The Breakdown - Winter Is Coming: Examining the Economy's Eight-Body Problem

Episode Date: August 22, 2020

The “three-body problem” is a physics issue that deals with unpredictable futures.  In a recent essay, John Mauldin argues the economy is actually experiencing an “eight-body problem.”  On today’s episode, NLW explores each of those dimensions shaping the challenge we face, including: Central bank intervention The destruction of the service industry The implosion of global trade  In the end, he argues that in a world ruled by chaos, fighting to control the narrative might be the only rational move.  Read Ben Hunt’s essay “The Three-Body Problem”

When a company has the ability to persist longer than it can even afford to service its debt, what it means is that it keeps talent away from other more productive uses. It keeps capital away from other more productive uses. The problem with propping up all of these companies that should die because we're scared of the jobs that might get destroyed on the other side is that they're sucking up resources that could go to better things. And while there might be short-term pain, ultimately those resources are doing nothing for us in the last.

long run. Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by crypto.com, BitStamp, and Nexo.io, and produced and distributed by CoinDess. What's going on, guys? It is Friday, August 21st, and today we are talking about the economy's eight-body problem. Now, we're going to get into exactly what that means to have an eight-body problem, but I want to let you know that there's no brief today because this is the type of episode where we're going to touch on a huge number of aspects of the economy, and so it would cover a lot of what I might touch on in the brief anyway.

So brief will be back on Monday just like normal, but today we're just going to talk about this particular and unique characteristic of the current economy. To understand the economy's eight body problem, we have to go to the origin or the reference point for this term, which is the three-body problem, which is a problem of physics. In short, the three-body problem has to do with the impossibility of identifying certain types of predictive patterns of phenomenon that are exerting force upon one another. Now, that is a very dense statement, so we're going to try to unpack it a little bit, And we're going to start with Ben Hunt's write-up of the three-body problem from an essay that he wrote in 2017.

Now, for those of you who are scratching their heads, because this three-body problem sounds familiar, it's the title of a science fiction book, which I've seen many claim is the best science fiction book that they've read in the modern era. It's about China and a game theory of civilization and is something that I've seen Naval and many others discuss. I haven't actually had a chance to read it, but obviously now, after having done this episode, it looks like I'm going to have to. So let's go to Ben's write-up of the three-body problem. He writes,

The three-body problem is a famous example of a system which has no derivative pattern with any predictive power, no applicable algorithm that a human could discover to adapt successfully and turn basis uncertainty into basis risk. In the lingo, there is no, quote, general close-form solution to the three-body problem. Imagine three massive objects in space, stars, planets, something like that. They're in the same system, meaning that they can't entirely escape each other's gravitational pull. You know the position, mass, speed, and direction of travel for each of the objects. You know how the gravity works, so you know precisely how each object is acting on the other two objects. Now, predict for me using a formula where the objects will be at some point

in the future? Answer? You can't. In 1887, Henri Poincere proved that the motion of the three objects, with the exception of a few special starting cases, is non-repeating. This is a chaotic system, meaning that the historical pattern of object positions has zero predictive power in figuring out where those objects will be in the future. There is no algorithm that a human can possibly discover to solve this problem. It does not exist. What Poincere proved is that there is no formula where you can plug in the initial information and get the right answer for where any of the objects will be at any future point in time. No human can predict the future of this system. But a computer can, not by using an algorithm, which is how biological brains evolve to make sense of the world, but by brute force

calculations. Remember, you know everything about these three objects. None of the physics here is a mystery. If you can do the calculation quickly enough, you can compute where all three objects will be one second from now, and one second from then, and one second from then, and so on and so on. With enough processing power, you can calculate where the three objects will be 100 years from now, even though it is impossible to solve for this outcome. It's a hard concept to wrap your head around, this difference between calculating the future and predicting the future, but it will change the way you see the world and your place in it. Now, I want to just go on a little longer in this piece because I think that the point that Ben is making about forward-looking versus past-looking

