Download The Asset Revolution, and the Sources of Volatility

The Asset Revolution, and
the Sources of Volatility
A Strategic Leadership White Paper by Robert McGarvey
History of Economic Volatility
Although economic volatility can have many
causes, it has historically been most common in
those periods of adjustment when a new class of assets with unknown and unfamiliar risks is being incorporated into the economy. There have been three
different periods of extreme volatility associated
with foundational changes in Western economies;
the earliest stages in each of the 17th century Commercial Revolution, the 19th century Industrial
Revolution and the emerging 21st century Knowledge Asset Revolution.
The Commercial Revolution:
At the time of the Commercial Revolution in the
17th to 18th centuries, for example, there were several notable episodes of economic volatility associated with growing international ‘trade’;
the most famous of which was the South Sea Bubble.
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The South Sea Company was a private company chartered by the English monarchy in
1711, granted a license for trading in the South Atlantic. Speculation around this new
‘monopoly’ enterprise was swift and excited. Unfortunately for the South Sea Company,
Britain and Spain went to war again in 1718, undermining the trading opportunities with Spanish
colonies in South America.
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But like many a modern day business, the significance
of these commercial reverses were not immediately
apparent to investors. Indeed, so popular was the
stock, that investors ignored the bad news and kept
buying. As a result, the stock kept rising rapidly,
encouraging more buyers and creating a momentum
of growth that seemed unstoppable. Behind the
scenes, South Sea Company management, seeing the
writing on the wall soon began to dump their shares
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The Asset Revolution, and the Sources of Volatility
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into the rising market. Eventually word got out, the bubble burst, and panic selling
initiated a market crash and economic crisis in England.
Although many see the South Sea bubble as simply a case of stock market greed, it was
in many ways a function of unfamiliarity of risk—there was ignorance on the part of
management, investors, securities regulators and the public at large with the nature and
scale of trading risks. A new class of assets was being incorporated into a medieval
economy that had been very slow moving and predictable; the Tulip bubble in Holland
and the South Sea, and the Mississippi company (La Compagnie du Mississippi) bubbles
were part of a steep learning curve associated with such changes.
The Industrial Revolution:
By the late 18th century, Britain was leading the world into a new industrial form of capitalism, another seemingly miraculous economic change of state. Industrialization standardized
and mechanized the production process, transforming the economy from manpower to mechanical power; vastly increasing industrial society’s wealth generating capacity.
Apart from being an extraordinary technological revolution, the Industrial Revolution was
also an asset revolution. Steam power, factory based production and reliable transport,
linked factories to customers and a stream of future earnings, which consolidated vital
collateral value in industrial class assets. These new earning streams were soon recognized and underpinned by institutional reforms in banking, accounting standards, building
codes and securities regulations; reforms that opened the capital flood gates to factory
owners, driving growth throughout the Industrial Age.
However, the early stages of this revolution ushered in another period of extraordinary
volatility. The years 1819, 1837, and 1857, marked the beginnings of periods of grave
economic disturbance that were caused by currency dislocations, stock market crashes,
banking and liquidity crises, and trade difficulties.
The Panic of 1819 was one of the most volatile of these disturbances. The industrial era
began in the United States with a great burst of nationalism. During the early 19th century several major economic reforms including the establishment of a national bank and
protective tariffs, were undertaken to protect fledging American industries. Beginning in
1819 with cotton prices already declining sharply, strict credit restrictions were imposed by
the new Bank of the United States. Although designed to curb inflation these restrictions
triggered a financial panic that swept across the economy. Unemployment rose rapidly,
banks failed, prices fell and investment collapsed.
These early industrial ‘recessions’ were very severe, more like the Great Depression than
modern recessions; (e.g. in 1819 in Philadelphia the unemployment rate reached 75%.)
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The Asset Revolution, and the Sources of Volatility
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Much was learned from these self-inflicted wounds, but more learning was required, as
volatile swings in economic fortunes became regular features of the primary stage of
industrialization.
The Knowledge Asset Revolution:
More recently and as a consequence of another Asset Revolution, Western economies–the
United States in particular, have experienced two great bubbles: first in line, the 1990’s
Dotcom bubble and more recently the financial derivatives bubble. In both cases new
types of assets were generating vast new economic potential, but were accompanied by
risks that were unknown and unforeseen. In the case of the Dotcoms, it was the Internet
with its strange “intangibles” and seemingly unlimited potential that captivated so many
for so long. In the case of sophisticated financial derivatives (where at least there were
real earnings), another period of unrecognized risk was initiated. This risk was obscured
by a host of novel financial innovations including securitization (insurance like credit
default swaps) and the globalization of financial markets all of which created a perception
of risk security where it did not exist.
