Discover more from The Rational Walk
We need to be aware of the limits of optimization
I own two sleeping bags that I use for backpacking trips. One is rated for temperatures down to ten degrees Fahrenheit and weighs one-and-a-half pounds while the other is rated down to thirty degrees and weighs just under a pound. Backpackers are loath to carry more weight than absolutely necessary, yet I have often accepted the extra half pound required to carry the ten degree sleeping bag, especially on longer trips with less predictable weather.
Optimization is a good thing, up to certain limits, but it can be taken too far. When the cost of redundancy is low and the cost of falling short is high, accepting some redundancy can make sense. You don’t want to find yourself in the Sierra Nevada at 12,000 feet during an August cold snap taking nighttime temperatures into the teens or twenties with only a thirty degree sleeping bag. While discomfort is the most likely end result of this example, hypothermia and death is possible in extreme scenarios.
Much has been written about disruptions in global supply chains over the past year. When the pandemic emerged in early 2020, the world retrenched not knowing how long the crisis would last and what the post-pandemic world would look like.
Retrenchment was a strategic choice for strong companies, but a matter of necessity for companies with weak cash positions in industries where revenues were about to dry up. No one wants to maintain excess liquidity during normal times, especially when interest rates are stuck at zero, but over-optimizing the balance sheet reduces flexibility when it comes to taking advantage of opportunities and reacting to a crisis.
In the case of public companies, the excessive focus on short-term results and the compensation systems commonly in use tilt managers toward financial optimization that can work well in placid times but backfire in a big way when the world falls into crisis. There is nothing sinister about repurchases when they are done for the right reasons, but if a company’s incentive structure rewards managers based on short-term stock price movements, it is all too tempting to leverage the balance sheet and goose the share price by buying back stock. Financial engineering of this type to “optimize” the balance sheet reduces redundancy and creates fragility.
Just as the world seemed to be on the verge of returning to normalcy two years after the start of the pandemic, there came another shock to the system with Russia’s invasion of Ukraine in late February. The invasion, and the sanctions that followed, disrupted global supply chains that were already struggling mightily to fulfill resurgent pent-up consumer demand.
What is true for companies is also true for countries. Germany has been in the process of decommissioning its nuclear power plants for several years and shut down half of its six remaining nuclear plants in early January. The phasing out of nuclear power, coupled with the inability of renewable energy to fully offset the loss, placed Germany in a position of increasing reliance on natural gas imports from Russia. When Russia invaded Ukraine, Germany was in the uncomfortable position of having an energy policy that had limited redundancy, and therefore they had limited flexibility to take the moral stance they wished to take regarding Russia’s aggression.
Global trade harnesses the benefits of comparative advantage, a concept familiar to any first-year economics student. During peaceful times, global trade has the potential to generate mutually beneficial conditions between trading partners.
There are always controversies regarding how far to take trade and to what extent domestic industries should be protected. Usually, these debates are prompted by the economic plight of individuals working in industries that are being displaced. However, the broader question for society is whether the macroeconomic advantages of global trade outweigh the fragility that is introduced into the system during times of crisis.
Another consideration that is often ignored is the extent to which we are willing to trade with countries that do not share the values embodied in the American creed, most notably the idea that individuals should be free to pursue life, liberty, and happiness in political systems that respect the will of voters.
Do we wish to trade with countries that, even in the best of times, do not afford their citizens any of these rights? Or are we only concerned with trading with such countries when they are engaged actively in wars of aggression?
Of course, the elephant in the room in any discussion of global trade is China. In the United States, we find ourselves in a situation where there is nearly universal agreement that we should not have economic relations with Russia, currently engaged in an active war of aggression in Ukraine, but there is much more debate over our economic relations with China.
If we continue our integration with China, we implicitly accept that we could one day be faced with a very difficult choice. China’s territorial ambitions with respect to Taiwan are well known, with China’s leadership making it perfectly clear that they consider Taiwan to be part of China and that they have not ruled out taking the country by force.
Many proponents of global trade extend the case for it beyond the economic benefits of comparative advantage and claim that trade will eventually open up the societies of our trading partners and force those countries to become more responsive to those seeking liberty. Perhaps this will be the case, but there seems to be little evidence of it so far.
The American economy is currently dealing with supply chain problems stemming from a pandemic and wartime sanctions. We should take this opportunity to honestly assess the level of fragility we have accepted in the name of efficiency. If we, as a society, wish to trade only with countries that have strong traditions of democracy, then we should implement such a policy before a crisis forces our hand.
This does not necessarily mean that we should stop trading with potential adversaries, only that we should always bear in mind the need for domestic capacity, or at least capacity in trading partners considered very solid allies. Ultimately, no country that wishes to maintain optionality in a crisis can afford to become excessively dependent on trading partners. Accepting some inefficiency in exchange for optionality in a dangerous world seems to be a price we should consider paying.
Copyright, Disclosures, and Privacy Information
Nothing in this newsletter constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC.
Your privacy is taken very seriously. No email addresses or any other subscriber information is ever sold or provided to third parties. If you choose to unsubscribe at any time, you will no longer receive any further communications of any kind.
The Rational Walk is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.