Musk’s Engineering Philosophy

Musk overviewed his five step engineering process, which must be completed in order:

  1. Make the requirements less dumb. The requirements are definitely dumb; it does not matter who gave them to you. He notes that it’s particularly dangerous if an intelligent person gives you the requirements, as you may not question the requirements enough. “Everyone’s wrong. No matter who you are, everyone is wrong some of the time.” He further notes that “all designs are wrong, it’s just a matter of how wrong.”
  2. Try very hard to delete the part or process. If parts are not being added back into the design at least 10% of the time, not enough parts are being deleted. Musk noted that the bias tends to be very strongly toward “let’s add this part or process step in case we need it.” Additionally, each required part and process must come from a name, not a department, as a department cannot be asked why a requirement exists, but a person can.
  3. Simplify and optimize the design. This is step three as the most common error of a smart engineer is to optimize something that should not exist.
  4. Accelerate cycle time. Musk states “you’re moving too slowly, go faster! But don’t go faster until you’ve worked on the other three things first.”
  5. Automate. An important part of this is to remove in-process testing after the problems have been diagnosed; if a product is reaching the end of a production line with a high acceptance rate, there is no need for in-process testing.

From: https://everydayastronaut.com/starbase-tour-and-interview-with-elon-musk/

Covid, wages and inflation in the US

In pre-Covid US, the unemployment rate had fallen to near 50-year lows and yet inflation and unit labour costs remained subdued;

aging of the population will continue to weigh on participation going forward,

wages have accelerated over the years,

and wage growth has been firmer at the bottom end of the wage distribution.

Powell, in his June FOMC press conference said that the pandemic has seen many placed on ‘temporary layoff’ who are now finding themselves having to find new jobs as the recovery is under way. He said, “in particular, despite progress, joblessness continues to fall disproportionately on lower-wage workers in the service sector and on African Americans and Hispanics”, a statement that reiterated the shift of Fed’s employment focus on max employment, defined as “broad and inclusive”.

Whereas in Europe, workers’ support concentrates on preserving existing employment relationships through wage subsidies, the US system abruptly forces temporary layoffs, which may also turn into permanent ones as relationships and ties with former employers weaken over time. 

This is a highly efficient system if post-Covid the US economy is to go through major structural changes such as large sector reallocations. However, this system becomes a problem if the shape of the economy remains the same as pre-Covid as it introduces further stickiness and major search costs.

Although the US labour demand appears resilient, almost 4 million people cited Covid as their reason for not looking for work and around 1 million went into early retirement. According to a Goldman report, the disproportionate layoffs of low-wage workers have led to an upward “composition bias” in series such as US average hourly earnings. Moreover, furlough schemes have transferred labour costs from firms to governments, which has artificially reduced compensation per employee.

Covid’s impact on inflation depends on the relative sizes of the supply and demand shocks.

In the same June press conference, Powell also mentioned that supply shocks narrow short-run productive capacity, leading to lower real activity and higher inflation. Some argue that this may persist much longer than the word ‘transitory’ implies. However, for transitory effects to turn into more persistent effects on the inflation rates, the price increase would need to substantially change inflation expectations, thereby starting a spiral of wages to prices and prices to wages increases.

I saw today that Powell said that inflation expectations are not at troubling levels. It’s good to know then that the institutional stability our modern times has built works, ensuring (so far cross fingers) that unanchoring of expectations doesn’t happen abruptly or out of the blue.

Subsequently, there might be downward pressure on wage growth due to output gaps, given wage stickiness and lags in the Philips curve. If we manage to get Covid properly under control faster than expected, this could also push wage growth down. The return of low-wage workers would also reverse the upward composition bias mentioned above. Increasing slack significantly reduces wage growth. 

As a rule of thumb, a 1 pp fall in the unemployment rate gap (decrease in slack) raises wage growth by 0.3-0.4 pp. In the modern era of low and stable inflation expectations, unemployment rate has a statistically highly significant and very robust effect on wage growth. 

Having said that, wage growth is not necessarily inflationary. This may be explained by the labour market structure. A greater coverage of collective bargaining is associated with higher pass-through from wages to inflation and the US has lower pass-through compared to Europe.

The impact of the Brexit deal in the long run

I thought I would share this from a JPM report:

What about the economic impact of the Brexit deal over the longer run? There are several pieces to this, but one of the most conspicuous is how regulatory change will impact the UK’s ability to export to the EU. In prior work, we examined how a full shift to non-EU status would impact the UK services sector. More specifically, we looked at how changes in the World Bank’s measures of services trade restrictiveness are reflected in the cross-country pattern of UK services exports. We concluded that a full reversion to non-EU status would tend to lower UK services exports to the EU by 29%, with a 10% reduction of non-EU exports owing to complementarity effects (for example when a US-based firm purchases services relating to activities in the EU from a UK-based one). Those declines would sum to a 2.3% hit to the level of GDP acting through regulatory change alone. With the Brexit settlement now in hand, we see little reason to moderate that estimate of the impact very much.

The absence of deep services provisions in the agreement does not come as a surprise to us. But compared to our expectations a year or so ago, the UK has also secured less regulatory recognition from the EU than we had anticipated in the goods sector. The absence of anything close to “equivalence” for respective regulations over goods, and of mutual recognition of conformity assessment bodies, provides levers for the EU to encourage manufacturers serving EU markets to base themselves in the EU rather than in the UK. While these changes may be more subtle and slower-acting than in the services sector, we find it easy to imagine them accounting for a hit in excess of 1% of GDP over time, even given the UK manufacturing sector’s already diminished size.

Work by ourselves and others has already identified a significant hit to UK GDP while the uncertainty over the UK’s relationship with the EU has persisted, acting primarily through weakness in business investment. The OBR, for example, has suggested a 2% hit from this source to date. The deal significantly increases the uncertainty over the UK’s relationship with the EU. While that may allow some investment that had been postponed to resume, we doubt that the nature of the settlement will boost business investment overall. 

Taking the near-2% hit to UK activity via regulatory change in the services sector, 1% hit in the goods sector from the same source, and 2% hit via depressed business investment to date sums to a near-5% hit from these sources alone. In addition to these, we also need to consider how Brexit may impact forces such as future migration flows and productivity growth. In our view, assessments of these impacts are even more speculative than those already discussed. While most expect migration flows from the EU to the UK to be lower as a result of Brexit, there is much uncertainty about magnitudes. The dynamics of the UK’s very weak productivity performance over the last decade or so are not well understood. However, most analyses expect a negative impact from Brexit from this source as the intensity of trade flows (and hence competitive pressure to innovate) is reduced. Ahead of the referendum analyses of the long-run impacts of a “hard” form of Brexit had tended to the 5%-10% of GDP range, and that remains a realistic ballpark, in our view.

Making sense of the Fed’s average inflation targeting policy

The Fed, on top of promoting maximum employment, is in the business of setting expectations and anchoring rates. Setting interest rates expectations is a tricky endeavour but a very important one. Anchoring rates is necessary, especially in the presence of inflationary inertia. Japan and Argentina on either spectrum come to mind.

The prospect of high inflation in the US still strikes fear in the hearts of economists. In October 1979, the Fed under Paul Volcker faced inflation that was around 10%, with every indication of climbing higher. The Fed’s policy at that time failed to stimulate growth or made no improvements in employment. Doubt about the Bank’s policies was high and it took the Fed more than ten years to restore its credibility and bring inflation and inflation expectations down to the magic number, 2%.

However, this is not the story of our times.

We are at historically lowest rates, the inflation in the Fed’s preferred measure has averaged only 1.5% over the last decade. Alongside with high unemployment and poor growth, we can expect the Fed to commit to “low for longer” (LFL) policy rates, close to zero, and a large balance sheet for some time to come.

“In another moment Alice was through the glass… Then she began looking about, and noticed that… all the rest was as different as possible.”

– Through the Looking Glass, and What Alice Found There, by Lewis Carroll.

Having travelled to the other side of Alice’s looking glass, the Fed now has to be wary of deflationary pressures.

The dangers of deflation include:

  • falling prices and wages,
  • people will put off buying,
  • negative rates policy is very hard to implement should it be necessary,
  • it’s not good for debtors as even though prices and wages fall the value of your debt does not – just to list a few.

Therefore, it’s important that we have policies that help mitigate the adverse effects.

For the Fed, declining interest rates would mean less scope to cut interest rates to boost employment during downturns. In Chair Powell’s latest speech, he said, “We have seen this adverse dynamic play out in other major economies around the world and have learned that once it sets in, it can be very difficult to overcome. We want to do what we can to prevent such a dynamic from happening here.”

Inflation targeting policies work through the public’s inflation expectations. Two main measures of inflation expectations are the survey-based and market-derived (e.g. breakeven inflation expectation) measures. A recent Fed note by Anthony Diercks and Isfar Munir found that divergent signals can arise out of these two measures. So how would one interpret such divergent signals? They found that during the last 15 years, predictions based on market quotes tend to provide better forecasts of the Fed funds rate.

(Breakeven inflation is defined as the difference between interest rates on nominal Treasuries and TIPS, equal to headline CPI inflation expectations plus an inflation risk premium (which could in theory be positive or negative) minus the TIPS liquidity premium. Since the Fed’s 2% target is in PCE terms, a target-consistent level for breakevens would be 2% + CPI-PCE gap + inflation risk premium – TIPS liquidity premium.)

The idea of inflation targeting is very easy, it is to create a nominal anchor for monetary policy as evidence of the Fed’s commitment to price stability. New Zealanders were the first to adopt inflation targeting in 1990, followed by Canada in 1991, the UK in 1992 and Sweden and Finland in 1993. Inflation targeting was implemented after previous inflation controlling measures had failed (e.g. Canada and NZ) or after the removal of policies such as pegged exchange rates (e.g. Sweden, UK and Finland).

In “Twenty-five Years of Inflation Targeting in Australia: Are There Better Alternatives for the Next 25 Years?”, McKibbin and Panton write that inflation targeting strictly speaking involves achieving and maintaining low and stable inflation, with a base drift, without consideration for controlling deviations in the output level. Shocks that affect price stability, whether temporarily or permanently are accommodated by changes to the policy rates.

