In the old days of the Soviet Union, say from 1920 to 1985, the Communist Party ran the economy in what was called the “command and control” model. The Party would make a five-year plan, and decide, for example, how many pairs of shoes would be produced in that period. Sometimes it would produce too many (rarely as it turns out) but usually not the right sizes, styles or colours. It was kind of like when Henry Ford started producing the Model T car: You could have any colour you wanted as long as it was black. In the Soviet days you would rush to buy whatever shoes you could and hope that you would more or less fit into the average size. Over time it became apparent that the Party could not get production levels right for most things. It was simply too hard to predict demand for each and every product and arrange production to make them. As times changed and the economy modernized, this ability became more and more deficient. The Russian retail economy has still not recovered from three generations of command and control. About 25% of Russians still do not have indoor plumbing.
Contrast this to, for example, a Walmart store. In the retail world every different item a store sells, say a 500g box of Cheerios, is called a stock-keeping unit, or SKU. The average Walmart has 120,000 SKUs. Imagine trying to forecast how many boxes of Cheerios to buy, how to price them, and where to put them, for a whole country, and for the next five years. And then multiply that by 120,000 SKUs. Walmart can do this because it has real time data from every cash register. It knows how many of each SKU it has sold in every store, every day. It can quickly and easily adjust prices to sell more slow-moving items and can increase prices on popular items that are in high demand. It is, in short, data driven based on millions of consumer choices made every day. It does not try too hard to predict these millions of choices because it knows it is impossible; it is reactive rather than proactive. It is the very opposite of command and control.
The mechanics of running a Walmart or any retail/wholesale seller of good and services falls into the sphere known as microeconomics. It is fair to say that the capitalistic world is very, very good at this. While every now and then some things run out (baby formula and some medications recently) we all expect that almost all the things we want will be available almost all the time. The logistics chains that make this possible (think of the number of suppliers of those 120,000 Walmart SKUs) are enormously complex and globe-spanning. While mostly very reliable, things like a global pandemic, natural disasters or a significant war can obviously cause breaks or delays in the chain. When that happens, prices are disrupted and consumers are forced to change their preferences.
The last two years have been unprecedented in the post-war era in regard to the combination of unexpected events causing disruption. The COVID pandemic has killed at least 7 million people worldwide and resulted in the shutdown of the Chinese export economy, by far the world’s largest, for periods ranging from weeks to months. The war in the Ukraine is the largest European land war since World War II and has roiled the market for fuels, metals and grains. Long-lasting and record setting droughts in California and western Europe and floods in British Columbia and other places have resulted in prices for things like lettuce jumping 60% in one year.
In short, nobody should be very surprised that prices and supplies for lots of everyday items are currently in a state of flux. The fact that things have worked as well as they have over the last three years seems to me to be a minor miracle. It also seems apparent that things are rather quickly returning to normal. Shortages are much less apparent and prices for commodities like gasoline and grains and items such as used cars are down very sharply. The microeconomy is doing its usual efficient job.
Why then, are central bankers still raising interest rates? John Maynard Keynes, the mid-20th century economist famously said:
“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back”
Macroeconomics deals with subjects like interest rates, inflation and economic growth. To say that macro is less understood, and less effective than microeconomics is to make a huge understatement. Today’s central bankers are doing their work using models developed over the last sixty or seventy years when conditions were vastly different than they are today. The notion, for example captured in one of the macroeconomist’s favourite tools, the Phillips Curve, first explained in 1958, is that labour shortages always cause price increases, and that the way to combat inflation is to fire lots of workers, eliminating the shortage. Increasing interest rates causes consumers to curtail spending, which causes companies to cut back on production, and to do so by reducing the labour force. Note that no central banker is dumb enough to say “We are going to fight inflation by getting you or your neighbour fired”. But that’s the basic idea.
But what if the price increases are caused by very different factors, as posited above? And what if the shortage of workers is caused by death or disease and a lack of immigrants, as is the case in the United States today? The 1958 Phillips curve was not designed to address these issues, nor were most of the other tools in the macroeconomist’s toolbox. As the old saying goes, if your only tool is a hammer, many problems look like nails that need to be hammered down.
There is no question that interest rates in the period following the Great Recession of 2008/09 were too low. There is no question that an increase back to more “normal” levels was warranted and needed. The question is, when will the central banks decide enough is enough? We think they are just about there, and we can expect to see much more stable capital markets in 2023.
Warren Buffett is not a believer in macroeconomics. He is worth quoting at length:
“Something different happens all the time. And that’s one reason economic predictions just don’t enter into our decisions. Charlie Munger – my partner – and I in 54 years now never made a decision based on an economic prediction. We make business predictions about what individual businesses will do over time, and we compare that to what we had to pay for them. But we have never said yes to something because we thought the economy was gonna do well in the next year or two years. And we have never said no to anything because we were right in the middle of a panic… There’s so many variables. I mean, in the hard sciences, you know that if an apple falls from a tree, that it isn’t gonna change over the centuries because of anything or political developments or 400 other variables that go in. But when you get into economics, there’s so many variables, and the truth is, you’ve got to expect good times and bad times in business.”
We are off to a very strong start in 2023, and maybe the smartest thing we can do is emulate one of the greatest investors in history. We will continue to pay lots of attention to how our portfolio companies are doing, and try to worry less about what the sometimes confused central bankers might do next.
Long Term Investing Podcast with Barry Schwartz