The Challenge Network

   go back   

A thirty year view of the financial crisis

A thirty year view of the financial crisis



There exist many layers of interpretation and special pleading about the current state of the world. This note brings together a range of studies that we have done for state and private clients over the past two years. It discusses the route into crisis from, we hope, a novel perspective and identifies the chief "problem owners" in today's environment. It goes on to develop scenarios for how the situation may play itself out.

In summary, however, we trace the origins of the crisis to four or five contributory factors that were unique to the 1990s. The consequences were a mountain of debt, but the causes were more subtle than simply over-extension. Asian savings provided the cash, but asset price inflation delivered the stimulus. Sates that should have reined in these excesses did not do so, for complex sociopolitical reasons. Two of these are still with us, and offer a major threat to our exit from the problem.

First, low skill people are now pitched into direct competition with low wage areas. It was possible to camouflage this with debt and subsidy during the 1990s, but that option is no longer open to us. Less welfare and debt "padding" implies contrarian or neo-traditionalist political movements at precisely the moment when room for manoeuvre is minimal, when industrial world populations are aging particularly rapidly and when global competition will intensify. If economic growth were so slow as to precipitate a consumer debt default, or to slow Asian exporters to levels where social unrest became significant, dangerous forms of feedback could trigger a major and lasting global crisis.

Second, states which indulged in wildly excessive social spending are now under huge financial pressure. This would not normally matter to any but their hapless citizens, for most of them are very small economies. However, some of them are in the Eurozone, crippling the entire structure until a resolution to this is found. We suggest the likely shape(s) of such a resolution.

The scenarios couple these two issues together. We offer three paths through this situation, none of them particularly appealing. The paper ends with a coda that discusses additional factors, from technology to the environment, management styles to consumer confidence.

There are six sections. Click on any link to jump to that section, or scroll down.

The complex boom of the 1990s
Managing the social impact
Premonitory bubbles
The crash and reactions to it
The future


The complex boom of the 1990s

The complex boom of the 1990s

We are going to identify a number of structural changes and delusions that characterised the 1990s. However, the roots of the crisis are deeper, and we need to go back to the 1980s to see what these are.

The end of the 1980s represented the final full stop in a paragraph that had described world history for a generation. The ending of the cold war, the collapse of the Soviet empire and the apparent triumph of the market model changed minds, opened up the world to trade and laid the foundations for change in many now-industrialising states, such as China, India and Latin America.

America emerged as a superpower without rival, and it set about transforming the world in its own image. The dollar became the world's reserve currency, American banks became supreme – notably after the economic collapse of Japan – and the next century was seen as being structured in America's image.

Starting as they did from this launch-pad of change, the 1990s saw an explosion of change in how commerce was seen and was run. Financial liberalisation in the 1980s enabled the active engagement of shareholders and others with management, usually demanding high rates of return. Analysts had always taken an independent look at large companies, but the teeming myriad of scrutineers that were loosed on every major company in the 1990s was unprecedented. Outsiders were often much more aware of the circumstances of the company than that management itself. The consequences of this were felt in every aspect of commerce. Poor management was exposed and penalised. Costs came under intense and detailed scrutiny, and the pressure to radically change or entirely drop entire cost centres grew in intensity.

Management was, however, able to react to this force in equally radical ways. This was due to a range of other forces that were in coming into play, amongst them an increasingly viable information technology, access to a global workforce and seemingly limitless access to cheap capital.

Information technology became truly important during the 1990s. Using information processing to make commerce more efficient was, of course, nothing new. Holerith punch card machines replaced networks of clerks as early as the 1930s, and mainframes had completely replaced mechanical systems by 1970. What these did not do, however, was to permit the restructuring of entire activities around instantaneous information systems, often bringing together remote locations.

The notion of "re-engineering" a firm, of rebuilding its activities into modules that flowed one into the other, was also nothing new. Frederick Winslow Taylor had introduced the idea of scientific management a hundred years previously, leading to time and motion studies, to the ergonomic optimisation of shop floors and offices and to the bureaucratisation of work, such that vast rooms full of clerks executed algorithms enshrined in ring-bound rule books. The detonation of the atomic bomb was simulated in this way, with huge number of people equipped with mechanical calculators, executing sequential calculations. However, what changed in the 1990s was the cost and ease of computing, the reliability of networking and the rise of a generation trained on personal computers.

