Monday, June 20, 2011

Absorbing shocks, not preventing them

I've written a couple of times on Russia, and I am going back to it given that last week, President Medvedev gave a lot of interesting statements thanks to the St Petersburg International Economic Forum. The FT got a long interview later on.

What caught my attention was the mention of openness, stability, and the risk of a closed economy. 
Economies are like parachutes: they only work when they are open.(...)If everything starts to work on a signal from the Kremlin (...)it means the system is unsustainable and must be organized around an individual”
The full story seems to be that Medvedev is trying to decentralize the Russian political system in order to make Putin less important in the future. I find it quite important: he's not trying to win the next election against Putin, and he does not seem to try to please voters. He tries to make the political situation more stable and less reliant on a single player, by making the economy less reliant on the Kremlin. He specifically says:
This project should be realized regardless of who occupies which job in our country for the next few years
 All this was already clear when he decided to forbid top ministers to hold a position on corporate boards. He also fired Moscow's mayor. 

This can be linked to a simple idea that emerged recently, though it has probably existed for a while, and that is in my vie extremely important. Nassim Taleb, in his Black Swan book, explains that the question is not to try to prevent a rare catastrophic event from happening. Almost by definition, those events occur with small probabilities, and are quite unpredictable. What matters is to make a system robust to those shocks. The book refers mostly to the financial crisis, but Taleb recently revived the idea in an article for Foreign Affairs, to discuss the autocratic regimes in the Middle East:
Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to "Black Swans" -- that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.
Interestingly, research in political science and game theory already had the idea in mind. Greif and Laitin(2004) have an amazingly interesting paper comparing the parallel history of Venice and Genoa. While both cities thrived  at the beginning of the 12th century, their path diverged  around 1150 when Genoa became embroiled in a civil war while Venice continued its growth. The difference were the consequence of the causes of growth on both cities' robustness to an external shock. In both cities, a fall in central authority led to an organization in competing clans and families. Despite this rivalry, those clans first held together against a common external threat: Genoa was threated by Frederick Barbarossa's Italian campaigns starting in 1154, while Venice was allegedly threatened by the Byzantine empire. While the common threat was present, a difference in political system meant that Genoa increased the clan divisions while Venice made it less salient. When the threats disappeared in Genoa when Barbarossa became concerned with  the civil wars in Germany, the clan divisions became exposed. Meanwhile, Venice had created a robust system where advisory councils were created and a nominating council was electing a Doge to prevent the distribution of rents to different clans. 

The bottom line is that you can have a system that works during a long period of time, thanks to exogenous parameters(external threat, strong demand for housing, term limits for Putin, weak communication technologies for arab countries). But if those parameters are removed, you end up with a civil war, a housing crisis, an autocratic state, or a popular revolt.

This is why it is important. Medvedev might think that he has no chance to stay in power if Putin becomes candidate, but he might also think that by creating change and making Russia less dependent on the central power, his legacy might be preserved because the system will be more stable. Getting rid of Putin won't work. The kings in Morocco and Jordan are making changes in order for their regime to be robust to the change in popular sentiment. Repression won't work. You can consider other examples, like natural catastrophes. This winter in France, the government was blamed for not reacting quickly enough to a cold wave, and the next week, was criticized for taking harsh measures against the circulation of trucks because the cold wave they were expecting did not come. But it should be quite clear that we cannot predict rare events. 

Those things seem probably obvious. Insurance is here for you to be able to take risks and smooth unforeseen events. But the lack of diversification in supply chains show that it does not seem to be taken into account in quite developed areas. A Chinese trawler navigating near Japanese ships is probably happening for a reason, but the day it arrives is hardly predictable. But when 97% of your supply of rare earths come from China, you will not be able to respond quickly to a sudden export ban. Likewise, when the triple disaster hit Japan, we realized that
“lean production” – shaving inventories to the minimum and pushing parts through the system as fast as possible to cope with sudden variations in demand – have made supply chains increasingly susceptible to the kind of disruption seen in recent weeks in Japan.
The graph in the linked FT article showing the market shares of Japan in certain manufacturing component is quite amazing

This led to a change:
But to be safe, circuit board makers are starting to redesign their products so that they can more easily switch components if there is a shortage
But the change could have been done before. The FT takes the example of Acme, a make of castings for cars, and its president's wise decision:
Mr Lovejoy has established three supply chains – each built around Acme’s three factories in Chicago, Brazil and Shenzhen, China. Each is largely autonomous but capable of supplying components to other parts of the business in the event of a sudden, localised disruption.

Bottom line: diversify your supply chain. Construct safety valve in your political system. Buy insurance and throw your ipod on the ground if you like it.

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