by Bill O’Grady
In our discussions of COVID-19, we have noted that part of the reason the virus has been so disruptive is because the world has adopted a stance that optimization is an unalloyed positive. When I was in graduate school, I participated in a seminar with several professional private sector economists. A question was posed about what the goal of economics should be, and the resounding response was “efficiency.” On its face, that position makes sense; after all, who wants to be inefficient? But the key is how efficiency is defined and measured.
There are two underlying issues that frame optimization. The first is the broad number of variables that may be considered in optimization. The second is that many actions designed to optimize suffer from the error of composition. In other words, what is rational at the micro level may be irrational at the macro level. Both of these factors are affected by globalization, thus making them appropriate for a geopolitical report.
One of the reasons COVID-19 has had such a drastic impact on the global economy is because companies and governments have optimized to a narrow set of factors and the lack of redundancies in the system has caused breakdowns in supply chains. As we have watched this crisis unfold, we have been struck by the fact that much of the impact was tied to the drive for optimization.
In this report, we will examine the issue of optimization. We will start by discussing the expanse of variables considered and why market participants tend to assume that slow moving variables are constant and thus they are vulnerable when they change. An analysis of the error of composition problem will also be included. We will conclude with market ramifications.