Re-engineering intermeshed with two other new managerial tools. Both were Japanese contributions to manufacturing: quality management and 'just in time' (JIT) supply. The importance of JIT has been considerably overplayed, as its chief contribution was a reduction in working capital and a one-off boost to cash flow. Its negative affect was that it increased corporate vulnerability to shocks. To compensate for this, Japanese firms both strove for much higher levels of quality, and diversified their supply across a range of external companies. This response, rather than JIT itself, has had a profound legacy.

Quality management is a discipline that is needed when product complexity reaches a certain stage, and when manufacturing standards require a uniform certain quality. Defects in complex manufacture bring all production to a halt. When products contain large numbers of interlocking components, such that no malfunctions are tolerable, then the degree of perfection of each part suddenly soars. It becomes essential for low cost, high throughput manufacture that every component is always exactly identical to a given standard.

Firms that source from a number of companies will demand precise and identical standards for the specification and quality of the product. This has an unexpected consequence. If you can foresee when you will need the product, and when you can be certain of its quality, then you become indifferent to physical geography. Provided that the product arrives on time and at the right cost and quality, then it can come from anywhere.

Turning back to re-engineering, we find that these discoveries had a profound effect. What a firm did to deliver its products and services could be broken into a series of discrete steps, each with exactly defined inputs and outputs, each with precisely defined and monitored costs and quality requirements. A firm could look at this pattern and decide, first, how best to structure these modules of activity and second, what it needed to do for itself, and what it could get someone else to do. Profoundly, it could outsource at least some of its activities. Further, it could outsource it to low wage, high skill areas that answered to the cost-quality concerns that it might have. IT and modern physical communications offered the required machinery by which to do this, to control quality and to manage flows.

Market scrutineers began, therefore, to question what activities a company needed to run for itself – indeed, to ask the same questions of the state. Issues such as cleaning, security and facilities management were quickly outsourced. Providers of these services underwent industry consolidation in order to win economies of scale, and became suppliers to the major industry. Governments began to ask themselves whether they needed to wash their own towels or collect municipal waste. Activities were widely outsourced, with impacts on employment that we will examine in a moment. The notion of the "core business" became commonplace. This was the reason that an activity existed, the embodiment of the mechanisms that only it and its immediate competitors were able to deploy. Everything else could be shed, and staff could be set defined, modular tasks with clear metrics against which they were rewarded. (More on this in the Coda section.)

Management was, therefore, under huge pressure, but was also presented with a range of powerful new tools. It took readily to these, most particularly to outsourcing. The post-Soviet political backdrop permitted routine international outsourcing, something that – combined with increasing international competition - came to be called "globalisation". Due to its economic and political preponderance – and its role at the heart of the telecommunications revolution - the US dominated these trends. US commerce has always thought in terms of vast scale, and these were the mechanisms that permitted gigantism to flourish.

Outsourcing ran into a happy coincidence, which was the doubling of the world's work force during the 1990s. These skilful, inexpensive workers arrived on the national job market just as countries such as China and India opened themselves up, both to export markets and to internal market reform. Latin America abandoned a generation of experiment with autarchic development.

Commodity prices fell throughout the 1990s, and energy prices remained broadly stable and low. Investment in agriculture, often due to land tenure reform, led to high production and falling food prices. Mineral finds were leading demand until China began to grow rapidly. It cost less to do things, there were wonderful new tools with which to play, and many hands helped to make light work. The firms of the IW reached out to these hands with enthusiasm, as the requirements of outsourcing were met by one labour market after another.

Capital was also exceptionally cheap. Inflation was under control, chiefly due to the list of deflationary pressures that have just been mentioned. However global and, aftr 2003, particularly Asian savings flowed into the IW. A great proportion following the dollar into the US. Banks therefore acquired huge sums with which to operate. Interest rates tracked down to historically low levels, and central banks worked to keep them there. Central banks had, from the 1970s, been tasked specifically with managing CPI inflation, and they were able to do this as a result of the deflationary pressures already discussed. Money was therefore cheap, and the new members of – in particular, American - boardrooms were susceptible to investment banker whispers of how much "shareholder value" could be "created" from this acquisition, from that merger. Corporate mergers and acquisitions reached record levels. Firms borrowed money for this, and many also borrowed to satisfy shareholders, on the fear that without a high share price, they too would be vulnerable to take over.

