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Beckett Advisors-The Asset Revolution 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 as- sets with unknown and unfamiliar risks is being in- corporated 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 Com- mercial Revolution, the 19th century Industrial Revolution and the emerging 21st century Knowl- edge Asset Revolution. The Commercial Revolution: At the time of the Commercial Revolution in the 17th to 18th centuries, for example, there were sev- eral notable episodes of economic volatility associated with growing international ‘trade’; the most famous of which was the South Sea Bubble. 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, under- mining the trading opportunities with Spanish Los Angeles, CA colonies in South America. Edmonton, AB But like many a modern day business, the significance Richmond, VA of these commercial reverses were not immediately Chicago/IL apparent to investors. Indeed, so popular was the Paris/FR stock, that investors ignored the bad news and kept buying. As a result, the stock kept rising rapidly, Shanghai/CN encouraging more buyers and creating a momentum 800.336.8797 of growth that seemed unstoppable. Behind the www.beckettadvisors.com scenes, South Sea Company management, seeing the writing on the wall soon began to dump their shares [1] The Asset Revolution, and the Sources of Volatility by Robert McGarvey 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 capital- ism, another seemingly miraculous economic change of state. Industrialization standardized and mechanized the production process, transforming the economy from manpower to me- chanical 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 recog- nized 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 cen- tury 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%.) [2] The Asset Revolution, and the Sources of Volatility by Robert McGarvey 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 100 AGRICULTURE According to the World Bank SERVICE the Rate of Growth in 50 Services is Like a wave Percentage employment INDUSTRY 0 Source: World Bank Per capita income over time [3] The Asset Revolution, and the Sources of Volatility by Robert McGarvey 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) (Secondary) (Primary) (Secondary) 500AD 1500AD 1800AD 1934AD 1973AD ???? AD Dot.Coms 2000 Credit Crises 07 US Financial Employee equity, Social Capital Crises, 1819, 1937 Brands, logos trademarks 1857, 1873, 1893 Customer Equity Tulip Bubble, 1673 South Sea Co, 1711 Copyright, Trade-secrets Mississippi Co, 1720 Patents, Licenses, Contracts Inventory Inventory Receivables Receivables Charted Productive machinery Productive machinery Trading Houses plant Plant Landed Property, Financial assets Land, Financial assets Land, Financial assets GDPGDP pperer capita <$700<$700 <$1000<$1000 <$10,000<$10,000 > >$25,000$25,000 >$35,000>$35,000 >$100,000>$100,000 (Equivalents)(Equivalents) Principal Asset = Land Principal Asset = Industrially based Principal Asset = Knowledge based tangible assets Intangible assets Engine of Growth = Mechanical Engine of Growth = Manpower Engine of Growth = Mental Power Power Primary Distribution = Sea, Canals, Primary Distribution = Railways, Primary Distribution = Internet, Roads Highways 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. [4] The Asset Revolution, and the Sources of Volatility by Robert McGarvey 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
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