportunity to take almost an active approach in a
passive arena – there are currently more stock market indexes than stocks and every single day the number is increasing.

Keep reading |  8 min read

Brexit

Progress and Economic Realism in UK-EU Relations

 5 min read / 

The architects of the Leave vote in 2016’s Brexit referendum will no doubt have been encouraged when EU leaders agreed to move to phase two of the ongoing transitional period on December 15th. The EU 27 summit will review the conduct of UK-EU negotiations expressed satisfaction that sufficient progress has been made in each of the priority areas.

This consists of the protection of EU citizens’ rights, the divorce bill,  and the Northern Irish/Ireland border issue – although the latter may still prove problematic in future phase three talks on trade. It was always assumed that phase one was the least difficult hurdle and EU Council President Donald Tusk warns that tough negotiations lie ahead.

The UK is unravelling 43 years of EU membership, effectively making it ‘EU accession in reverse’. Westminster has to state what kind of relationship it wants and this remains unclear, except that Parliament wants more say in any future trade relationship. This is acting as a break on the aspirations of more ardent Brexiteers.

Future Trade

Eurosceptics on both sides of the political spectrum have failed to judge the impact of Brexit on future trade with the EU27, the UK’s biggest partner. There is still an amateurish belief that the outside world is itching to get into cosy trade arrangements with a new-look ‘global Britain’. Many old trading partners such as Australia and New Zealand previously felt their special trade links with the ‘mother’ country were unceremoniously ditched 43 years ago when the UK joined the European Economic Community (the forerunner of the EU), leaving them scrambling for new markets nearer home.

But having successfully opened up trade in Asia and the Americas, these nations are now in a stronger position for any future bilateral negotiations with Britain and will no doubt have a menu of tough conditions for renewing increased trade. The difficult quid-pro-quo discussions in November between Theresa May and the Indian Prime Minister, Narendra Modi, also provide a taste of what’s to come. While keen to expand commercial links, Modi used the meetings with May in New Delhi to trigger demands for more immigration visa quotas and for Britain to re-introduce the right of Indian students to work in the UK after graduation.

Other potential trading partners such as the United States have more relaxed regulations than in the UK in the sale of agricultural products. Indications are that they will raise objections to any deal with Britain if UK trade authorities boycott any American produce. The Cabinet Minister for the Environment, Michael Gove has already made it clear that Britain is not about to reduce its foods standards policy to accept US chlorinated chicken products and GM crops that are banned under EU regulations.

The UK farming sector has been the beneficiary of vast EU subsidies for many years and has deep concerns that these will not be replaced despite government promises to the contrary. This belief is compounded by fear their industry will be decimated by cheaper US and South American imports when ‘global Britain‘ takes off.

Post-Brexit Regulations

Getting a ‘bespoke’ trade deal with the EU is paramount for the UK and its success decides the future of the Tory party. The EU is toughening its stand on both transition and trade talks and is anxious not to convey any expectations of special treatment so a Canadian Comprehensive Economic and Trade Agreement (CETA) or “Canada plus” trade deal will not be a model they would likely agree for the UK.

This is unless the UK recognizes it will lose access to the Single Market for its Financial Services industries – a vital export driver contributing £71.4bn in revenue in 2016. There are some EU members, in particular, Italian Prime Minister Paolo Gentiloni, who are more disposed to granting Britain a ‘bespoke deal’.

This view, however, is not broadly not shared by other EU leaders who are waiting to see how the British government intends to move negotiations forward. This cannot be done without reference to many sectors of British industry. Manufacturers in the car industry with complex product supply lines have been prominent in voicing their anxieties about the difficulties of trading outside the Single Market. This led to some ‘private’ assurances by Theresa May that their interests will be protected. Other sectors are joining a chorus of pressure on the government to bend towards a softer Brexit – to stay under EU rules – to obtain the best possible trade deal.

Final Thoughts

As the world’s largest consumer market, the EU effectively exports its regulatory standards through its economic weight. The UK ‘Reform Bill’ will transfer EU regulations into UK statute recognising the ever-present ‘Brussels effect’, which dominates trade regulations throughout the world. How far this influences future upcoming transition and trade talks remains the subject of a separate detailed discussion.

Keep reading |  5 min read

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