Geopolitics, economics and good decision making
A Changing World
The world was a very different place in the mid-1980s when I started my career as an economist at the UK Treasury. The Soviet Union still existed, Thatcherism was in full swing, and the Lawson boom had just begun. We never really thought about the geopolitical situation – inflation was the big beast yet to be slayed and macroeconomic forecasting was largely a mechanical process.
Within a few years however, the Berlin Wall had fallen, the West was exporting economic liberalism/inflation targeting to the rest of the world, and the era of ‘hyper-globalization’ was underway. Still, mainstream economics as practiced at central banks, banks and investment firms was largely unaffected by these tumultuous events. The focus was squarely on the next payrolls number or interest rate decision. The international geopolitical order was just too big a subject, too messy, too un-modellable to spend much time trying to understand.
Eight Key Geopolitical Events Shaping the World
Previously, I’ve written about the eight key geopolitical developments that have shaped the modern world, moving it away from the liberal consensus of the 1990s and forcing economists to start taking political economy seriously again.
Chronologically, these were:
- Russia’s failure in the 1990s
- The Asian financial crisis
- The rise of global Islamism
- China’s entry into the WTO
- Rising inequality and the revolt against elites
- The 2008 Global Financial Crisis
- The Covid-19 pandemic
- Russia’s invasion of Ukraine
These events illustrate the growing complexity in connecting global politics to economic forecasting.
Forecasting in an Uncertain World
I remember being asked in 1990 to produce a 50-year forecast of the sterling exchange rate against three major crosses – the dollar, the deutsche mark, and the yen. I knew at the time this was a ludicrous exercise, but the client had asked, so I produced it. Before the end of that decade, one of those crosses had ceased even to exist, thanks to the ERM crisis of 1992 and the European political response: the creation of the Euro in 1997/99. For me, this was confirmation that long-range forecasting is plagued by radical uncertainty (Kay and King, 2022), because the stuff that really matters is literally unpredictable and deeply political in nature.
That said, I looked up those dollar and yen forecasts ($0.85 and Y250) the other day and, while significantly wrong so far (albeit with16 years to go), they weren’t ridiculous and most of my error was down to the fact I’d assumed a much higher inflation rate for the UK than the US and Japan – my real exchange rate forecast wasn’t that badly out of line. Perhaps a bigger lesson is that while, in the short run, economists assume the economic structure is broadly unchanged and prices adjust, in the longer run, in response to huge geopolitical change, economic structure (the trade share, the manufacturing share, the importance of hydrocarbons, the general shape of the economy, etc.) is endogenous, while real asset prices are pinned to a long-term return on capital that remains broadly unchanged.
Geopolitics in Short- and Long-Term Forecasting
This introduces the idea that economists need to think about geopolitics in two different ways, depending on the horizon they’re considering. Monetary policy makers and tactical asset allocators worry about the next year or two, so they need to think about geopolitics as a set of events that could derail their central forecasts. What next for Russia and Ukraine? How might the situation in the middle east develop? What about China and Taiwan? What will the next American president do about US economic policy at home and abroad?
That calls for scenario analysis that investigates the main transmission channels of interest carefully and draws conclusions about the impact on inflation or asset prices. How will commodity prices react? What are the implications for product markets and international supply chains? What about capital markets, access to finance and local returns to capital? Is there an international labour market dimension, through migration or the impact on regional and international labour supply?
In technical terms, this often means implementing a shock on a model, but seeing how it plays out when economic agents are faced with different budget constraints (e.g., restrictions on their ability to source intermediate goods from anywhere, or having to find alternative basic commodity suppliers, or being unable to borrow in international financial markets).
By contrast, strategic asset allocators or foreign policy specialists need to take the longer-term questions seriously. They need to do so humbly, knowing they can’t possibly predict what economies will look like in 2074, let alone generate precise exchange rate forecasts. However, they need to demonstrate they have thought about these issues when publishing capital market assumptions or formulating long-term foreign policy positions. Too little of that goes on now.
The Role of Geopolitics in Modern Economic Decision-Making
It’s difficult to incorporate the behaviour of a government that isn’t interested in maximizing the economic welfare of its citizens into standard economic models. And the game-theoretic nature of the relationship between nation-states throws up enormously complicated play-and-respond scenarios, all of which are ex-ante plausible, but many unrealistic. The best we can do is try to understand what is going on now and map that into plausible outcomes for equilibrium asset prices, acknowledging that we’re only capturing a fraction of the uncertainty out there. That was the approach I took recently when writing a research paper on the implications of geopolitics, climate, demographics, and technology for the global equilibrium real interest rate and, by implication, other capital market returns.
Conclusion
The subject is fascinating, and one thing is clear – the days in which we practical economists could stick to the old script and ignore developments in the political world are gone forever.