The scale of these financial setbacks was huge; the ongoing volatility was striking, but
not surprising historically. Once again the economy has entered upon a foundational asset
transformation on the order of the commercial and industrial revolutions. The economy’s
engine of growth is transitioning from the mechanical workhorse of the industrial age to
the more agile and faster moving mental powerhouse of the new age, as knowledge and
the ability to master knowledge becomes ever more valuable.
The Changes are Remarkable
Manufacturing’s decline in developed economies has been dramatic; consider that
between 1995 and 2002 the world's 20 largest economies lost 22 million industrial jobs.
Nevertheless, despite the shrinking of their industrial work forces, the output in these
countries as a measure of GDP increased by an astonishing 50%.
Growth in the Service Economy
Percentage employment
100
AGRICULTURE
According to the World Bank
the Rate of Growth in
Services is Like a wave
SERVICE
50
INDUSTRY
0
Source: World Bank
Per capita income over time
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The Asset Revolution, and the Sources of Volatility
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According to the Organization for Economic Co-operation and Development (OECD),
post industrial economies (i.e. Western developed economies) are now solidly ‘service’
oriented. By some estimates over 75% of US GDP is composed of services, the UK
comes in at 71.6%, Switzerland at 72.1%, and Luxembourg at 79.4%.
Capitalism’s Expanding Asset Foundation
Pre-Capitalism
Mercantillism
Industrial Economy Industrial Economy Knowledge Economy Knowledge Economy
Fedualism/Communism
(Commercial Revolution)
(Primary Stage)
1500AD
500AD
(Secondary)
1800AD
(Primary)
1934AD
(Secondary)
1973AD
???? AD
Dot.Coms 2000
Credit Crises 07
Employee equity, Social Capital
US Financial
Crises, 1819, 1937
1857, 1873, 1893
Brands, logos trademarks
Customer Equity
Tulip Bubble, 1673
South Sea Co, 1711
Mississippi Co, 1720
Charted
Trading Houses
Landed Property, Financial assets
GDP
per capita
(Equivalents))
<$700
<$1000
Principal Asset = Land
Engine of Growth = Manpower
Primary Distribution = Sea, Canals,
Roads
Copyright, Trade-secrets
Patents, Licenses, Contracts
Inventory
Receivables
Inventory
Receivables
Productive machinery
plant
Productive machinery
Plant
Land, Financial assets
Land, Financial assets
<$10,000
>$25,000
Principal Asset = Industrially based
tangible assets
>$35,000
>$100,000
Principal Asset = Knowledge based
Intangible assets
Engine of Growth = Mechanical
Power
Engine of Growth = Mental Power
Primary Distribution = Railways,
Highways
Primary Distribution = Internet,
Networks
© Robert McGarvey 2008
Today, in the U.S and other Western economies in particular, market services have
displaced industrial production as the primary engine of growth; World Bank statistics
suggest that intangible assets are now contributing over three-quarters of U.S. GDP.
Unfortunately this transformation of economies from industrial to service presents a
series of problems. Economists, being economists, describe it in terms of productivity.
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The Asset Revolution, and the Sources of Volatility
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For instance, according to the UK Treasury: “The service sector is at least one third
less productive than manufacturing.” In some sectors, services reach only 50% of the
productivity per head of old line manufacturing. Many believe that services have not
been designed with the ‘rigor’ applied to traditional tangible assets.
The Rise of Intangibles
At present, GDP calculations ignore or seriously undervalue the growth contributions of
newer non-traditional (intangible) assets. According to a recent University of Maryland
study, (Corrado, Hulten and Sichel), when intangibles are added to the statistical mix,
Western economies looks measurably stronger than reported.
Consider capital deepening, the economist’s measure of capital efficiency. In the period
1973 – 1995, the efficiency of capital as a measure of capital stock per labor hour was .43;
the equivalent figure for the period 1995 – 2003 (the period of most rapid growth in
non-traditional assets) is .84. The average productivity per worker in the United States as
a measure of output per hour has jumped from 1.36 (1973 – 1995) to 2.78 (1995 -2003);
put another way, productivity per worker has more than doubled.