According to Frederick S. Mishkin, inflation targeting is a monetary policy strategy that encompasses five main elements:

1) the public announcement of medium-term numerical targets for inflation;

2) an institutional commitment to price stability as the primary goal of monetary policy, to which other goals are subordinated;

3) an information inclusive strategy in which many variables, and not just monetary aggregates or the exchange rate, are used for deciding the setting of policy instruments;

4) increased transparency of the monetary policy strategy through communication with the public and the markets about the plans, objectives, and decisions of the monetary authorities; and

5) increased accountability of the central bank for attaining its inflation objectives.

Comparing Inflation and price-level targeting

comparing inflation and price level targeting

This chart from VoxEU, shows how expectations adjust according to the regime in place. If the Fed commits to a 2% inflation target and inflation unexpectedly rises to 3% in period 3, the public will expect future inflation to be 2% at periods 4 and 5. However, if the regime is a price-level target, the public will expect future inflation to be at 1% in period 5. In the face of a shock, the price level jumps in the inflation targeting regime. A slight difference, but good to note at this point is that price-level targeting may give different outcomes compared to inflation targeting.

The effective lower bound (ELB) is the rate below which it becomes profitable for financial institutions to exchange central bank reserves for cash. Practically, the lower bound for nominal interest rates is not zero but negative due to cash storage costs. Hence, it is an “effective” lower bound rather than “zero” lower bound.

In a world without ELB, a successful discretionary policy should counteract the effects of a demand and/or supply shocks as well as anchoring inflation expectations at the desired target. However, at the level where the ELB is binding, interest rates move will not be as responsive to shocks, leading to lower inflation and a larger output gap.

The bad news is that economists believe that the economy will frequently hit this lower bound for the foreseeable future. The Fed’s new monetary policy framework can be affected by the frequency, depth and duration of this bounce off the ELB.

“Opportunistic reflation” is a good phrase to describe Fed’s recent aspiration. In Governor Brainard’s latest speech she said, “By committing to seek inflation that averages 2 percent over time, flexible average inflation targeting (FAIT) means that appropriate monetary policy would likely aim to achieve inflation moderately above 2 percent for a time to compensate for a period, such as the present, when it has been persistently below 2 percent. Consistent with this, I would expect the Committee to accommodate rather than offset inflationary pressures moderately above 2 percent, in a process of opportunistic reflation.”

Mertens and Williams, in “Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates”, reinforce this idea of mitigating downward bias in inflation by following an AIT framework by aiming for above-target inflation when not at the ELB. Raising inflation expectations when inflation is low can both anchor expectations at the target level and further reduce effects of the ELB on the economy.

Unlike the conventional inflation targeting method where expectations can end up being anchored at a level below the inflation target, which in turn exacerbates the negative effects of the ELB, AIT hopefully can correct for the downward bias in inflation expectations.

beckworth tweet

Historical dependence is a very important component of calculating AIT. What do we mean by historical dependence? It is how far back we look in time to calculate the target. The lag in the AIT equation or the size of the time window we use to calculate the average is not disclosed by the Fed.

In fact, Chair Powell has specifically said that the Fed will not commit to any AIT formulas, “In seeking to achieve inflation that averages 2 percent over time, we are not tying ourselves to a particular mathematical formula that defines the average. Thus, our approach could be viewed as a flexible form of average inflation targeting.”

This sentiment is reiterated by the Vice Chair Richard Clarida, “nor is it a commitment to conduct monetary policy tethered to any particular formula or rule…at the risk of repeating myself, let me restate it verbatim: “… following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” FULL STOP.” (Bold and capital letters inserted by me).

But just for the sake of discussion, what would the AIT formula even look like?

It could look something like this:

AIT formula

(φ is weight on the targets)

For good measure, included are inflation targeting rule and price-level targeting rule (PLT) from “Average Is Good Enough: Average-Inflation Targeting and the ELB” by Amano, Gnocchi, Leduc and Wagner  for us to notice and compare the slight differences.

All three work through raising the inflation rate above the target rate when policy is not constrained. All three also depend on influencing private sector expectations so policy credibility and public understanding are important in ensuring each policy’s success.

Alternatively, the formula could be such as the one from Reifschneider and Wilcox’s paper (two former top Fed staff economists), “Average Inflation Targeting Would Be a Weak Tool for the Fed to Deal with Recession and Chronic Low Inflation”, where they assume the Fed would simply modify a “balanced approach” Taylor rule to put some weight w on the trailing inflation gap:

Policy interest rate = r* + current inflation + 0.5 * (current inflation – 2%) – 2 * (unemployment rate – structural unemployment rate) + w * (trailing inflation gap)

The lookback window for the trailing gap varies for different policies. Traditionally, the lookback is over last year’s inflation. For price-level targeting, it may be the full inflation gap since the start of the policy. For AIT however, it could be the whole gap since the start of ELB binding or, the lookback could be an intermediate window, e.g. 5 years. The weight w could be the same as the year-on-year gap weight that conventional policy uses, which is 0.5.

Another variant is put forward by Goldman Sachs, which suggest two possible alternatives of AIT formulas where for the first one, the policy rule raises the inflation target temporarily when inflation has persistently run below 2%. The second formula adds instead the cumulative inflation shortfall, perhaps since the start of the recession, as an additional term to the policy rule.

AIT_all

Looking at all these formulas it’s clear that no matter which form it takes, the lookback is a very important aspect of AIT.

Questions about the speed of adjustment are difficult to answer, mainly because of the flexible element of this monetary framework. Having said that, the seminal work of Brainard cautions us against too quick of an adjustment, considering the uncertainty in economic data and the reaction of participants to this unconventional policy.

The gradualism approach tells us that policy calibration is not a one-off process but rather an iterative one, with what should be plenty of feedbacks. The Fed needs to listen to the market and the market needs to be educated and informed at every step of the way. This feedback loop will inform the efficacy of the policy and its transmission mechanism. Prudence should be the basis of every Fed’s decision or as Yellen used to say, “data dependent”.

The exception to this would be when the degree of inflation persistence is likely to be high and risks de-anchoring inflation expectations. At that point, policy anti-attenuation should be the rule of the day, where the Fed responds aggressively to inflation (or deflation).

Flexible in the “flexible AIT” means that AIT is applied in conjunction with considerations of unemployment, output and general domestic and global conditions. Chair Powell in his statement on the 27th said, “In seeking to achieve inflation that averages 2 percent over time, we are not tying ourselves to a particular mathematical formula that defines the average. Thus, our approach could be viewed as a flexible form of average inflation targeting. Our decisions about appropriate monetary policy will continue to reflect a broad array of considerations and will not be dictated by any formula. Of course, if excessive inflationary pressures were to build or inflation expectations were to ratchet above levels consistent with our goal, we would not hesitate to act.”

In other words, the ultimate decision will be more subjective than it is objective.

Perhaps the connection between unemployment and inflation today can be summed up by this paragraph from Joe Weisenthal’s newsletter: “While many people say that the problem for the Fed is that inflation has consistently come in beneath its 2% target, that’s not really it. The real issue is that it has consistently underestimated how strong the labour market could get, without triggering inflation. In the wake of the Great Financial Crisis, the Fed’s first hike came at the end of 2015 when the unemployment rate was still at 5%. Over the next few years, the unemployment rate just kept falling without triggering sustained inflation, indicating that there was far more “slack” left in the labour market than they had appreciated back in 2015 when they first raised rates.”

Thus, there seems to be plenty of slack left in the economy, but what happens when the slack starts to decline? Declining slack significantly boosts wage growth. According to Goldman Sachs, the rule of thumb is that a 1 pp fall in the unemployment rate gap raises wage growth by 0.3-0.4 pp. The unemployment rate has statistically highly significant and very robust effect on wage growth in the modern era of low and stable inflation expectations.

The effect of the unemployment rate on wage growth is also statistically significant when looking only at data from the current expansion. Most datasets suggest that the Phillips curve is non-linear, strengthening at low unemployment rates. All this underscores that slack is a key driver of wage growth.

Domestic cost inflation is one of the main drivers of medium-term inflation pressure with wage inflation as the largest component of domestic cost inflation. When other temporary factors such as import prices affect inflation, wage inflation is a very useful indication of the underlying inflation pressures once the temporary factor goes away.

From the recent Fed’s press release, “On maximum employment, the FOMC emphasised that maximum employment is a broad-based and inclusive goal and reports that its policy decision will be informed by its “assessments of the shortfalls of employment from its maximum level.” The original document referred to “deviations from its maximum level.””

Another way to say this is that it will be a high bar for the FOMC to tighten just because the unemployment rate goes below the estimated natural rate of unemployment.

The “broad-based and inclusive goal” in the press release is an effort to avoid opportunity cost of reducing accommodation in terms of the employment of minorities. In her latest speech, Governor Brainard said, “The decision to allow the labour market to continue healing after the unemployment rate effectively reached the 5 percent median Summary of Economic Projections (SEP) estimate of the normal unemployment rate in the fourth quarter of 2015 supported a further decrease of 3-1/2 percentage points in the Black unemployment rate and of 2-1/4 percentage points in the Hispanic unemployment rate, as well as an increase of nearly 3 percentage points in the labour force participation rate of prime-age women. It also created conditions for the entry of a further 3-1/2 million prime-age Americans into the labour force, a movement of nearly 1 million people out of long-term unemployment, and opportunities for 2 million involuntary part-time workers to secure full-time jobs.” In this there are lessons for the carrying out of future Fed decisions to be more inclusive.

The AIT policy framework is not without its disadvantages. The presence of lags between policy to the inflation outcome as well as the current parameter fuzziness means that there will be weak accountability on the Fed’s side. If applied more rigidly AIT also brings about the possibility of passing through big shocks to the economy in cases where maintaining the average would run counter to the immediate needs of the economy, as well as the question of whether AIT will affect the exchange rates.

Referring once again to Reifschneider and Wilcox’s paper mentioned before, the criticism they have for AIT is that the policy might not realistically be able to deliver the large inflation overshoot needed to reach the average 2% target. At the other extreme where the ELB is binding, AIT will not be able to influence expectations very much and therefore, is not an effective tool in fighting recession or boosting the economy.