Domestic commerce across the IW seemed to be doing well. Equally rosy prospects began to present themselves abroad. China was still an enigma, a miracle with dubious statistics and wobbly banks, and India was as yet unproven, but the Asian Tigers – Korea, Hong Kong, Thailand, Malaysia – were booming. Most were past their peak in total factor productivity growth, and most had national accounts with no connection to reality, but all of that had yet to be revealed. The BRIC nations (Brazil, Russia, India and China) were supposed to be the next in the queue for foreign investment. At home, there was an evident boom, cheap money and investors were enchanted by the amazing new prospect presented by that magical new thing, the Internet. Telecommunications shares boomed, then Internet companies themselves acquired ballooning market values. What could possibly go wrong?

Managing the social impact

Managing the social impact

Debt accumulation was driven, first and foremost, by consumer attitudes, notably in the US. Recovery is dependent on consumer confidence, and threatened by personal loan default. Much of the reason why states accumulated deficits were to do with masking the impact of globalisation on low skilled workers. All of these factors are addressed in this section.

Corporate profit has to find its way into investment, wages or dividends. Companies were under pressure increase dividends. Investment calls on cash had also soared. Proportionately, therefore the amount going out in wages fell. This phenomenon had been in existence for several decades, but it was accentuated in the 1990s.

Low and lower middle class US incomes had been flat in real terms for nearly thirty years. Many goods had become more feature-laden and cheaper in real terms – consider the home computer or the car – and so the quality of life for this group had increased. Many had also run up debt in many different forms, but often set against the value of their property. Re-mortgaging property to buy consumer goods was a common activity.

Lower middle and lower income has changed relatively little since the 1970s

House price inflation fuelled the good life. However, asset price inflation extended to other assets. The US stock market valuation had tended to track the US economy on a 1:1 basis, doing so until deregulation in the early 1980s. It then took on an exponential character. If pre-1980 trends had continued, then the current US economy would support a Dow Jones Index of around 4000. If the exponential inflation of the 1980s and 1990s had continued, it would now be around 35,000. (It is, of course, around 10,500 at the time of writing.) Anyone with savings that they had invested in equities, therefore, sat upon a comfortable balloon of asset price inflation, all driven by the inflow of Asian savings, corporate borrowing and the characteristic mentality of the bubble.

Borrowing against assets – or unsecured borrowing – increased enormously. US households doubled their debt in the decade that led up to the 2007 crash, to a total of $13.8 trillion. This funded about three quarters of the economic growth that occurred in the US during the 1990s. By 2007, household debt was 138% of income, or 98% of US GDP. Plainly, this was unsustainable and equally plainly, repaying this debt will be a long term burden that will eat into potential growth. Before this has been achieved, however, US household debt remains one of the greatest source of potential economic instability to the world because, were the US economy falter significantly, an unstoppable wave of defaults would be triggered, utterly submerging the financial system.

Household debt is now focused on the middle classes, which comprise half the population and now represent 46% of US consumption. Their debt-to-income ratio is around 200%. The poorer 40% of the US have debts of around 150% of income. They are responsible for only 12% of consumption. The top 10% of society generate the remaining consumption – 42% - and are less exposed to debt.

Despite relatively static real incomes, therefore, asset price inflation made the middle classes felt safe when they ventured on this extraordinary plunge into debt. Not all incomes were, however, static. People with high skills saw their income rise sharply over the same period. This is often attributed to boardroom remuneration committees and cosy cabals, but the reality occurred across the spectrum and related directly to skill levels. According to the US Census, median earnings in 2003 for someone with a professional degree were exactly $100,000, for a bachelor degree earnings were $73,376, for a high school graduate $37,620 and for someone with less than 9th grade qualifications, $23,013.

