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The Asset , 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 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 was a private company chartered by the English in 1711, granted a license for trading in the South Atlantic. around this new ‘monopoly’ enterprise was swift and excited. Unfortunately for the , 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 , the significance Richmond, VA of these commercial reverses were not immediately Chicago/IL apparent to . 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 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 (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 - ism, another seemingly miraculous economic change of . 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 , 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 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 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 these restrictions triggered a financial panic that swept across the economy. rose rapidly, banks failed, prices fell and investment collapsed.

These early industrial ‘’ were very severe, more like the 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 including securitization ( like credit default swaps) and the 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 . 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- Mercantillism Industrial Economy Industrial Economy Knowledge Economy Knowledge Economy Fedualism/ (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 , 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 perper capita <$700<$700 <$<$10001000 < <$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 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. 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 re- fining 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 as- sets began to dominate growth in Western economies, creating a new platform underpin- ning 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.

[5] The Asset Revolution, and the Sources of Volatility by Robert McGarvey

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).

[6] The Asset Revolution, and the Sources of Volatility by Robert McGarvey

All of this activity has gotten the attention of governing bodies in major accounting institutions. The -based International Accounting Standards Board (IASB) in com- pany 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 materi- als, 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

[7] The Asset Revolution, and the Sources of Volatility by Robert McGarvey

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 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 restruc- turing rapidly. Nations with combined populations of roughly 2.5 billion people are expe- riencing 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 .

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 . Growth in trade flourished in spite of the South Sea crisis and other bubbles, In- dustrialization motored through a staggering number of recessions and depressions and the knowledge asset revolution continues despite the dot.com bubble and the present fi- nancial crash. But there are hard lessons to learn; history does teach us some thing’s that are critical to business leaders today:

[8] The Asset Revolution, and the Sources of Volatility by Robert McGarvey

1. The Age of Volatility First and foremost, there will be stormy weather ahead. The new century has brought with it a 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 eco- nomic 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 ‘’ banking approach. “Money banks… issued notes on the basis of obligation of merchants and man- ufacturers, in contrast to land banks which issued their notes on the basis of land and per- sonal 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 in- trinsic value from older to newer asset classes. Their conservative approach in a transition- ing 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 organi- zation’; 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

[9] The Asset Revolution, and the Sources of Volatility by Robert McGarvey

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 circum- stances 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 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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