In their own words, “The combination of the ELB constraint and the flatness of the Phillips curve prevents monetary policy from raising inflation back to 2 percent quickly; with the return instead taking many years, the average inflation gap is thus modest by the time actual inflation is close to 2 percent again. As a result, the rules do not call for a materially easier stance of policy at that point compared with the balanced approach rule and so do not support the tight labour market conditions needed to push inflation materially above target.”

To reiterate, the case today is such that a moderate application of the AIT will mean a very long time for a return to the 2% average, especially since the Phillips curve is flat. (Let’s not get into the discussion of whether the curve is dead or alive).

In addition, AIT cannot reduce the unemployment gap in a very bad recession. Reifschneider and Wilcox find that none of the AIT rules markedly improve simulated labour market conditions or check disinflationary pressures during the first five years after the onset of a recession. There are other concerns outlined in the paper that may be of interest to some.

According to “From Taylor’s Rule to Bernanke ‘s Temporary Price Level Targeting (TPLT)” by Hebden and Lopez-Salido, strict adherence to Taylor-type rules would usually lead to early departures from ELB episodes, but with a high likelihood of a relatively prompt return to the bound.

In the paper, Hebden and Lopez-Salido compute the efficient policy frontiers that trace out the best minimum obtainable combinations of output and inflation volatility given the ELB constraint on the policy rate and the assumed structure of the model economy. Each point on a frontier corresponds to an optimal trade-off for a central bank with a particular preference for minimising inflation volatility relative to unemployment volatility.

They found that an inflation-averse policymaker will have to tolerate greater and greater increases in unemployment volatility to achieve negligible improvements in stabilising inflation. The frontier also indicates that an unemployment-averse policymaker will face a steep trade-off in accepting higher inflation volatility if exclusively concerned with minimising unemployment volatility. In a nutshell, policies would fare better when aversions to inflation and unemployment volatility are relatively balanced.

AIT is neutral in terms of fiscal policy. Whereas ten years ago, the concern with inflation targeting was that it cannot prevent fiscal dominance, today’s problem is that Congress may not be doing enough in giving substantial fiscal policy support for the economy.

In a recent NPR interview Chair Powell said, “So Congress did respond very strongly. I sense that there’s – you can see that there is pretty widespread agreement on both sides of the aisle that something needs to be done. I guess there are differences, it appears, as to what needs to be done and how big it needs to be…But those sorts of things are for Congress to decide. But I do think there’s agreement that something needs to get done. And my guess is that in time, more will be done. And certainly, I think more will be needed.”

The credibility of this policy rests on the efficacy of the AIT model itself, and how the Fed’s policy framework is explained and understood by the public. For now, the public still has a murky understanding of it – not only because there are some aspects of the policy that is kept hidden from the public such as the actual not-a-model used and its parameters, including the list of additional criteria that define its “flexibility” – but also with the way the Fed is explaining the policy to the public.

Perhaps the Fed should keep in mind that the public can deal with any uncertainty thrown its way, as long as they know what they are supposed to be uncertain about.

Supply chain resilience

After decades of uninterrupted growth in global trade, which led to ever greater specialisation, efficiency and lower inventory levels, the twin shocks of the trade war and the pandemic require an urgent reassessment of how to organise supply chain in the future. This post will outline some key considerations and trade-offs in the search for more robust solutions to reduce supply chain risk. The focus will initially be on choices and trade-offs within Asia before exploring the challenges if re-shoring.

What price for what labour?

A manufacturer needs to think long and hard when choosing a location. There are many factors that need to be weighed in finding the right spot and often, compromises have to be made to ensure production remains efficient and economical. The first consideration for a location is often the supply of labour.

India is a good example of a large labour pool. However, only 30 million people in India are in manufacturing compared to 100 million in China. Urbanisation is still lower there and livestock farming is a much bigger employer than manufacturing. Vietnam and Philippines have an even smaller pool which is a tenth of China’s. The foremost concern for labour-intensive manufacturers would be labour costs as well as wage growth, such as in the apparel sector where 20% of costs come from labour. The apparel sector also normally employs at minimum wage. China’s minimum wage is almost double that of Vietnam, Cambodia and Indonesia with Bangladesh being on the extremely low side.

Vietnam has frequently been suggested as a good alternative location outside of China. Comparing China and Vietnam shows that the minimum monthly salaries in Vietnam range from US$120 to $173, which is below the US$265 to $329 in China (Shenzhen, Kunshan, Chongqing and Chengdu). The minimum wage requirements in Vietnamese industrial parks such as Bac Giang, Bac Ninh and Binh Duong are around 50% lower than cheaper inland locations like Chongqing or Chengdu.

Labour cost advantage exists as long as productivity growth remains above the wage growth. According to the Institute Labour Organisation, the representative manufacturing hourly wages in USD for US, China, Mexico and Vietnam show China at double the rate of Vietnam, with Mexico right in the middle.

Manufacturing labour costs per hour for China, Vietnam and Mexico from 2016 to 2020 (USD)

statista 1

Average hourly earnings in U.S. manufacturing from 2006 to 2019 (USD)

statista 2

In Vietnam, between 2017 and 2019, the minimum wage and average salary have increased by around 6% and 5% respectively annually. Apart from the minimum wage, other considerations include the remuneration of supervisors that can speak both English and Mandarin, or other mother tongue of the employer. Language skill is important when setting up at a foreign location.

Even if labour is plentiful and the wages are relatively low, cultural differences become a major operational challenge and may be the difference between success and failure. An example that comes to mind is the 2019 Netflix documentary “American Factory”. This program about a newly opened Chinese-owned glass factory in Ohio exemplifies the huge differences between the workers in America and the China, not only in skills but also in work ethic and culture.

Quoting from the FT, “the culture clash sees the Chinese regularly describe American workers as inefficient or fat-fingered. Americans complain about Chinese disrespect for local laws, a lax approach to health and safety and mandatory overtime that eats into the weekend.”

Other prerequisites

Infrastructure includes utilities (water, gas, internet, electricity and waste), transportation access and land to build on. The more heavily reliant on these a manufacturer is, the higher the standards need to be, not just at the national but also at the local level. A garment maker can get by with diesel backup for a few hours but a chip foundry needs the very highest quality of everything.

An adjacent but not much thought of factor is environmental pollution. According to YOFC, an optical fiber maker, Indonesia tends to have cleaner air than Wuhan which makes the manufacturing of optical fiber easier.

Regulatory requirements, policies and tariff burdens can incentivise a manufacturer to select a particular location. In Vietnam for example, tech companies are allowed tax exemptions for the first two years and a 50% tax reduction for the next four years. Apart from tax incentives, governments can also play a huge part in funding support, providing cheaper land and subsidising research and development.

At the same time, forcing foreign investors to partner with locals and share IP can very easily deter investment. A careful balance between maintaining firm-specific IP protections and raising the general local level of know-how can make an attractive combination.

Proximity to the supply chain is also important because of higher transportation costs and longer shipping times. The US-China trade war has propelled some companies in the Greater China tech space to expand to Vietnam because of its proximity. For Chinese factories situated in Vietnam, these are within two to three hours’ drive from Guanxi on the Vietnam-China border.

The costs of shipment from Chinese cities to Vietnam is higher than shipment to domestic cities because of the distance. For instance, average distance from Kunshan, a city near Shanghai where the factories of several tech companies are located, to four cities in Northern Vietnam is 29% more than the distance to Chengdu or Chongqing.

The alternative is sea freight but this will take longer as compared to road. The average number of shipment days from coastal cities in China to Hai Phong port in Vietnam is six days and to Ho Chi Minh port is seven days, both longer than the maximum 4 to 5 days it takes to ship domestically.

Limited port capacity also reduces capacity. UNCTAD shows Vietnam’s share of global container port throughput is only around 2% as of 2017 versus 33% for Greater China. According to World Shipping Council, 16 ports in Greater China are among the top 50 world container ports by shipment volume in 2018. Only two ports from Vietnam are on the list – Ho Chi Minh port and Cai Mep port, which rank 26 and 50, respectively.

From a paper by Antràs and de Gortari “On the Geography of Global Value Chains”, “With costly trade, the optimal location of production of a given stage in a GVC is not only a function of the marginal cost at which that stage can be produced in a given country, but is also shaped by the proximity of that location to the precedent and the subsequent desired locations of production. We show that, other things equal, it is optimal to locate relatively downstream stages of production in relatively central locations.”

Barriers to diversify

There are several reasons that it might not be ideal to diversify location at all. Using China-Vietnam as an example, China’s emerging wafer producers and leading memory start-ups could expand semiconductor production to Vietnam to avert tariff issues but the industry is still at an infant stage. China needs to catch up to the US in terms of innovation and leading-edge technology.

In terms of talent supply, Vietnam cannot produce the same number of engineers as those in China. Perhaps the solution is to attract Vietnamese students to study and train in China. In terms of non-engineering talents, challenges include training workers who have no prior experience in specialised products and raw material procurement as well as management.

From the International Labour Organisation, “investing in human capital via extensive training and education, as well as improving the innovative capacity of clusters within a process of both economic upgrading for firms and social upgrading for labour can support the competitiveness of these clusters in global markets. The process of industrial upgrading must be accompanied by a process of social upgrading for labour, which involves improved working conditions for workers, as well as providing social recognition and greater opportunities for education and professional training that would raise their skills, incomes and human capital.”

In addition, the supply chain is still under development in Vietnam. Compared to China with easy access to materials, equipment and services as well as the fact that major global suppliers are situated there, Vietnam is still incomplete. Vietnam will still need major support links from China to operate as part of supply chains. Hence, any US trade policies adverse to China will still hit the production in Vietnam.

The hysteresis effect in trade shouldn’t be overlooked when there is a regime change in trade policies. The presumption is that companies will shift production to lowest costs locations. Incomplete supply chains can result in higher costs as the incomplete parts need to be outsourced more expensively. Hence, a location change is not necessarily feasible should trade policies become unfavourable.

These outsourcing costs usually end up being passed on to consumers. This is possible as long as the prices remain competitive. The inconvenience of the exercise, the uncertainty of how long the new policy will remain unchanged and the unfamiliarity of the possible new locale deter production from being moved and firms opt instead to remain in China with its vastly more comprehensive supply chain ecosystem.

At the end of the day, the diversification out of China rests on how entrenched China is in the global value chain such that a true decoupling would be too costly, and the continuing trend of protectionism.