The reasons for this can be debated, but ultimately devolve to the increasingly complex tasks that management had to handle. That is, although commerce was dropping low skilled jobs, it was also generating many requirements for which skills were in short supply. These often required often multiple skills: for example, a firm that sold accounting software might need people who knew enough law and accounting to understand what was sensible, but who could hold and articulate conversation with a customer from the perspective of a software engineer, suddenly switching to address the training of their customer's people in India. It takes ten years of on-the-job training to acquire such a portfolio of skills.

The fate of the low skilled has been and remain dismal. Real terms wages of the lowest decile remained static, where work could be found. Often, it could not. Such people have been pitched into competition with a highly motivated, skilled and low wage foreign workforce, and have to compete with automation at home. In addition, restructuring or outsourcing of former state activities reduced the need for low skilled service jobs.

Governments faced – and continue to face - a dilemma. They owed a duty to all their citizens, not merely to the capable, but nevertheless the nation had to remain competitive. They needed to encourage economic processes that added overall value. Studies showed clearly that every dollar paid out for supply chain activities in low age areas earned something in the order of $1.30-1.70 for the economy. Cheap clothing imports may have put local workers out of a job, but they also reduced the cost of living for the rest of the society.

The confidence in market-based solutions that had emerged from the defeat of Communism also made most states loathe to interfere. However, a purely market solution – letting local wages fall into equilibrium with those of foreign competition – seemed neither humane nor, to elected politicians, attractive. The general consensus that emerged was to soften the impact on today's low skilled individuals with a mixture of welfare, job creation and low interest rates. It was agreed that increased educational spending would boost the next generation into the "knowledge economy", as the then-official future was known,

Bank regulators and central bankers took this message on board, and – both through persistently low interest rates and by means of "benign" approaches to bank regulation – permitted personal debt to grow, as we have seen, enormously. Although this seemed a sensible accommodation at the time, it had two weaknesses. It failed to ask what would happen when the music stopped, and it disregarded the very weak response of the IW education systems to increased educational spending. The first of these gives us the proximal cause of the financial mess in which we now stand, and the second goes beyond the scope of this note, but shades in messes yet to come.

Premonitory bubbles

Premonitory bubbles

Two crises foreshadowed the crash, each larger than the last, all of them symptomatic of the imbalances that we have discussed. First, the economic bubble in the Asian Tiger economies burst. The true imbalances in regional national accounts had become clear. Korea's foreign debt was ten times the official number, for example; Thailand had built enough dollar-denominated debt-funded office blocks to satisfy demand for the next twenty years. The rest of the world passed over this bump almost without noticing it. The Internet bubble was running at full strength, and the growth of China was stoking fantasies about an endless gilded future for investors.

The collapse of the Internet bubble in 2001-2 was felt more strongly, both because the IT industry laid off many people and because share prices fell sharply. Equilibrium seemed, however, to have been gained three years later. Debt levels had now risen to levels that could no longer be ignored, however, and China's demand for raw materials and energy was driving up commodity prices and stoking inflation, Central banks were beginning to increase interest rates and consumers could no longer meet their interest payments. Additionally, it began to emerge that rather than merely indulge low skilled individuals, financial institutions had lent them very large sums to them which they had consumed. As these debts were secured on often-valueless property, this left nothing behind.

A second, more deeply hidden bomb was the fact that some countries – notably, those within the European Union - had been indulging in an orgy of subsidy, running up extraordinary debts in order to do so. This will be discussed in more detail later in this text. However, the world was suddenly confronted by the realisation that both sovereign and private debt was heading for an unsustainable situation, and nobody had a clear idea of what the situation actually was.

The crash and responses to it.

The crash and responses to it.

There are many finely-detailed histories of the crash, and we do not propose to replicate these. In brief, therefore, banks had developed instruments that were supposed to prune assets of their risk, thereby turning them into capital on which further capital could be raised. This permitted them to repeat the process. All of this was theoretically sound, but crucially it was also predicated on there being no defaults, as this would break structures that were supposed to insure against risk. The investment group LTCM had built themselves on similar principles, and crashed as a result of a Russian default. This lesson had not been learned, and the structure now had orders of magnitude more exposure.