“The key finding of this research is that intangible investment by U.S. businesses
averaged $1.2 trillion per year during the 1998-2000 period (it has now risen to
$3 trillion per year, 2010). This amount is equal to the total amount spent by businesses
for their tangible plant and equipment. This is also the amount by which U.S. GDP is
increased by the capitalization of this broad list of intangibles. In other words…
intangibles matter.” (Corrado, Hulten and Sichel, 2009)
Although many of these changes, and the assets themselves, have been evolving and refining for decades, (in the case of patents and copyright, centuries) a critical mass was
reached in the economy by the late stages of the 20st century when knowledge-based assets began to dominate growth in Western economies, creating a new platform underpinning the economy.
Significantly the growth in knowledge assets is not confined to the technology sector,
according to the Washington-based Brookings Institute, intangible inputs account for
over 70% of value added, even in the traditional ‘bricks and mortar’ industries such as
automotive and consumer goods. Given the massive changes that have and are occurring in
the economy, it is clear that the ‘new economy’ is not simply IT (information technology)
or the Internet, but a seismic shift in the underlying asset foundation of the economy.
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The Asset Revolution, and the Sources of Volatility
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Knowledge Economy only Beginning: Significant Work Remains to be Done
And while it’s clear we’ve reached a point of no return in respect to these new knowledge
and relationship-based engines of growth, there remains a significant learning curve
before ‘knowledge’ moves beyond mere services and becomes an asset that is as reliable
and sustainable as the more traditional assets.
The accounting definition of an asset is anything you own or control from which you can
expect future benefit. According to Corrado, Hulten and Sichel (CHS, 2005), there is no
clear-cut distinction between tangibles and intangibles that would justify a distinction
between the former being capitalized and the latter being expensed. In fact “any outlay
than is intended to increase future rather than current consumption is treated as a capital
investment” (CHS, 2005, p. 13).
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The Asset Revolution, and the Sources of Volatility
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All of this activity has gotten the attention of governing bodies in major accounting
institutions. The London-based International Accounting Standards Board (IASB) in company with the U.S. Financial Accounting Standards Board (FASB) are at present formalizing
reporting standards for customer-related (and other intangible) assets, building on FASB
Statement 141. The IASB statement on intangible assets (IAS 38) recognizes a number of
non-traditional assets including various forms of intellectual property, copyrighted materials, including software, customer lists and a variety of customer and supplier relationships.
As a consequence of these changes in accounting standards, there is a growing consensus in
boardrooms that the newer non-traditional assets are of strategic importance.
In other words there are significant modifications that need to be made in asset handling
practices, compliance standards as well as in banking, accounting practices and government
securities regulations before we’ll be able to realize the full potential of these new engines
of growth. These factors that will contribute significantly to ongoing volatility in the years
to come.
Emerging Economies:
Industrial Asset
Revolution:
Fortunately for global demand
(but unfortunately for global
stability), there is more than
one asset revolution going on
at the moment. In a study
conducted by Global Insight
for London’s Financial Times,
it was revealed that China is set
to become the world’s largest
manufacturer by 2020.
China’s industrial growth over
the past couple of decades has
been astonishing. Consider that
in 1995, China’s share of the
world’s manufacturing was just
4.6%; this proportion more
than doubled to 12.1% by 2006
– the year of the study. The
study concluded that China’s
share of global manufacturing
will continue to grow, reaching
25.9% in 2025. Consider that
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The Asset Revolution, and the Sources of Volatility
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at the height of the industrial revolution, Britain became the world leader–number one in
manufacturing, with a share of roughly 30% in 1850, which then fell to 23% in 1880,
19% in 1900 and to just 4.7% in 1995.
Although both India and China are developing service economies as well as industry, the
vast majority of their growth is focused on manufacturing and other industrial development.
As a consequence (of China and other ‘BRIC’ economies), the world economy is restructuring rapidly. Nations with combined populations of roughly 2.5 billion people are experiencing rapid, primary stage industrialization.
The Emerging Global Middle Class
The CASS (Chinese Academy of Social Sciences) has estimated that the Chinese "middle
class" now accounts for over 10% of its massive population. This Chinese middle class
will certainly grow over the next thirty years. India, for its part, is expected to become the
world’s fifth largest consumer market; its ‘middle class’ is expected to grow over the
period from roughly 50 million to an estimated 250 million.