A few sector examples

The US has issued many trade regulations concerning semiconductor manufacturing and technology IP for the past year, making it more difficult to situate in China. For the US, pressure via trade regulations is possible as long as the US remains the leader in this field, especially at the higher level of complexity such as software design and semiconductor manufacturing.

On the other hand, after over twenty years of building infrastructure for this industry, China is migrating to upstream semiconductors. US trade policies have accelerated China’s localisation of their semiconductor supply chains. China’s domestic diversification of their supply chains have given new opportunities for emerging local suppliers.

The massive scale of some Chinese brands has also allowed domination of their own domestic markets. Experience at supplying a market this large leads to a rapid move up the learning curve. The ability to directly interact with intermediate and end consumers also helps in product improvements.

In a Goldman report on semiconductors, “The long-term winners in China semiconductors are leaders in technology, scale and SKUs and are best placed to benefit from the localisation of supply chains. A cycle of accelerated tech migration, expanding product lines and rising market share will drive outsized earnings growth over the next five years.”

As for smartphones, in 2019 there were 149 Apple suppliers in China. Southeast Asia countries will stand to benefit if these suppliers have to relocate. There are talks of shifting a fifth of iPhone production from China to India over the next five years with most of the production for export. In comparison, Google’s Pixel 4 phone is rumoured to be partly manufactured in Vietnam. The company is planning to repeat it this year with its new low-cost Pixel 4a as well as its next flagship model Pixel 5.

According to the BGR site, “Google is not as heavily tied to China from a manufacturing standpoint as a company like Apple is, so a move like this doesn’t entail the logistic headache that you might imagine. Google shipped 7 million smartphone units last year, compared to the 200 million or so Apple sells every year, according to data from IDC… This shift is both fortuitous and yet still problematic for Google, which had already converted a factory in Vietnam for exactly the kind of production it will now be ramping up there. However, there’s still one hiccup the company hasn’t figured out how to overcome yet – the fact that many of the components that need to be supplied for the Pixel production still come from within China.”

In other words, the supply chain ecosystem still needs time to be built.

A recent ING report stated that “Supply chains in the automotive industry consist of a large group of specialised suppliers that are clustered within regions. Most value is added in the region where the cars are sold, but the inter-regional links were still able to stop the global automotive industry in its tracks early in the Covid-19 outbreak. The lockdown in Hubei province in China forced factory closures in Europe weeks before European countries went into lockdown. The costs of supply chain disruption are considerable.

In early June, the European Automobile Manufacturers Association (EAMA) reported that factory shutdowns due to Covid-19 (30 days on average at the time of reporting) had resulted in a production loss of 2.5 million vehicles in Europe, of which around 617,000 were in Germany, the hub for European car manufacturing.”

For the automotive industry, finding remedies is a gigantic task. Diversifying suppliers who need to produce to detailed specifications, quality and safety standards and holding more inventory where many of them are bulky is difficult and costly. However, even though it took a long time, it is possible to do – witness how Slovakia and Mexico have become a vital supply backbone in Europe and America over the past few decades.

People vs. robots

Covid-19 has impacted labour supply such that automation efforts are likely to be accelerated. In the long run, this will reduce the importance of labour when choosing a location. The consideration of whether to automate depends on how long a product is in production, the construction of the product, the type of labour required for automation and of course, the number of engineers and tech personnel needed.

robot collaboration supply chain

From a recent Goldman Sachs report, “automation has the potential to reduce the number of traditional line workers in phone assembly but create new engineering roles. One expert estimated that automation can reduce the number of people needed for final assembly by 40% to 70%. However, this would require OEMs to change the product cycle or design to make automation practical.”

The number of robots shipped to China is the highest in the world, although at 140 per 10 000 employee, robot penetration per employee is still higher in more developed markets.

The Republic of Korea has 774 industrial robots per 10 000 employees, more than twice the number of Germany (third with 338 units) and Japan (fourth with 327 units). Singapore leads with 831 robots installed per 10 000 employees.

IFR 1

This chart from an IFR 2019 presentation shows the region where automation is the highest:

IFR 2

After eight years of strong automation growth, annual installations of industrial robots in China is experiencing a slight dip. Whether this slowdown in China is a continuing trend remains to be seen. Having said that, China has surpassed the global average (99 units per 10 000 employees). Considering Tesla and others are in the midst of expanding their operations there, we should not be too worried about automation stagnation in China.

In keeping with the previous China-Vietnam comparisons, the annual industrial robot shipments in China were around 17 times that of Vietnam in 2017. Vietnam also has the lowest number of industrial robots installed per 10 000 employees among the Asian countries, a far cry from Chinese levels.

David Autor and Elisabeth Reynolds, in their recent Hamilton project paper “The Nature of Work after the COVID Crisis: Too Few Low-Wage Jobs” write, “In interviews of small and mid-size manufacturing firms conducted by the MIT Work of the Future Task Force during the crisis, several employers reported that, rather than shut down or curtail production, they found instead that it was feasible to reconfigure their lines to be less labour-intensive without sacrificing output.”

Forced automation may be the trend for many manufacturers who find themselves subjected to greater protectionist tariffs and difficulties in finding labour that meet requirements. Autor and Reynolds conclude in the paper that the unexpected pandemic has “simply brought the possibility of an increasingly automation-intensive future closer to the present.”

A side note on Global Value Chains

We can no longer think of trade simply as a Ricardian comparative advantage, although that consideration still stands too. Instead, we must look at global value chains (GVCs) which is about combining value added from different sources.

A more complex definition would be “a global value chain or GVC consists of a series of stages involved in producing a product or service that is sold to consumers, with each stage adding value, and with at least two stages being produced in different countries. A firm participates in a GVC if it produces at least one stage in a GVC.”

A measure of the length of supply chain can be derived from ‘value-added to gross exports ratio’. A long supply chain is where each country specialises in producing a small part of the final goods, and then intermediate products are shipped across country borders multiple times before finished goods are made. In such a case, the ratio of total value-added exports to total gross exports is relatively low.

A trend of shortening the supply chain in China has begun even before the trade war. The share of products made in complex GVCs in most industries (except a few such as electronics, automotive and textiles) have seen a decline on average since the global financial crisis.

It is misleading to look at bilateral trade imbalances as Trump and Navarro do, especially when trade is usually reported in gross rather than value-added terms and doesn’t capture a country specialising in assembly of foreign parts at the end stage of the global value chain.

The politics of GVCs

The recent crises have highlighted how more complex GVCs can lead to less resilience. This has started to influence how governments form trade policies as well as trade agreements with other countries. The structure of GVCs could also influence governments’ strategies where governments increase protectionism to cement the strength of domestic manufacturers in important industries.

According to an article in Foreign Policy, “China frequently uses non-objective claims on product regulations as Europe does, to block imports on alleged health or safety grounds. US-European disagreements have entrenched the idea that product regulations are purely a national matter, even if they are often intentionally used to block trade”. It’s not just China, trade has become a highly political issue everywhere else, as can be seen by Brexit and Trump’s talks of “bringing the jobs back”.

trump bring back job

This dream of Trump might not be that simple. The number of manufacturing jobs in the US from early 2000 (i.e. even before Covid-19 struck) has been roughly flat due to outsourcing and automation. It is unlikely this trend will change as the considerations of economic costs and sheer practicality have not changed either. Policies that cause only parts of the supply chain to move may not create many jobs.

Estimates are that a moving smartphone production to the US would lead to a 37% increase in production costs, which in turn would lead to a 15% increase in the price for consumers. It would also take at least five years to move supply chains for smartphones to the US. A 46% increase in production costs if moved for apparel would lead to a 14% increase in the retail price. Incidentally, China is a larger market for phones and apparel than the United States. The US is not competitive with respect to labour as labour is the main driver of higher costs in the US (95% of increase in total costs for smartphones and 100% of increase in total costs for apparel).

On the other hand, the Chinese problem currently is not with labour costs but talent, as well as how to provide IP protection such that innovation can flourish. Having said that, labour costs are rising rapidly in China, reducing this competitive advantage. In fact, labour cost per unit of output after adjusting for exchange rates has more than doubled in China from 2001 to 2017. This has already made an impact as can be seen from the decline in China’s share of global exports in labour-intensive sectors from 2015 to 2019.

Quoting the NYT, “The challenge today is that an enormous manufacturing ecosystem is required to make products for mass markets, and that ecosystem has largely moved to mainland China, where some 450,000 people have worked at a single iPhone plant.”

Nevertheless, onshoring is not just about efficiency and costs. It may have intangible benefits such as ESG. A smaller carbon footprint and more carbon-efficient local production is a boon for the environment. Better labour laws ensure that production is not marred by human rights issues. Near-shoring means that production is closer to the demand and this too, bears some of the same benefits of onshoring. This may not be a long-term advantage either as China has become serious about decarbonisation.

As tempting as it is to keep trade policies out of politicians’ hands, trade represents legitimate democratic choices that voters and politicians need to make. Unfortunately, this political process is not very representative of the people and often abused by administrators and lobbyists.

Reducing supply chain risks

GVC participation by manufacturers are usually not anonymous, one-shot transactions as described in traditional trade theory. Manufacturers often require highly specialised and custom inputs on repeated basis. Manufacturers spend a lot of resources in searching and contracting these suppliers, building a custom production network that cannot be redesigned overnight.

An analysis of aggregate network metrics made by the ECB describes the structure of GVC as, “very centralised and asymmetric networks, with a few large economies acting as hubs. These networks are also characterised by small-world properties, showing a hierarchical structure with a dis-assortative pattern.”

The US-China trade war and now Covid-19 have forced businesses to think about building resilient supply and distribution systems. Right now, that means shifting supply relationships to firms that have proved capable of continuing production even in the midst of a pandemic and continuing trade war.

Manufacturers with more advanced production processes will be favoured as less risky if they have the ability to scale quickly and have chosen locations in politically and economically stable countries. In addition, scaling known products and processes lowers costs and lead times.

Resilience is not only about reliability but also about redundancy and the ability to rebalance load away from stressed supply chains. This is too big a task on a local level but it is easier to carry out with large global networks of supply system. Consequently, this will create strong incentives for incumbents to consolidate.

