By Daniel Archibald | CFA
The recent concerns over Glencore, and its comparison to the likes of Enron and Lehman Brothers, got me thinking about an article I read a few years ago. For those who aren't familiar with John Mauldin, his books and blogs are well worth the time, and his piece from 2013 on 'The QE Sandpile' has remained a favourite.
In it he mentions a group of physicists, who in 1987 wrote a computer program to mimic what would happen if you kept adding grains of sand to a sandpile. As would be expected, some of the virtual sand stopped where it landed in the pile. While other grains would roll down and off the pile. But what they were most interested in was the grain of sand that started an avalanche.
Findings from this study highlighted the precarious nature of seemingly stable environments and the risk of interconnected instabilities.
I like to think of this experiment as happening on a nice white dinner plate. Dropping grain by grain would take a long time but as long as you drop the sand on the plate, it would certainly take a very long while for any sand to fall off the plate. But once the plate is full, every new grain of sand could cause a number of grains to fall of the plate. If this experiment goes on forever, the only real way to make sure that you don't lose any grains of sand is to make sure that your plate keeps on getting bigger.
From a financial and economic point of view, the plate could be likened to the resource base of an economy and grains of sand like money and debt. The resource base consists of natural resources (commodities, etc), human resources (labour) and capital resources (machinery, etc) and the efficiency in which you use these resources. If you found a brand new land (new plate) and supplied it with labour and equipment, you could probably throw as much money at it as possible and not really lose any grains of sand. However, most economies are not brand new and are well-laden with money and debt.
The problem that seems to happen in business and Government is instead of focusing on growing the base, the focus tends to be on stopping avalanches. They do this by manipulating markets, over-regulation, hedging exposures and inefficient policy settings. These examples would be like building fences or maybe using blankets to try and prevent any sand being lost from the sandpile. And the big part of the problem is that these measures work… until they don't.
Overall, such measures end up creating bigger risks of bigger avalanches. And with more fences and blankets, the sandpile becomes more interconnected, so that a grain of sand that would normally only cause a minor bankruptcy, ends up bringing a big chunk of the economy down with it.
The focus should be on growing the plate. This would mean more resources or better productivity from our resources.
Unfortunately, our pool of natural resources is likely to continue to be depleted, but using these more efficiently might help grow the plate. On the human resource front a healthy birth rate and immigration rate can help grow the labour pool and technologies are likely to continue to improve labour productivity. New technologies are also likely to help improve the size and efficiency of our capital resources.
So growing the plate isn't really the issue. But if money continues to be thrown on to the pile, without regard for the size or growth of the plate, it is likely that we will continue to suffer from the odd avalanche or financial crisis.