There are approximately 400 to 700 million people in the BRIC (Brazil, Russia, India and
China) nations and other emerging economies whose per capita income is expected (in
the next decade) to pass through the important threshold of US $3000/annum. According
to the IEA (London-based Institute of Economic Affairs), this is the income point that
triggers major lifestyle changes including the purchase of a first car and buying a house
etc. These lifestyle changes require a vast (normally urban) infrastructure; building this
infrastructure in emerging economies will have a dramatic impact on commodity demand
and global economic growth in the years to come.
The BRIC’s are not alone; there are many other parts of the world experiencing primary
industrialization, adding a new class of productive assets to their economies. As manufacturing
continues its decline in Western economies (today it’s less than 25% of GDP) it continues
to rise rapidly in emerging South America and (despite the recent crisis) in ‘transitioning’
Eastern and Southern European economies, as well as in Western Asia and Africa.
The Lessons of History
All previous periods of extreme volatility had their roots in a brave new commercial
world, with dreams of staggering wealth. And although the crises themselves were very
disruptive, what none of these enormous crises did was reverse the course of economic
history. Growth in trade flourished in spite of the South Sea crisis and other bubbles, Industrialization motored through a staggering number of recessions and depressions and
the knowledge asset revolution continues despite the dot.com bubble and the present financial crash. But there are hard lessons to learn; history does teach us some thing’s that
are critical to business leaders today:
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The Asset Revolution, and the Sources of Volatility
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1. The Age of Volatility
First and foremost, there will be stormy weather ahead. The new century has brought with
it a new world economic order. For the first time in history, all major economies, in both
the developed and emerging nations are transitioning, entering exciting new stages of economic growth. Since they are all, however, incorporating new (for them) classes of assets;
they can be expected to experience the inevitable disruptions associated with that growth.
2. You’ll need to Change your Mind-Set, to take advantage of New Opportunities
Volatility is a reality for business today. As a leader expect the unexpected and learn to
live with and manage fear, for it will be your constant companion in the years to come.
Remember that success in the future will come wrapped in different packages; leaders
will need courage and a new lens to see opportunities and approaching dangers.
3. Don’t Retreat, Advance Strategically
While retrenchment might have been a good strategy a few years ago, it’s not today. If
you’re contemplating a status quo approach consider the fate of the ‘land’ banks at the
last major asset transition a few centuries ago:
At the time of the Industrial Revolution there were two different banking approaches, an
older more conservative ‘land’ banking approach and a new merchant or ‘money’ banking
approach. “Money banks… issued notes on the basis of obligation of merchants and manufacturers, in contrast to land banks which issued their notes on the basis of land and personal estates. The latter type of banking was considered (prior to the War of 1812)
preferable to banking on mercantile credit because land banks were supposed to stand on
solid ground and not to depend on the success of their borrowers as did the money banks.”
Ultimately the land banks missed the historic transformation in value, the migration of intrinsic value from older to newer asset classes. Their conservative approach in a transitioning economy turned out to be the highest risk position, as land banks consistently lost the
competitive struggle to the more nimble, commercially savvy, merchant banks.
The Strategic Organization
There is no returning to the status quo of a few years ago, organizations must adapt to a
new normal, one that is far less certain and predictable than we’ve grown accustomed to
in the past. Today it’s not enough to have a strategy, you need to build a ‘strategic organization’; one that works together effectively as a team, can plan and move with speed
when the inevitable changes in economic circumstances occur.
Remember the old adage, ‘nothing fails like success’, beware that the contrast could not be
greater between the recent past, that period of reliable, steady growth and the circumstances
going forward. Foundational assumptions must be revisited: for instance, it’s quite popular
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The Asset Revolution, and the Sources of Volatility
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in many industries to use ‘rolling thirty year averages’ for commodity prices in capital
projects. It was a useful and reliable planning assumption until recently; present circumstances have rendered it completely obsolete.
Furthermore, the need for high performance planning, with real effective contingency
plans in place, ready to go will be a survival necessity – not a luxury. Importantly, it is
becoming a critically important role of leaders to communicate a new message, to impart
a positive new mind-set in order to prepare their organizations to win in this new, more
challenging, commercial environment.
About the Author
Robert McGarvey is a founding partner in Beckett Advisors and a strategist specializing
in global trends and strategy development. A version of this article, titled “The Asset
Revolution” was first published in Risk Management Magazine, March 2007, prior to
the financial crisis and other recent volatility. This article also appeared in the house
publication of the Economic Research Council, Britain and Overseas. To read other
articles by the author and to stay in touch with Robert’s latest thinking please visit his
blog: www.ageofvolatility.com
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