Companies that have the capacity to consolidate some parts of the chains are able to build these networks. Those that offer a platform for this networks of supply chains as well as those who operate on these platforms may stand to have an advantage over those who don’t. Perhaps future supply chains will be dominated by MNCs which are global in stature but maintain strong local presence, enabling them to easily rebalance production during disruptions.

Governments too, can play a part in reducing supply chain risks. Traditional trade agreements have always focused on specialisation within their own borders rather than studying the production networks within and across borders. Governments might support weaker nodes by giving incentives for redundancies, or multiple governments can work together to strengthen the networks’ resilience. Trade agreements can be written with a view of how industries involved in complex GVCs can withstand tail risks. This way, supply chain resilience does not have to depend only on the actions of MNCs and lead firms of a production network.

Building this resilience may lead to higher costs through more consolidation, more locations, less competition and higher inventory levels. Prudent action by governments and companies is required to keep these ongoing costs to minimum. Let’s hope that in future crises these efforts will more than pay off through much smaller economic damage.

Scrabble and Innovation

scrabble tiles

Business books are full of chess analogies and they’re frequently overextended. Thinking twenty moves ahead is nice and well in chess but rarely if ever translates into the real world. Instead, to think about innovation in particular, it helps to have played Scrabble.

Whereas in chess the only randomness comes from your single opponent’s moves, in Scrabble the additional randomness comes from the tile bag as well as the vastness of the dictionary. New words are also constantly added – Scrabble’s official lexicon is updated every four to eight years to match the latest words and slang.

That allows the set of playing words to grow over time, which brings more richness to the game. Similarly, the fields in which innovation can happen also grow over time. Examples include software, self-driving and biotechnology, which did not exist half a century before.

The first thing we realise as we start playing is that small words are relatively easy to think of but words that make a Bingo (a word using all of the tiles) require inspiration. In other words, small innovations are available via exhaustive permutations but really radical or big innovations are almost always born out of inspiration.

Looking at the tiles and the board in front of us, we begin to understand that the chances of success in the game rely on a few factors, mainly the selection of tiles on our rack, spaces available on the board, the existing words on the board, the opponent’s rack and responses and luck of the draw when we replenish our tiles at every turn.

Correspondingly, innovation is constrained by the availability of resources, smart allocation of these resources, opportunities to build something out of all of this, competitors and just like with everything else in this world, a generous share of fortuitous fate.

When it comes to employing resources, creativity is an important part of innovation. In Scrabble, this is achieved by permutations, active randomisation and plain guessing of what sounds like it could be an acceptable word. I’ve come up with many words that I’m convinced should be a word but nonetheless, not an accepted Scrabble word. For instance, how could there be no two-letter word containing the letter “V”?

Resources

Is innovation a mechanical, inorganic process where it’s just a matter of adding two and two together, or of producing one part oxygen to two parts hydrogen? No, innovation is an organic, creative activity and perhaps the most organic parts of an innovative process are the people.

Many people when given the right support and situation will easily shine as if they are talented, but that is not genuine talent. The letter “Q” has the highest score but the words we think of when it comes to “Q” usually have a “U”, such as “QUEEN”.

That would be alright if there are many “U”s but there are only 4 “U”s in the game. True talents are like “Q” word individuals that do not need a “U” to outperform, words such as “QABALA”, “QAT”, “TRANQ”, “QWERTY” and “SHEQEL”. Most of these words are unique and have foreign or diverse origins.

Thus, when it comes to employing human resource, innovators must recognise talent and have the ability to keep them. One rare genius is worth a lot more than ordinaries, but even a genius can’t do it alone. In addition, talent breathes dynamism into the process of innovation. Without talent, the path followed would be rote, uninspired and would probably bear an average outcome.

This paragraph describing Nigel Richards, a New Zealand–Malaysian Scrabble player who is among the most successful players of all time beautifully illustrates the type of creativity a talent should have:

“In a game in 1998, then-newcomer Richards had a rack of CDHLRN? (“?” denotes a blank tile). There was an E available on the board; Richards could have played CHILDREN for a bingo and a 50-point bonus. Instead, Richards played through two disconnected Os and an E. The word? The 10-letter CHLORODYNE.”

According to Carmine Garzia in her book, “Managing The Strategic Innovation Process”, “A unique positioning requires a unique set of resources. The first level concerns the concept of uniqueness. Positioning choices, possibly resulting from a combination of several strategic initiatives, are unique and this uniqueness is a source of competitive advantage. The uniqueness of the position must be supported by a unique set of resources.”

The more access an innovator has to unique resources, the greater the competitive advantage he or she holds. A successful innovator knows that eking out these advantages, large and small over time would bring greater rewards in the long run.

Allocation of resources

At times, it pays to sit out a round or swap our tiles rather than go for an easy play with low points. Tiles are limited, be they on the rack or in the bag. Judicious use of the tiles is the key to Scrabble success.

Similarly, innovators need to be clever resource allocators to see to the success of their projects. The most valid parallel here comes from the decision when to deploy tiles / resources – don’t waste them on low scores but don’t wait around for impossibly low odd combinations either (except for a few cases where the funders really are asking for moonshots). There is a wide spectrum between “minimum viable product” and “with all bells and whistles” and good innovators know how to make these trade-offs.

Opportunity

In Scrabble, the board can pose cruel limitations. We might have arranged a beautiful Bingo on the tile rack, pat ourselves on the back congratulating our genius and yet have nowhere to put it! Think of the frustration!

Christian Seelos and Johanna Mair in their article “When Innovation Goes Wrong” found that in examining less successful organizations, what holds them back is not an inability to innovate but a failure to embed their innovation efforts within a robust process for translating those efforts into impact.

Thus it is the same for that wonderful innovation, there must be a space and need for the innovation to be built, otherwise it is nothing but an expensive intellectual trophy.

Conversely, what is already on the board can be the root for a longer word. “REST” can be “RESTAURANT”, “FISH” can be “FISHING” or turn “HOST” into “GHOST”. Compounding previous innovations is a powerful engine of innovation growth. The phrase “standing on the shoulders of giants” means “Using the understanding gained by major thinkers who have gone before in order to make intellectual progress” and nowhere else is it more true than in innovation.

At one point, my Scrabble-playing, innovation-thinking friend observed that “the return structure is quite convex”. If we take into account the double word and triple word fields on the board it is worth trying to expand the number of letters employed to reach a certain square.

In the process of innovation, reaching a certain milestone in innovation is sometimes worth a lot more than if you had just stopped on a less ambitious rung. In other words, there are non-linear payoffs on the path of innovation. It’s fundamental for an innovator to think about scaling and where it is most profitable to do so.

Alex Lazarow, the author of “Out-Innovate: How Global Entrepreneurs – from Delhi to Detroit – Are Rewriting the Rules of Silicon Valley” writes that “…entrepreneurs must be creators who build industries rather than disruptors who change them because there are few existing businesses to disrupt. The companies they create must be global from birth because local markets are too small. They focus on resiliency and sustainability rather than unicorn-style growth at any cost.” In other words, scaling existing and proven models is often the more profitable path than pursuing only loosely connected greenfield ideas.

By the way, there are only 4 “S” tiles in the bag. It is prudent to keep the “S” tiles to attach to an existing word and pluralise it, while creating a whole new word using that very “S”. Do not though, waste the “S” on any play that scores less than 10.

At the other extreme, crowded space can restrict innovation. Towards the end of the game when the board gets filled up, the word length and the variation of words get limited. Two letter words become ever more important to know in the race to finish the leftover tiles on the rack.

Squeezing in one more slightly differentiated product may end up costing more in development than the gains in doing so. Several innovations suffer this fate of slow-death, saturated space, for example cramming yet another camera into a phone.

Negative space/Negative opportunity

Sometimes, what deters me from putting a combination on the board is knowing that it would open up opportunities for the other player. It is an even bigger threat if it involves the other player being able to reach a “Triple Word” square.

Innovation also sometimes appears to be carefully managed and sequenced. Companies with dominant market positions may sometimes delay the introduction of new features in order to provide reasons to upgrade and charge higher prices in the future. This is something that shareholders may like but something that hurts innovation overall.

Competitors and Specialists (Who else is in the game?)

A well contested game normally has a total of 700, so that is 350 for a 2 player game, around 230 for a 3 player game and so forth. Scrabble players usually prefer to play with someone that at least matches their average Scrabble score if not more. This is because having a good opponent bring out the best in your play. From the variety of words that are placed on the board, to just plain “I don’t want to lose out to this guy” mentality.

Innovating in a space where the incumbents are creative and motivated enhances the outcome. It also attracts equally vibrant minds to join the fray. There is a positive feedback on the firm level – an innovative firm will further attract valuable talents as its performance increases in excellence and achievements accumulate. More talents hopefully means more innovations and therefore, the virtuous cycle continues.

According to Professor Ricardo Hausmann, heterogeneity of know-how is key to development, not just the usual suspects of capital, education, or even institutions. In particular, his theory states that in order to move into new industries a country needs expertise in adjacent areas, just like tiles on the Scrabble board. In the end everything must be connected, nothing can develop on its own.

Luck

Annie Duke, the American professional poker player who used to be the leading money winner among women in ‘World Series of Poker’ history, connects hidden information with outcomes. In her book, “Thinking in Bets”, she writes, “Chess contains no hidden information and very little luck. The pieces are all there for both players to see. If you lose at a game of chess, it must be because there were better moves that you didn’t make or didn’t see.” In Scrabble, how well we play depends a lot on the tiles we draw from the bag.

On November 8, 1895, German physics professor Wilhelm Röntgen stumbled on X-rays while experimenting with Lenard tubes and Crookes tubes. Microwave ovens came as an idea when Percy Spencer accidentally melted a chocolate bar in his pocket in the 1940s. Velcro was thought of by George de Mestral who when walking his dog, found burdock seeds had stuck to his clothes.

The theoretical highest-scoring Scrabble word is “OXYPHENBUTAZONE”. The odds of this happening, especially in a tournament where the other player wouldn’t even allow you the opening to do so, is almost zero but nonetheless imagine the thrill of putting this down on the board. On the other hand, picture a woeful game where you’re unluckily withdrawing one vowel after another onto a rack already full of them.

In all endeavours there is an element of luck – especially in the process of innovation where so many factors, be they ideas, resources, people, events, etc. need to come together serendipitously. The innovator must always be conscious of his or her silent partner, the Lady Luck.