is really relevant in this case. Here's an observation I can't emphasize strongly enough. This is not how we use computers in our investing strategies today. The way that computers can calculate an answer to the three-body problem is straightforward. They can be programmed with the physics rules for how one object influences another object so they can simulate where the object will go next. There is zero examination of where the objects have been in the past. This is entirely forward-looking. The way that computers cannot calculate an answer to the three-body problem is by examining the historical data of where the objects have been. In a chaotic system, it doesn't matter how hard or how fast or how deeply you look at the historical data. There is no predictive

pattern, no secret algorithm hiding in the data. And yet this is exactly what we have. have all our computers doing, examining historical data to look for patterns that will give us the magic algorithm for predicting what's next. The only thing that the past gives you in a chaotic system is inertia, which can look like a pattern or an algorithm for some period of time, depending on how all the objects are aligned, but it's a mirage. It will not last. Examining the past of a chaotic system can give you lots of little answers, like sparks off a bonfire, none lasting more than a few seconds. And certainly if you're efficient with your inertia identifying spark-capturing effort, you can make some money using computers this way. But this examination of the

past through naive induction will never give you the answer, because the answer does not exist in the past. The answer, which is another world for algorithm, which is another word for general closed-end solution, doesn't exist at all in a chaotic three-body system. So the example that I thought I'd bring in to try to help wrap our heads around this is the difference between the seasons as we experience them now and the seasons as they are in Game of Thrones. We design our world and our experience around fundamental phenomena that can be predicted, specifically that the Earth will always orbit the Sun in predictable ways, and that the Moon will always orbit the Earth, again, at a completely predictable rate. That means that we can design and we have designed our world around

those constants of time and season. The three-body problem shows that in more complex system, that predictability does not apply. You can calculate where things might be based on how they interact with each other, but you can't design a formula that holds constant and predicts where things will be by definition. It's about the pattern. In our gravitational system, there is a knowable pattern. In more complex systems, there is no pattern. Or, alternatively, the pattern is constantly reinventing itself, making it impossible to plan around. Put differently, to the extent our present or future resembles the past, it's more of an accident of chaos than a predictable pattern replicating. The net result is that it makes it extremely hard to organize our behavior around a

predicted future because that predicted future does not exist. The best example that I can think of from literature that you probably have all come into contact with is winter in Game of Thrones. In Game of Thrones, winter isn't just the thing that happens after fall in the same way. Winter is a thing that happens at a certain time based on factors that are unknowable that all have interacted to create a winter and you don't know how long it's going to be, how bad it's going to be, what it will bring. This is an example of a system where there isn't that predictability. And the not knowingness, the unpredictability, has actually given shape to everything in that culture that will eventually experience the winter, however it comes. So that's...

the complex pattern, and clearly this is a Friday episode, as you'll probably be able to tell. But let's now go to the eight-body problem, and this is from an essay from John Malden, who I think might be on the show in a few weeks. And basically, he wrote yesterday, we have an economic eight-body problem. And really, in some ways, the eight-body problem idea for him is just a heuristic to show how many different complex phenomena are interacting. And so what I want to do now is actually go into point by point all the bodies in the system that he's discussing so that we can really wrap our heads around just how many factors are converging. And of course, this is why I literally can't imagine doing only a weekly show and why even a daily show sometimes

feels insufficient to really explore everything that has context and is shaping what's going on around us. Body number one, the service economy has imploded. Obviously, this is one of the most apparent parts of our experience today. You have industries that have been decimated. The way that people interact with restaurants has fundamentally shifted. Demand around flights, around hotels, around experiences that happen out in the world are all shifted. And those are a huge part of the economy. The service economy is a key part of keeping things afloat. Even just travel specifically is more than 10% of global GDP. We are experiencing not a short-term shock, but a fundamentally demand shift, demand destruction in many cases, and even where there's not destruction, certainly a wholesale

change in many parts of the service economy. We don't know what that's going to mean. We just know that it has a huge and large impact on a wide array of people. Body number two, we have seen the largest central bank intervention, not just in the U.S., but in many parts of the world ever in history. This one is obviously at the epicenter of so much of what we talk about here on the breakdown, but I think that the key idea here and the analogy to the three-body problem is the idea of central banks as one of, if not the most powerful, gravitational force in the economy. Now, depending on who you ask, that gravitational force is either because it's real or because it's imagined. It may be that the Fed's tool is the monetary policy itself, or it may be that

