Wednesday, 17 September 2008

The new new new economy

If the leveraged financial structures supporting the operations of the world economy are unravelling, what will happen?

In the short term, it's dangerous. Today, according to the FT, banks are refusing to lend to each other. Soon that will start to have knock-on effects for exporters, and soon after that for domestic business too. They can't borrow money because their banks' risk models require the loan to be laid off to other parties who will no longer play. So companies won't be able to get export finance, and won't be able to take on domestic projects that require financing either.

Why is that? If the money is out there but the banks won't lend to each other, people who need it are going to have to start finding new financial suppliers. Let's say that bank A has a strength in lending foreign exchange to manufacturers, and usually finances this by swaps with banks B and C in the forex markets. The money is spent by the manufacturers and comes back into the market soon enough where it is recycled. If all manufacturers go to bank A, the specialist, they still have access to the asset pool of all three banks which is enough to lubricate the market (almost by definition - as the amount of trade will grow until it uses the available capital).

But if the interbank market seizes up, bank A will run out of funds to lend - the recycling process leads to B and C having more forex than they can find customers for, but they'll hang onto it just in case. So the manufacturers will be forced to go out looking for funds with B and C - who are not really set up to lend it, and don't understand the market or the risks as well as A. The manufacturers incur more cost in having to find and switch suppliers; banks B and C incur a higher cost of supply than A would; the economy becomes less efficient as a result, and everyone has less time to spend on actually making things. We are making manufacturers do the job of interbank traders, and traders do the job of retail lenders, and we lose the benefits that specialisation brings to the economy.

In reverse, this process is one of the reasons the world economy has been able to grow so strongly over the last eight years. The efficiencies provided by financial specialisation and intermediation have been greater than most people ever anticipated. We're used to the our businesses growing and being more efficient because of 'real economy' technological developments, and sometimes managerial innovation, but we don't really notice that financial structures are a big reason for it too.

These are structures of specialisation, knowledge leverage and abstraction. Specialisation lets the people who are best at something do it, so that more output is generated by the whole system (comparative advantage). Knowledge leverage means that the investment in developing one set of knowledge (e.g. how to deal efficiently with manufacturers requiring import finance) is spread over the maximum number of customers, reducing the number of people who have to learn it and allowing that learning time to be used for something else productive. Abstraction means that we can deal with a concept that's close to us and ignore the myriad complex things behind it. We are therefore able to spend less time thinking, and think more accurately when we do. An important special case of abstraction is being able to make decisions based on the present which will affect us in the future. The ability to 'shift time' in this way is a crucial aspect of economic effectiveness.

These three factors are the causes of economic growth. They are expressed in thousands of different ways, and in recent years (since the technology boom of the late 90s calmed down) financial market structures have been the dominant generators of these factors.

So if the finance markets stop working, the growth of the real economy could potentially be hurt badly.

Now it won't be as dreadful as some people think. Whatever the levels of real economic output and consumption that were happening before the markets stopped, people know what those levels were. Consumers expect to buy a certain amount of stuff, manufacturers know how to make that amount of stuff, and there is a shared belief that this is a sensible amount of stuff to trade. And people are pretty smart. So they will find a way to make, market, transport, sell and buy the same amount of things as they ever did.

But without the coordination of the finance markets, they'll have to find another way to do it. Another way to look at those markets is transmitters of (relatively) reliable information. They can tell a Chinese manufacturer what the demand is for their output (through the prices in the Chinese economy and the exchange rate between the yuan and dollar); they can tell the Saudi government how much to invest in new oil terminals (through the price of a futures contract in the oil market); and the more complex and liquid the markets get, the more detailed and accurate (and harder to deliberately manipulate) the information becomes, if you know how to read it.

So the financial markets act as a giant computer, factoring in the information about demand and supply, and risk, and the past and future, and coming up with the answer: here is the best way to allocate your resources, world - this will get you the results you want.

And if the computer has crashed, but we still want to get the same allocation? We had better come up with some new methods.

There seems little doubt that GDP will slow or shrink for a little while, as people adjust to having to send their allocation signals in a new way. But there are other ways to do that. Before there were complex financial markets, it used to happen (much more slowly) through conventional trading and the interactions of the markets for real products. In some societies it was done through central coordination. In others, cultural trends emerged (the blacksmith's son became a blacksmith and the farmer passed his land to his children) which provided a reasonably effective allocation of resources.

Personally I think the new coordination mechanism in the economy - the new structures that will ensure specialisation, knowledge leverage and abstraction - the new way for us to communicate resource allocations to each other - will be by designing mathematical economic structures and learning to trust them.

After the Internet and telecoms bubble that accompanied the new economy of the 90s, after the finance and derivatives boom that came with the new new economy of the 00s, the new new new economy - that will dominate the 2010s - is based on this. The people will take back their understanding of economics from the Internet geeks and the investment bank gamblers; people who work in businesses will be, democratically and self-interestedly, in charge of the abstract structures that govern them.

And there will be another wave of growth, and we'll look back on this as a quaint, backwards decade, like every decade does, and we'll all be a third richer in ten years than we are now, just like we are a third richer than ten years ago. And then, maybe there will be another pause when the new structures have run their course - but I'm not ready yet to predict what will come after that.

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