Becoming better innovators

How do we become good at Scrabble? The obvious answer is to study Scrabble words. This would also help in recognising potential words from the tile rack. Memorise all 2 and 3 letter words, “AZO” and “QI” being recent favourites of mine. Not all students are innovators but all innovators must make studying a life-long habit.

The other thing is learning how to persevere. In many games, I was behind by over 100 points but managed to claw myself back into winning. In this climate of despondent belief that all the low-hanging fruits are gone, it’s very easy for an innovator to get discouraged and throw in the towel when they could have made it had they persevered. For motivation, look at Alexander Graham Bell and Thomas Edison!

Of course, issues such as the role of government policies and institutions, intellectual property rights and legal infrastructure, finance and a whole host of other factors that help nurture innovation are out of scope here. Nevertheless, many of the unique game features of Scrabble are mirrored in the challenges faced by innovators today.

The Legacy of Theresa May

The most frustrating thing about Theresa May must be the way she handled questions during interviews and PMQs. It was almost like she was a robot that gave pre-programmed answers regardless of the input.

Phrases such as “deliver on the results of the referendum” or “take back control”- and who can forget “strong and stable” which has its own Wikipedia page.

As a leader May’s mistakes were many. It’s debatable whether the errors arose from the circumstances she was put into. The many impasses she created could well be due to her being, as a male Conservative party grandee described, a “bloody difficult woman”.

This is all forgivable, had the stubbornness been based on being right or having a very good reason, but often times many of us watching felt that she had committed to a position because and just because it was passed down to her by predecessors. She was a car stuck in the first gear and could never transition to the second, third, or even reverse if need be. This lack of nimbleness, this immovability has brought the UK to where it is today – massive economic uncertainty and a political stasis.

Undoubtedly, Theresa May felt very proud to have fallen into the role of the second female Prime Minister, with hopes to even outshine Thatcher’s legacy. Reportedly, when at Oxford, she was not pleased upon discovering Thatcher had become the PM because she herself wanted to be the first.

From the very beginning May had wanted to give the impression of a strong leader. Strong words soon accompanied this aspiration such as “Brexit means Brexit” and she told her cabinet that “politics is not a game”. Regrettably, May continued to adopt this clumsy posturing well into her Brexit negotiations.

On 29th March 2017, disregarding prudence, absent of due diligence and against expert counsel May rushed a letter to Donald Tusk triggering the article 50 to begin the Brexit process – complete with a veiled threat of withdrawing security cooperation should the EU27 fail to deliver on a trade agreement. Such was the unwise show of strength made by May and her advisors. This kind of thinking permeated her whole leadership. She mistook inflexibility for strength and knee-jerk reactions for decisiveness. In justifying these actions she skirted hard truths and practical realities, trying to convince herself and others that this is “the will of the people”.

Red lines in the negotiations were drawn surprisingly early. In negotiations, there are normally two different types of red lines. One type is the condition you put on the negotiating table to extract as many concessions as you can while the other type is the condition based on existing circumstances you’re unable to change because it’s baked into your structure. The EU’s red lines were made with keeping the integrity of the Single Market in mind. The EU’s red lines were 1. sequencing, 2. the four freedoms covering persons, goods, services and capital and 3. that there is no hard border between Northern Ireland and Ireland.

At the time, it was assumed that the protection of rights of the UK citizens in the EU or respectively the EU citizens in the UK were more or less agreed. It was only a footnoted red line because of the assurances May gave and because the EU team believed that both parties understood it was the right and fair thing to do. Having said that, I’m sure that many still have May’s speech during her party conference ringing in their ears when she said, “But, if you believe you are a citizen of the world, you are a citizen of nowhere. You don’t understand what citizenship means.”

Perhaps May should have asked the EU citizens who lived here in the UK for over twenty years what they think about this statement or looked at the numbers of British people frantically tracing their Irish roots as to apply for an Irish passport and asked them what citizenship really means.

Michel Barnier helpfully drew his now famous staircase diagram, spelling out the freedoms and access for every increase in the number of red lines. Of all the UK’s red lines, ending freedom of movement became a priority borne perhaps from her previous position at the Home Office. Alas, it meant that the upper rungs of the staircase, a “very close and special relationship”, was not available to the UK.

Ending freedom of movement appeased the portion of British citizens who felt threatened by immigration numbers but at the same time angered many in businesses and academia who rely on immigration. We shall see what the long term effects of ending FoM will be on the viability of many business sectors as well as the prestige of British universities.

It was not an economically wise decision as the UK’s comparative advantage is overwhelmingly concentrated in services industries. For the financial sector, the loss of passporting means the loss of the UK’s status as a financial centre, including its ancillary services that are major drivers of UK GDP.

May seemed to be repeating the same act of miscalculating her odds, betting erroneously that her gamble would work and finding time and time again, that after the dust had settled down her gambit had landed her in even deeper waters.

As she became further and further mired within her red lines that should never have been, her statements became more and more canned and robotic. A similar rise of unsubstantiated opinions from questionable academics about which Brexit is best were dispersed to the public on the BBC and other supportive media.

Those who knew better tried to correct the misinformation but without the loudspeaker and active rubberstamping of the government, it was hard to reach the general public. Many still do not understand what they are asked to give up in return for “sovereignty and a proper Brexit”. Those sounding alarm bells are branded elitists who condescend and think that the people didn’t know what they voted for.

May steadfastly surrounded herself with people who would deliver the ultimate “take back control” and banished those who would counsel a balanced approach. Brexit secretaries came and went so frequently that people had trouble keeping track who was responsible for negotiations. Same with parliament – here is a list of cabinet resignations during her premiership.

It was nothing short of a shamble, a painful spectacle to watch as May dismantled UK’s global reputation as a competent, moderate government piece by piece. Her increasingly confusing stands and chaotic parliament opened up a door for stronger populism to spread through the country. A movement brandishing the promise of getting Brexit done, whatever it takes. A recent poll of the European election showed that the Brexit Party is leading. What this means for the future of the UK is frightening.

To her credit, May did eventually concede that her deal is flawed, claiming, “I would say don’t let the search for the perfect become the enemy of the good because the danger there is that we end up with no Brexit at all.” However, did she sufficiently spell out what these flaws are to the British people? Will the failure to educate the public on the issues of Brexit be held against her once she is long gone? Will future generations still be enduring the negative consequences of Brexit?

cake

Although the biggest harm of May’s creation was to embolden the extreme Brexiteers in her party, perhaps the most significant service that she did for the country was to actually keep ‘No Deal’ at bay, despite her previous mantra of “No deal is better than a bad deal”. She could have taken the easy political route and walked away from negotiations and refused the multiple extensions. Deep down inside, she knew that a ‘No Deal’ would bring the UK to its knees and for this, she hedged and hummed and tried to ram “Theresa May’s Deal” not once, twice but three times through parliament. Thus in the end, this bloody difficult woman really did love her country after all.

Trade Peace

Those who insist that a trade war is about who wins or loses either in the short or long run most likely do not understand what international trade is.

Those who surmise that anyone pointing out the American consumers, especially the less well-off bear a huge brunt of the consequences from the trade war, are framing it as “Americans lose most” miss the point that trade is neither a war nor a competition of who loses most.

To understand trade, there are a few fundamental concepts that we must bear in mind when discussing this topic. So let me list them here, some taken from my previous tweets and posts, giving flavour to each of the concepts and trusting readers to dive into the definitions or deeper discussions available elsewhere if they so wish:

  1. Trade is a system

Trade is a system of networks consisting of:

  • Various agents, from entire countries to the smallest wholesalers who import and export widgets,
  • Manufacturers and producers, companies with their relative advantage derived from their respective locations, efficiencies and way of business, access to raw materials and natural resources, know-how and above all, their ability to scale,
  • Standardisation, rules, regulations and agreements forged by a history of drawn out negotiations,
  • The supporting financial, legal and logistical structures such as insurance, credit, guarantees and loans, collateral, contracts, shipping, warehousing, brokerage, advertising, trade-related technology including data and platforms. Furthermore, foreign direct investments and capital flow play an important part.
  • Governments and central banks with their policies, custom systems, currencies.

If trade is a system, therefore, a trade war is a system that is going to war with itself; like a man’s arm reaching for a saw to cut his own legs off.

  1. Comparative advantage

A country that does not appreciate its own comparative advantage will not make the best decisions, let alone policies on trade. For example, the UK’s comparative advantage is overwhelmingly concentrated in the service industries so it baffles me why it hasn’t tried harder to protect this sector from the effects of Brexit.

In the technology sector, China is quickly building up a workforce that are able to handle both design and high-tech manufacturing. My favourite example is in the development of neural networks which was going nowhere before 2011. Then, only a few hundred people were working on NN. It took ten thousand smart enthusiastic Chinese graduates to enter the field for it to move forward. In terms of the sheer number of graduates, organisation and pure profit motive, China now has the upper hand.

Currently, there is a massive push in China to advance its semiconductor and battery technology, which also covers technology for ancillary activities, such as lithium extraction for batteries. In fact, a Chinese government report declared that the cost of extracting lithium has been slashed to a “record low” of RMB 15,000 (US$2,180) per ton by a new breakthrough process.

It also niggles me that Donald Trump is so gung-ho on protecting steel and aluminium as well as certain agricultural sectors, rather than focus on what the US wants its future workforce to look like, with a long term plan that includes education and training. Just like China, the US needs its own “Made in US 2025”.

  1. Exchange rate pass-through

Exchange rates matter a lot. According to the IMF a few years ago, large depreciations substantially boost exports. The results indicate that these depreciations average 25 percent in real effective terms over five years. The export prices in foreign currency fall by about 10 percent, with much of the adjustment occurring in the first year. China has been accused of artificially keeping the RMB exchange rates low in order to maintain competitiveness.

What about the US? A 2016 study showed that the pass-through on imports and consumer prices is relatively modest. A 15 percent dollar appreciation reduces consumer prices by a quarter of a percentage point in the short run, and by four-tenths of a percentage point after two years.

It is not the same story for the US exports. Most of the trade balance adjustment following a dollar appreciation takes place through the export (and not the import) channel. The reason for this is that the US exports and imports are predominantly denominated in US dollars.