their tool is the ability to manifest their monetary policy or the behavior that should come from monetary policy by pure force of perception that they have that power. Whatever the case, the thing that I think Malden is recognizing that I think is right on, is that what we consider normal in terms of central bank involvement in the economy has certainly shifted in fundamental ways. How that will shape how other bodies in this ecosystem change is yet to be seen. But one thing's for sure is that it is having an impact. And when people are so gobsmacked by the difference between the markets that are racing to new all-time highs and the economy, which is still languishing at a 10% plus unemployment rate, you can see that this gravitational force of central bank intervention

is one of the bodies that make up this complex melange that is our economy. What's going on, guys? I'm excited to share that one of this month's breakdown sponsors is crypto.com. Crypto.com offers one of the most cost-efficient ways to purchase crypto out there, as they've just waived the 3.5% credit card fee for all crypto purchases. What's more? With crypto.com's MCO Visa card, you can get up to 10% back on things like food and grocery shopping. When you buy gift cards with the crypto.com app, you can get up to 20% back.

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destruction and moral hazard. He goes on to say companies with the lowest rated junk bonds are refinancing their debt at lower rates. In some cases, that means we are keeping zombie companies afloat. Zombie companies are basically companies that not only can't pay back their debt, but can't even afford to service their debt. They can't pay the interest on their debt from their revenue and profits. These companies are net drags on our entire economic system because they keep things afloat that simply should die. And this is the creative destruction cycle that he's talking about. When a company has the ability to persist longer than it can even afford to service its debt, what it means is that it keeps talent away from other more productive uses. It keeps capital

away from other more productive uses. The problem with propping up all of these companies that should die because we're scared of the jobs that might get destroyed on the other side is that they're sucking up resources that could go to better things, and while there might be short-term pain, ultimately those resources are doing nothing for us in the long run. Body number four, global trade is beginning to implode. This is a longer-term factor than just the COVID-19 crisis, but certainly it is exacerbating things. We've seen a turn away from global trade for the last couple years, and there is now a narrative alignment that has a shift to protectionism and tariffs. Certainly the best example of this is the larger U.S.-China trade war

and the balkanization of the internet that it is creating. This is a particularly complex body in the global economy because lots and lots of people are, on the one hand, very uncomfortable with the way that China is allowed to both play by its rules but also be fully integrated into the global system, while at the same time being very concerned about a larger shift towards protectionism, towards tariffs. These things don't have a good track record, and it's really going to be difficult to figure out how to thread the needle of returning some parts of the economy back home to domestic manufacturing while at the same time, figuring out how to not entirely ignore a globally integrated world that has created significant prosperity for people around the world.

Body number five, on average, six companies with assets larger than 50 million have fired for bankruptcy every week since April. Malden writes, this is going to increase and become a tsunami. Small local companies don't even bother filing because it's too expensive. Every one of them represents jobs. So on the one hand, there's the economic destruction of companies going out of business, but I think the point that I want to hone in on is the absolute destruction and total wipeout of small and medium-sized enterprises in America. This was, like many of the things that were discussing, a longer-term trend. In many ways, the writing has been on the wall for small businesses, first by the introduction of big box stores, which created such economies of scale for so many

of the businesses that had been on Main Street before, but then it was super accelerated by the introduction of internet-based business, by the Amazon's of the world. And these are very complicated things, because on the one hand, we all love Amazon. We love the convenience of Prime. On the other hand, we have to ask ourselves if we want to exist in a world where Amazon is the only option, or rather, and this is the thing that's happening now, where Amazon branded subsidiaries or Amazon non-branded but fully owned subsidiaries are the companies building everything that we interact with, because the economies of scale around the data that they have are so differentiated in terms of their ability to give us exactly what we want, to produce exactly

what we want in exactly the iterations and the exact numbers and the exact right sizes, how can anyone compete? The answer, of course, is that they can't. And part of the of what we're seeing now, part of why the stock market is the S&P 5, not the S&P 500, is that this is just the natural evolution of network scale businesses. This body all on its own would challenge even the most sophisticated and the most competent economies and set of policymakers, and God, we don't have that. Body number six, Malden calls the hard one. It's the working class will be last to see the recovery. This one is also highly visible. You have right now the bifurcation of the economy even more acutely than it was before into those

