The Convexity of Recovery

As always, Nassim Taleb loves to ruffle the feathers. More often than not he comes with a proposition that seems odd with everybody else. From Black Swan to Anti Fragile to Incerto to Skin in the Game, he has taken very interesting and unusual stands. The line of thinking revolves around the behavior of extremes as opposed to behaviour of means in the orthodox analysis.

As the Wuhan pandemic continues unabated in its toll, the discussion has shifted towards the recovery period post the pandemic. There is increasing discussion on the recovery package that needs to be addressed by different governments. The post Second World War led to the development of Marshall Plan that allowed US to offer money to Europe to rebuild their society. The Marshall plan acted as a fiscal and monetary booster in restarting the European economy.

The debate therefore today is revolving again on a new Marshall Plan post the pandemic. The devastation it is likely to create will need a huge resources. Countries like Italy or even Spain not counting out Iran all likely will find it difficult to rebuild the economies. As PM Modi pointed out, the current scene is such that no country is in a position where it can come to help the other countries. Each country is fending its own borders.

The economic costs of recovery will be significantly higher than the losses incurred. This is where Taleb makes an unusual proposition. He argues the costs would continue to increase even during the decline period of the infection. He traces the variations in this behaviour to the very nature of the distribution of the costs of the pandemic and the costs of the recovery.

Pandemics have a ceiling. There is a finite population and thus any pandemic will hit a ceiling at any given point of time. Therefore rather the assumption of an exponential growth function should give way to treating it as a sigmoidal function. The complex systems that the universe is full off usually begin in increments, takes an accelerated jump before flattening out.  In other words, over a period of time, the climax is approached over time rather an infinite upward movement. Therefore like any continuous function, something that has a ceiling will naturally have a concave function. In contrast, anything has a floor, the function being continuous will demonstrate a convex behaviour.

Therefore, the context gives the backdrop for understanding the differences in behaviour of the pandemic and the costs of economic and social recovery thereafter. Implied in Taleb phraseology is x is not f(x). Costs demonstrate the convex behaviour and thus demonstrate an increasing scale. The example used is of the hurricane. Hurricane is good example in Taleb’s words of a fat tail distribution. However, he contends, the costs of recovery is even more fat tailed. The answer lies in the shortage of materials as they begin a process of rebuilding. There are continuous shortages whereas demand is relatively higher. The demand arises from destruction of the existing infrastructure and the subsequent need to rebuild the existing infrastructure.  In contrast the very destruction of existing infrastructure creates a shortage of materials resulting in the rise in prices. An outcome of the same is the sharp rise in costs of recovery.

As the Wuhan virus originated in China, it is without doubt a key disruptor of equilibrium. China over the last few decades has emerged as the factory of the world. Moreover, the backward linkages ensued the raw materials originated in China. The paradigm was built on the cost minimization for given level of revenues as contextualised in economics. To many firms, given the competition and thus shrinking shelf space meant that gains in revenue would be limited. The orthodox option would be to opt for cost minimization. This paradigm entailed the production being continuously relocated to centres of low cost production. The first wave saw relocation to South East Asia and later to China. The sheer size of China and thus the labour pool along with the Faustian deal with the Chinese Communist party apparatchiks ensued the production being completely under control of China. The O-Ring effect had to take effect some day or the other. The mantra thanks to flourishing of the Japanese management system led to over focus on optimization. The optimization obsession leads to ignorance of the fat tails and thus a prospective ruin events.

The over concentration of supply chains was to inevitably face an acid test in the presence of a prospective ruin event. The management thinkers and economists fail to see these as the events are more located on the extremes thus a very low probability of the occurrence. Therefore very little redundancy was built into the same. In the context, the current state of affairs is an outcome of the same.

The answer would be to factor in the adverse events of the fat tail and thus evolve into supply diversification. The optimization models work well yet they stand to yield very high perhaps significantly irrecoverable returns when confronted with an occurrence that would be very low but nevertheless a positive probability. Force de majeure is not an answer to the convex problem that presents before us.