Fast forward a few years, the most recent episode of tariff drama shows that the main channel for the US is the inflation channel. Studies found that Chinese exporters did not absorb any of the tariffs in their profit margins and import-competing US producers raised their prices in response – a double-whammy for the American consumers.

In a small, open economy however, a depreciated currency may not be enough. UK exporters saw little benefit from the Brexit depreciation while UK consumers mostly had to pay up for increased import prices.

In contrast, Japanese exporters have a strange fixation to maintain the stability of their export prices in overseas markets and absorbing exchange rate fluctuations through profit margins.

  1. Barriers to trade

Free trade agreements increasingly focus on NTBs or non-tariff barriers to trade, with special emphasis on competitiveness and regulatory alignment. The EU-South Korea FTA for example, includes a competition chapter which prohibits and penalises certain practices which distort competition. Competition is hard to monitor and regulate. According to Cecilia Malmström, the EU trade commissioner, the EU is not particularly happy with the level of South Korean compliance.

Regulatory transparency and a new approach on trade and sustainable development are also features of the agreement. These may also monitor standards and values, including workers’ rights and environmental commitments as “comprehensive” trade agreements take on a whole new meaning in modern trade – helped along by woke consumers’ ethics and sensibilities.

Perhaps we should also not be naïve that there are “informal” non-tariff trade barriers where non-friendly countries can delay customs formalities at the ports or borders.

  1. Substitutability and intermediate goods

Roughly half of US imports are intermediate goods and not finished products. Tariffs will increase the cost of production for imported foreign components, unless these inputs are sourced domestically. For example, around one-third of auto imports for finished cars or trucks used at US factories are intermediate products. The larger the share of non-substitutable intermediates, the more problematic tariffs are for the firms.

Trump hopes that the tariffs on steel will induce investments in domestic steel production. The question remains, will there be investments and if so, which kind of steel will be prioritised by domestic companies? Will the choice of investments fulfil all the different types of steel products that the US requires? Investment decisions are taken with multi-decade horizons, far beyond anyone’s presidency. These are things to think about when it comes to substitutability.

Furthermore, global value chains are designed such that they are regulatory and logistically efficient. For that to happen, it is beneficial to belong to an economic area and even more beneficial that intermediate goods can ping-pong across borders until they become finished products. This is the gravity theory of trade – the less distance, customs formalities at the borders and time spent in transit the better.

Many goods are tied up with services as well. The EU head negotiator Michel Barnier complained that Theresa May wanted regulatory alignment for goods only and neglect services. He said that services are in every product – for a mobile phone it is 20-40% of the total value.

Speaking of phones, more than 50 percent of jobs in smartphone manufacturing are in the final stages of production, so policies that cause only parts of the supply chain to shift may not create many jobs. An estimate of a 37 percent increase in production costs if they were made in the US which in turn leads to about a 15 percent increase in the price for consumers in the US. It will also take at least 5 years to move supply chains for smartphones to the US.

  1. Globalisation and agreeing to a rules-based system

A rules-based system has its disadvantages but to my mind, the certainty and efficiency it provides to the global market is invaluable.

Rules may shape the global value chain. For example, the rules of origin in trade agreements that require a certain amount of content to be produced in a particular country determines the way companies organise their supply chains.

Rules give rise to arbitration facilities, consequences that will come into effect should a clause in the trade agreement be broken. Despite the poor health of the WTO, it is still an idea and institution that should be championed. A trade agreement is only as good as the legal infrastructure that upholds it.

Rules normally result in standardisation, which begins at the technical aspect of production and may eventually result in the rise in the quality of products through positive spill-overs, technology transfers and know-how.

In addition, the nobler purpose of trade as a tool for peace as both Ireland and Northern Ireland have found out, should not be underestimated. Trade peace rather than trade war should be the bandied terms to nurture a global prosperity.

The main message of this post is that if you want to discuss any trade war, you need to look at all these other issues as well, and more.

Mr Barnier, you love the mountains.

barnier faz1

Mr Barnier, you love the mountains. Were you free to leave this summer?

I hiked in my homeland, in the Tarentaise, in the Savoy Alps. I grew up near Grenoble and represented this area in the French parliament for almost twenty years.

What did you have in mind when you were at the summit?

It was very nice. You feel a sense of serenity. I need nature, trees, forests and mountains. I need this for me personally. You spent a lot of time in closed negotiation rooms. I negotiate with passion and energy because I know that I can go back to nature afterwards. When you know the mountains, you need stamina and you have to divide your strength. You also have to watch where you put your feet so you don’t step into a hole or roll over. And you can’t go too fast to keep your rhythm. It helps if you keep an eye on the summit.

Are you talking about Brexit already?

I have always believed that we must broaden our political horizons. I had this experience when I supported and co-organized the 1992 Olympic Games in Albertville. The head of a team has to see the next horizon. If, on the other hand, you lower your eyes, everyone sees only himself. In Europe it is the same: we all remain who we are, with our culture, our language, our traditions. But we have a common horizon that relativises conflicts and differences. That is why I very much regret that the British are leaving the Union.

Is there nevertheless a broader horizon in the exit negotiations that you lead for the EU heads of government?

This can be seen in the unity of the 27 Member States, which from the outset have followed a clear, uniform line, together with Donald Tusk, Jean-Claude Juncker and the European Parliament. The Brexit electric shock, the attitude of the Trump government towards Europe, our difficulties with Russia, the stability of the Middle East, the challenges of migration, and ultimately the instability of the whole world – all this has caused a feeling of common responsibility and seriousness to grow among the heads of government. When they look at all these challenges and threats, one has to ask oneself: How are we going to face it? Every man for himself or all of them together? That’s the common horizon.

And it lasts until the end of the negotiations?

(Barnier digs a chart out of his records.) Here is a table showing David Cameron around five or six years ago, when he was Prime Minister and I was Commissioner for Internal Market and Services. It shows how the economic performance of the eight strongest countries will develop with normal growth. In 2016 there were four Europeans in the top 8, in 2030 there will be three, in 2050 only Germany; in seventh place behind India, Indonesia and Brazil. I have changed this table somewhat, adding together the economic strength of the EU-27 instead of the individual states. And lo and behold, the EU-27 will still be in fourth place in 2050! The United Kingdom, on the other hand, is completely out of the rankings.

The British nevertheless remain in Europe, as they themselves repeatedly say. And the negotiations are also about future relations. Is a common horizon developing for this?

Our perspective is an ambitious partnership such as has never existed before with a third country. We offer the United Kingdom a free trade agreement, cooperation in the fields of security, foreign policy and defence, police and judicial cooperation, research, transport and transport. We respect the fact that the British want to regain their national sovereignty completely. We expect them to respect our sovereignty as EU-27, our common market and what we stand for.

Now the British conservatives, both in government and in parliament, have different ideas about future relations with the EU. There are even two White Papers, the official one of Prime Minister May and an alternative one, which was written under the former Brexit minister Davis. Under these circumstances, how can we negotiate a common future with London?

We know, of course, that the situation in the United Kingdom is complicated. We are following the debates there and I am talking to all kinds of people, including the British opposition. In the referendum on the resignation, many consequences were concealed. But now we are sticking to the decision of the British alone, the position of Prime Minister Theresa May and her chief negotiator.

David Davis, as chief negotiator, had other priorities than Theresa May, as it turned out.

This is a negotiation with the British Prime Minister. In their view, the vote in the Brexit referendum means that the majority of British no longer want to respect the role of the European Court of Justice, no longer want to pay membership fees, no longer accept the four basic series of the internal market and conclude their own trade agreements. We respect that, and our proposal for future relations does justice to the restrictions chosen by London itself.

Mrs May has given the EU a written commitment on Northern Ireland: If it is not possible to avoid a hard border on the island of Ireland by consensus, Northern Ireland can remain in a customs union with the EU. In mid-July, the House of Commons decided that Northern Ireland should not become part of a separate customs territory. This means that this recidivist position, which was fought over hard in December, is now off the table again!

Mrs May tells us that this decision is not in contradiction with the commitment she made to us in December and which she reinforced in March. We’ll see! I kept to the word of the Prime Minister, for whom I have great respect.

Much has been said in recent weeks about the failure of the negotiations. The head of the British central bank has classified the risk as “unpleasantly high”, the Chancellor of the Exchequer has quantified the economic losses for the kingdom at eighty billion pounds a year. The EU Commission and now also the British government point out the consequences of an unregulated withdrawal in “technical notes”. What does that mean? Is there now a real risk that the negotiations will go wrong?

At my first press conference as chief negotiator in October 2016, I said that the Brexit will have many consequences: human, social, economic, technical, legal and financial. This applies to an orderly withdrawal as to a disorderly one. We need to prepare for all scenarios. We have therefore published 70 papers on all consequences of the Brexit. It’s high time the British did the same. When I meet British entrepreneurs, I tell them no matter what happens, there will be no business as usual.

Are the other Europeans well prepared?

I’m not more worried today than I was a year or two ago. Since then I advise everyone to use the time of the negotiations to prepare. However, it seems to me that sometimes the consequences are underestimated.

What does that mean in concrete terms? Which deficits do you mean?

More needs to be done in the transport sector and in the value chains between the United Kingdom and the rest of the European Union. This is, of course, the responsibility of the companies. Many products move back and forth in the manufacturing process between the UK and the EU. Outside the internal market and customs union, there are customs formalities and controls that hinder just-in-time production to a great extent. Or take the topic of rules of origin. In order for EU car manufacturers to benefit from the customs benefits of the EU-Korea Agreement, only a certain part of the services may have been provided in a car in a third country. The companies must therefore ensure that in future they will not install too many parts from Great Britain in their vehicles. Such rules of origin would also have to be agreed in a future free trade agreement between the EU and the United Kingdom. If the British Government were to decide on a customs union with us, which is still possible, then much would be easier. Because in a customs union like the one we have with Turkey, there are no rules of origin. In any case, I recommend the industry to make its value chains “Brexit-proof”.

Another problem arises at the borders. If every truck in Dover has to be handled individually, with customs forms, the British government estimates that the traffic will accumulate several dozen miles back because there is not enough space in the port. The same problem exists on the other side of the canal in Calais. Are the authorities prepared for this?