who are well off and can work from home, and those who have blue-collar jobs who can't. This is where schools, no matter what you think about the right decision to open them or not, become incredibly complicated. You have a huge number of people who feel like they can't go back to work because they have to stay home with their kids for school. They simply don't have options. Their kids can't just become latchkey kids because they're too young. The other aspect of this is that the 50% of people who don't have the capacity to participate in the stock market, don't have any capacity to see the upside of this, right? The V-shaped recovery, the great American recovery, as Vice President Pence called it earlier

this week, might be complete in the minds of people who have assets and who now see that their S&P stocks are up over where they were in February, but that is cold comfort to someone who's never been able to buy in, and in fact, the more expensive that stocks get, the less the meager money that they could potentially put in the market actually does for them. It is this body that is going to be the most source of not just economic turmoil, but social and political upheaval in the next 10 years. Now, the last two bodies in the economy's eight-body problem, according to Malden, are positive. Body number seven, entrepreneurs will reemerge and new ones will seize this moment to shine. Basically, his point here is that when we allow the normal business cycle to proceed, what happens

is the entrepreneurs who have the wherewithal, the vision, and the figure out the, access to capital, take the spots and take the talent and take the energy and take the capital that is unlocked when other businesses fail and turn that into new things. This is an incredibly important part of this crisis. And frankly, like everything else, it's being hyper-accelerated right now. I'm glad the way that this is put in the context of all these other problems, because it's really important as we sift through all of this complex and noisy data that we don't just focus on things that tell us a story of total desperation, but that we also don't over-lionize things that are going to be enormously difficult. I, like John Malden here, feel like there is a huge

opportunity on the other side of this for entrepreneurs. We're already seeing people swing into entrepreneurial action around new types of behavior shifts that are in the process of happening, be it homeschooling, be it a move to the suburbs, be it a numerous other things. Entrepreneurial energy is the way that societies reorganize their economies around new phenomenon and new behaviors, and the more that we can do to, one, get out of their way, and two, make it easier for them in some way, whether it's capital or something else, the better will be. Body 8 is in some ways an extension of Body 7, but Modlin puts it, we are in the midst of the

greatest transformation in history. Elon Musk just launched and landed a massive rocket as a test. That is just a very visible example of tens of thousands of new technological revolutions happening all around us. I agree. I think we sometimes forget just how much is happening. In fact, in some ways, part of what's so challenging right now is that the pace of change is far more than we can really handle in some ways, certainly as not just as individuals, but as

societies. That pace of change is stretching us to our very limits. However, if we reorient our framework and we accept that we are in a moment of transition, and in fact, that transition and acceleration of change is simply the new normal, it can allow us to build different types of habits and different types of expectations that can allow us to thrive, to be more resilient, to be ready to maximize the potential for moments of great shift, these liminal moments, these in-between moments. In this way, we might become an anchor force in the system around which other parts of the system organize. And this, I think, brings me

back to the point that I wanted to conclude on. In many ways, the outcome of the three-body problem is that we have to shift our thinking from finding a predictable pattern that algorithms can view and understand and make predictions on the basis of, we need to shift to start calculating specific outcomes, right? Specific inputs of data that come up with specific outputs based on those factors and those factors alone. That's one theory. That's one possibility. However, another is to instead simply reject trying to predict and instead to try to shape. In a world where there is no organizing pattern to uncover and design around, it becomes much more rational to try to become gravity, to exert the gravity on the system and drag it to where you want it.

This is the battle for self-fulfilling prophecy that I always talk about around narrative. The desire to try to shape narrative and leverage narrative to bring the world where you are is a hyper-rational response in the context of a world where we've recognized that there is no easy pattern to predict where we're going. Every time you see someone try to drag people into their worldview, regardless of what the historical input says, recognize it as a recognition of the chaos that rules the system. In a world of chaos, be the constant. That, in some ways, is the game. Anyways, guys, I hope you appreciated this slightly different type of episode. I hope that you're headed off to a great weekend wherever you are. Enjoy the last

embers of the summer, although I'm sure it'll be hot all the way through September, much to my chagrin. But I appreciate you listening. And until tomorrow, be safe and take care of each other. Peace.