Mesoeconomics

From wartime planning to green steel

A recent op-ed by Gillian Tett led me to Bill Janeway’s latest in Project Syndicate. The jump off point for this piece is George Lincoln of the US Military Academy’s Department of Social Sciences lessons learned from mobilizing for World War II, subsequently revised after the Korean War.

“Although it is comparatively easy to speak of converting requirements for forces into terms of end items and of end items into needed raw materials, machine tools, manpower, and facilities and of converting these factors into money, the actual detailed action of conversion from one category to another is a difficult process requiring judgment and a great deal of toil and time. The capabilities side of the equation is even more difficult. We need to know what exists in the United States economy, how it can be adjusted to a security effort and the timing of the adjustment. A security effort is dynamic, with integrated activities proceeding concurrently. A miscalculation which is small, measured in dollars or tonnage, a shortage of copper, for example, may create a major disruption.”

I could not agree more - modelling these things are hard and important and I have mentioned this at length here. Very coarse or high-level approaches to modelling this have horribly let the world down in the case of recent inflation shocks, both underestimating impacts on the way up, overestimating on the way down and until very recently central banks have struggled to disentangle how much of recent inflation was energy, food and supply chain snarls as opposed to underlying conditions leading to profound uncertainty with regards to monetary policy. Recent work by Bernanke and Blanchard and Mai Chi dao et al at the IMF came to similar conclusions:

Credit where it is due, Isabella Weber was onto this almost two years prior to the others but is being studiously not cited by them for reasons unknown. Employ America has been all over this and gets very deep into what supply chains are broken how and where and which are binding. The Cato Institute naturally is not there yet because facts getting in the way of deeply held priors and a good story are so troubling that posting through it is less cognitively burdensome than grappling with the implications of a changed world.

Acknowledging that details matter for more extreme inflation dynamics outside of the labor-unemployment trade-off is the easy part. Deciding what to do about it is vastly more troubling. Weber and some others are advocating price controls in crises and while I am not a member of the CATO institute it is not hard to see how crisis definitions could be loosened so far that you wake up one morning in Buenos Aires. Similarly trying to regulate “corporate greed” and “greedflation” out of existence seems hard - having adequate competition seems much easier but even there you can see (alleged) covert collusion emerge. Common shocks like the Ukraine-Russia wars energy impacts tend to create space for all firms to raise price at once according to Weber but I think that ascribes far too much agency to these businesses. In a market shock, spreads widen and volatility increases. It generally is more lucrative for market makers who have to compete less for more chaotic volume from less price sensitive buyers and sellers. The more central you are in liquidity terms in such a shock (bank trading desks, Citadel, etc) the better it is. For a real shock the most central entities with the best information are probably Walmart and commodity trading houses. It is no surprise both did well over the period. The question in my mind is not “how do we stop businesses that are designed to profit from volatility not do that” but “can we structurally reduce or curtail certain types of volatility in the first place and at what cost relative to benefits”.

If recent events were not enough a literature is now emerging showing that supply networks are “inefficiently, and insufficiently, resilient”. It is hard to argue that key inputs like energy, food and critical components are things regulators can wholly disregard because of both market failure and very high costs to those failures. These large categories that are hard to disrupt because people need to eat, and we cannot replace the entire auto fleet with EVs that quickly are natural places to start. Similarly as Janeway notes it is also important to be realistic about what you can reasonably plan:

Lincoln’s second mention of a newly critical material referred to germanium, which “makes possible the transistor.” With unwitting historical irony, he was writing just before silicon supplanted germanium, owing to its relative ease of processing and stability at high temperatures. But the message is the same. Whatever the profile of final demand for output – and thus the shape of those outputs – the same upstream materials are essential both to a growing economy and to its mobilization base.

Semiconductor transistor demand exceeded anyone’s projections, but Germanium based ones went away. We face similar issues today with batteries. Batteries have comprehensively won over hydrogen as Michael Liebreich has noted in a series of devastating dunks articles but what those batteries will be made of is far from settled. Sodium vs lithium, lithium iron phosphate versus nickel based cathodes, is cobalt even going to be around now? Electrochemical storage is going to be enormous but exactly which and how is still far from solved.

To that end the hand of government should focus on different interventions for differing circumstances. For large inputs that are not going away quickly the focus should be on existing efforts to drive substitution over the long term but hedging over the short term. Employ America’s work on oil and the SPR is a good example but it can be extended to smaller markets that are growing in importance and unlikely to go away like their work on lithium. Decarbonization is an important driver of reducing these risks over time: energy was a major share of recent shocks, and food which uses energy for fertilizer was second. Moving more energy sourcing to electricity that is domestically produced results in lower risk and having more of that energy contracted long-term also suppresses volatility. This has the same impact as Weber’s price controls but without arbitrary state action and it works very well both financially and politically. The experience in Canberra is illustrative and has led to lower volatility and smoother pricing through the various COVID and Ukraine shocks through long term power contracting from renewables.

For these critical materials and inputs much can be done with lending to increase supply (via the LPO) or to reserve material in downtowns (per this work) but offtakes remain an under-explored area. Offtakes are in general strictly preferred to subsidies or incentives for the simple reason that they are durable outside of a single election cycle. There is a lot of ink being spilled gaming out what happens to the IRA if Trump wins and what happens to individual companies. If people have offtakes or some kind of collar structure that runs past the election that matters a great deal less. Where the end product is well defined and easy to price - something on the periodic table, or commodity solar wafers - this is something worth looking into particularly in the early stages of development of an industry. An industrial finance corporation along the lines of Senators Coons’ proposal may be a step in the right direction here.

To that end, green steel might be a good place to start here. The product is well defined - iron please, hold the oxygen - and there are now a dizzying array of pathways to get there. Form Energy, a battery producer has entered the fray this week on top of numerous other ARPA-E grant recipients doing everything from similar electrochemical approaches to hydrogen to lasers. A simple way to sort subsequent rounds of funding would be to have them “bid” on what the minimum price they might accept for a put option on their output. This put in turn would make them easier to fund in private markets and put less of a financial burden or risk on the government - the government would be sitting on a risk the iron or steel market collapses which like most commodities tends to happen in recessions when their borrowing costs also collapse - a classic example of “right way” risk: your exposure or funding requirement increases when funding costs fall and that might be the exact right time to build a stockpile.

This area is fascinating to me because it is clearly an area where laissez-faire has had a mixed record, there are very clear and well-defined strategic risks and challenges and technological change is changing the state of play all the time. Modelling these kinds of flow charts of production across geographies is also a very heavy computational lift and something that has really only become possible in recent years. I suspect aversion to looking into any of this outside wartime was simply due to this cost - you can’t manage what you can’t measure, but similarly you might not even bother trying to measure what you know you cannot compute. That is less of an issue now and the increased need is self-evident as well as the tend to work out what are focus areas as well as how to evaluate what optimal interventions are whether they are worth the trouble. We still lack some way to trade off these risks versus returns, which is a baseline for designing policy interventions. There is just so much more work to do here but it seems we have passed the first phase: accepting the work needs to be done in the first place.