We are working on making controls as simple as possible with modern technology. But there will have to be border controls when the United Kingdom leaves the customs union. There’s no way around it. The Netherlands employs 700 additional customs officers, Belgium 400, France 1000. 440 million consumers, 22 million companies and the single market must be protected by our external border controls. Let me be clear: Brexit does not add value, it creates problems and new bureaucracies.

On the island of Ireland, both sides want to avoid a hard border. But if Northern Ireland cannot remain in a customs union with the EU, that will be difficult. The British government has proposed that it impose customs duties at its borders not only on goods that remain in the kingdom, but also on those destined for the EU – this revenue would then be passed on to Brussels. This should facilitate all trade in goods and at the same time be a solution for the Irish island. Why do you refuse?

For two reasons. We cannot transfer control of our external borders and revenue there to a third country – that is not legally possible. Incidentally, infringement proceedings are under way against London because, in the Commission’s view, Chinese textile imports have not been properly cleared through customs. Moreover, the British proposal is not a practical course, because it is impossible to determine exactly where a product ends up, on the British market or on the internal market. Sugar, for example, is transported by the ton in 25 kilo bags, so you can’t track every bag to its destination. This would only be possible with an irrational and unjustifiable bureaucratic effort. That is why the British proposal would be an invitation to fraud if implemented.

Since then, the British Government has been determined to prevent a hard border in the Irish Sea, i.e. between Northern Ireland and Great Britain, from replacing a hard border on the island of Ireland. Isn’t that legitimate?

There is no such thing as a hard border in the Irish Sea, as we have never proposed. Of course we respect the unity of the United Kingdom. We are only looking for a practical solution that does justice to the special situation of the island of Ireland. There are already certain controls in almost all areas, in particular veterinary and plant health controls for goods and raw materials brought to Northern Ireland from the rest of the United Kingdom. That’s all we’re talking about, no more.

The other major challenge besides Northern Ireland concerns the future trade in goods and services. Mrs May wants to establish a close regulatory link for goods, but not for services – she also recognises that British service providers will have less access to the European market. Isn’t that in Europe’s interest? Finally, the European Union has a huge surplus in trade in goods with the Kingdom, while in services itself it has a considerable trade advantage.

The interest of Europeans is to preserve the integrity of the common market. This is our special strength and the reason why we are respected all over the world, even in the United States. We have a coherent market for goods, services, capital and people – an ecosystem of our own that has grown over decades. You can’t play with that by picking parts. There is another reason why I am strongly opposed to the British proposal. Services are in every product. In your mobile phone, for example, it is 20 to 40 percent of the total value. .

. . but this is only the case with electronic devices, not with agricultural products.

You’re mistaken! As former Minister of Agriculture, I can tell you that agricultural products are produced under laws that regulate hygiene, health and environmental issues in the production process. Every litre of milk and every apple contains services. We must therefore prevent unfair competition if the United Kingdom has weaker legislation than we do. Otherwise we would be disadvantaging and weakening our own companies.

So the long-term protection of the internal market goes beyond short-term benefits that could be achieved in trade in goods with the UK?

That’s how it is. A great French politician, Pierre Mendès France, said that the future must never be sacrificed to the opposition. By the way, the British have a choice. They could remain in the binary market, like Norway, which is not an EU member either – but they would then also have to adopt all the rules and contributions to European solidarity associated with it. It’s your choice. If, however, we allowed the British to pick the raisins out of our set of rules, the serious consequences would be obvious. Then all kinds of other third countries could also insist that we offer them the same benefits. That would be the end of the internal market and the European project! I’m often accused in the United Kingdom of being dogmatic. But in fact, I’m only looking out for our fundamental interests.

If the problems are so serious, how is an agreement to be reached with London in the next two months?

About 80 percent of the resignation contract has been negotiated. We are close to our goal when we find a pragmatic and realistic solution for Northern Ireland. In addition, there will be a political clarification setting out the framework for future relations. We haven’t written a text yet, but we’ve done a lot of work. There is a great deal of agreement on foreign and security policy, as is internal serenity. We will be able to start writing this declaration in the near future. The conflict concerns the picking of raisins in future trade.

How do you envisage the political explanation? The British White Paper is a hundred pages long.

The decisive factor is not the length, but the content. My mandate, those are the guidelines of the European Council of March 2018, which are only a few pages long, but very precise. The aim of the negotiations is to identify the similarities between the position of the EU-27 and the British government. I think it could fill 15 to 20 pages.

If there is not enough time and all 28 states agree, the negotiations could be extended beyond 29 March. Are you considering this as an option?

The British have decided to leave the EU. Ms May herself chose the term in her letter of resignation and also enshrined it in British law. If there is a deal by then, we agree that the UK should be treated as a member for a transitional period until the end of 2020, albeit without voting rights. If we take account of the time taken to ratify the withdrawal agreement by the British Parliament and the European Parliament, we must conclude negotiations by mid-November. That’s possible. We don’t need more time. What we need are political decisions!

Thomas Gutschker spoke with Michel Barnier.

Barnier Interview 2 Sept 2018

 

 

Possible reasons the inflation and wage growth in Japan resist rising

Possible reasons why the inflation and wage growth in Japan have stubbornly refused to rise:

  • institutional factors in CPI,
  • using published unemployment in the Phillips curve,
  • a decline in potential growth,
  • structural changes in the labour market,
  • the long run stable relationship between wages and labour productivity.

Three of them are to do with prices and the last two with wages.

These are my notes based on a DB report.

Institutional factors in CPI:

Health care and education costs are largely decided by government policy, hence demand/supply effects are limited in Japan.

Enrolment in health insurance is compulsory for everyone in Japan. It is also government policy to lower drug, medical diagnostic and treatment costs. As a result, the share of medical spending in the CPI is much lower compared to France or the US.

Education up to secondary level is free while tuition for higher education is regulated by the government. Note: As a share of CPI, Japan has the highest education spending compared to other developed countries. This is attributed to spending on supplementary education (e.g. tuition classes, private school, prep school). However, the growth of the education cost is the slowest among the developed countries.

Imputed rents are more influenced by old houses, of which quality improvements/ renovations have been limited. Imputed rents in owner-occupied housing are not included in the CPI weighting in the main European countries. Japan has a tendency in which owner-occupied houses exhibit a deteriorating quality relative to rental houses because the former consists of a larger share of older wooden homes with limited maintenance being done and the latter consists of relatively new condos and homes with better maintenance. The price of the latter (actual rents) is less likely to decline than imputed rents. We also believe that quality adjustment to prices in this case has not been properly reflected. In other words, we need to raise imputed rents in order to reflect the quality deterioration, but this is not done. It is an opposite bias to the prices of IT goods. (In IT goods, an improvement in quality has to be reflected as a fall in prices in the CPI.)

Using published unemployment in the Phillips curve:

The Phillips curve shows the short-term relationship in the business cycle that exists between inflation on the vertical axis (not the rate of rises in wages but prices) and indicators showing the utilisation of factor inputs on the horizontal axis (e.g. the unemployment rate).

The Phillips curve is just another analytical tool to help with policy making. Like any other tools, analysis using the Phillips curve has its limitations.

Short-run constraints:

  1. It is common to use unemployment rates as indicators of labour market slack but if there is a long term structural change, this will also be reflected in the unemployment rate.
  2. When work sharing is carried out (e.g. with Japan’s part-time workers) because of the negative incentives to labour supply in the tax system, using published unemployment (e.g. headcount) may overestimate the tightness in the labour market. A polarization of labour markets between part-time and full-time workers in Japan and the fact that the interaction between the two has been limited is thought to be a Japan-specific factor contributing to the lack of emerging upward pressure on wages despite an improving economy. The order in which companies respond to an economic recovery is to increase part-time workers, to raise part-time workers’ wages, to increase the hire of new graduates and raise their starting salary, and to increase overtime pay and bonuses for full-time workers, with a very high hurdle to raising existing full-time workers’ monthly salary.
  3. Operating rates of capital are not reflected on the horizontal axis. Low capacity utilisation has been a global feature after the GFC, and not only in Japan. Focusing on just labour in the chart may over-estimate improvements in the economy.

Medium to long-run constraints:

  1. The slope of the long-run Phillips curve is vertical or extremely steep (economic policy is unable to sustain the trade-off between short-term improvements in prices and unemployment).
  2. Potential growth influences the location of the Phillips curve. A rise in potential growth accompanied by an upward shift in the Phillips curve. Similarly, a fall in potential growth is accompanied by a downward shift in the Phillips curve.

There is a general over-estimation of the utilisation of factor inputs (labour/capital) as it does not take into account voluntary job leavers, work-sharing by part-time workers and low utilisation of capital.

Japan is at the steeper part of the Phillips curve but the probability of Japan remaining there has been steadily falling since September 2015.

A decline in potential growth:

In the long run, inflation is influenced by:

  • Growth of broad money aggregates
  • Nominal GDP
  • Potential GDP

Over the past 21 years growth rates of these indicators have been lower compared to other developed countries.

A decline in potential GDP corresponds to a downward shift of the Phillips curve, thus accompanying a decline in terminal inflation.

A widely held argument in financial markets is that because potential growth declined in the US, economic expansion would easily cause the supply-demand gap to shrink enough to cause higher inflation, or that if Japan’s potential growth rose due to Abenomics, the supply-demand gap would struggle to shrink even with economic expansion and that deflation would continue. These stories however are one-dimensional and ignore the fact that the long-run correlation between potential growth and inflation is positive, not negative. For example, inflation in EM countries tends to be higher than in developed countries, partly because potential growth is higher in the former.

Structural changes in the labour market:

Increases in these contribute to the decline of nominal wages.

  • the employment rate (via diminishing marginal returns on labour)
  • part-time employment rate (including involuntary part-time workers)
  • increase in female participation
  • small amounts of immigration
  • relative wages of manufacturers over non-manufacturers

The long run stable relationship between wages and labour productivity

Wage growth falls when the decline in labour productivity is structural rather than cyclical. This in turn lowers terminal inflation.

Summary

The probability of Japan hitting the 2% target inflation is rather low. The only hope is to keep an accommodative monetary policy such that businesses and households that need to borrow could continue to do so. That in turn could lead to a faster rise in broad money and economic activity (nominal GDP), resulting in a rise in prices. If maintained over the long run, it may lead to an expansion in factor inputs or faster technological progress. All of this will perhaps raise Japan’s potential growth.