There was no single default that triggered the crash. Rather, it became clear that whole classes of loan were non–performing, and that in the economic slow-down, this was becoming worse. Mortgage companies in the US had offered loans on terms that made sense only if house price inflation continued. The complex instruments that had been used served to focus the risk of this on certain banks and other institutions. Other banks had gone out of their way in order to court these risky assets, the first of which to fail was Britain's Northern Rock.

In part due to the esoteric nature of the instruments and also to over-reliance on ratings agencies to assure the quality of these instruments, banks were often unaware of their own exposure. The slice-and-dice approach to assts, automated trading and over-confidence all had roles to play in this. Nevertheless, the key role of banks is to connect savers to people with good projects to offer, and to do this reliably and with absolute accounting transparency. This was dereliction on a vast scale, driven by foolish systems of motivation and reward, poor oversight and a senior management disconnected from the skills and ambitions of their juniors.

Whatever the benefits of hindsight may now reveal, the situation in 2006-7 was that all banks were aware that there was a massive problem, but few knew their own exposure and nobody knew the overall position. Flows between banks began to slow, risk insurance became expensive or unobtainable and the entire system ground to a halt. As the state became involved, immense losses were declared and states had to decide whether to allow the system to "reset" or whether to support it by recapitalising the banks. It chose the latter, acquiring huge chunks of bank equity. Only Iceland allowed its banks to collapse, chiefly as the scale of the problem was irretrievable.

This was, of course, expensive, but it was undertaken with the belief that the shares could eventually be sold, and that the banks would meanwhile recover. However, this was not deemed to be enough to resolve the situation, because a slow down of a scale similar to the 1930s great depression would have triggered consumer debt default – a hugely much greater sum, as we have seen – and this would have brought down the system irretrievably.

Almost all states therefore began programs of "stimulus", in which titanic sums were borrowed or printed and then thrown at the problem. The two Obama stimulus programs amount to more, in real terms, to the sums spent by the US on every war and major project on which it has engaged throughout history. As with most sudden and enormous increases in spending, the money finds its way to arbitrage rather than real activity, and the cash injections may have added a percent or to economic growth. However, they will now need to be repaid.

The reality behind investing in the banks is also that the IW consumed – destroyed – Asian savings for the best part of two decades, and now has to pay the money back to them. As the money was chiefly spent by the lower echelons of society and is now financed by taxes from the upper earning groups, this is one the greatest transfer from rich to poor in history. Its legacy is not encouraging.

The curiosity of this situation is that companies are now sitting on mountainous surpluses and record profits, because they are not investing or cannot find safe projects in the uncertainty. Interest rates are essentially at zero, but nothing is happening because the population are vastly over-borrowed, scared for their jobs and disinclined to consume. Productive capacity is under-used, and a mixture of uncertainty and bewilderment prevent economic re-engagement.

The Eurozone

The Eurozone

A contributory factor to the uncertainty – at present, its very focus – is the Euro-zone. Nations differ in the attractiveness of what they can offer the rest of the world, as defined by cost and functionality. If a nation is extremely productive – can generate goods cheaply and at high quality – then it will be in an advantageous position when it wants to import things. Balances are achieved through exchange rates and through labour costs, as well as through issues such as technological prowess, global brands, their capital base, natural resources and so forth.

If a group of very dissimilar nations choose to peg their exchange rates together, therefore, then their innate differences will have to manifest themselves in the remaining variables. As many of the variables, such as technological capacity, are slow to change, or may not be open to the country in question, almost all the weight of adjustment falls upon labour costs. Nations which are unable to keep up with the leaders have to cut wage costs, which they do by reducing the number employed and, consequent upon labour markets, the wages paid.

The Euro was initiated in part as a symbolic project, in much lesser part in order to reduce transaction costs in the European Union. As the latter were nugatory, the former bore most of the weight. As with all prestige or "strategic" projects, it received scant analysis, objections were waved away and the Euro was launched to much fanfare.

Nations such as Ireland, Spain, Portugal and Greece found keeping up with Germany and France very difficult. Spain had a 30% unemployment at one stage, with youth unemployment reaching half of the potential work force. Nevertheless, its labour costs have risen by 26% between 2000 and 2010, at a time when those of Germany fell by 1%. Other nations – Greece, Portugal and Ireland, in particular, and perhaps Italy, where we simply do not know because their national accounts are not credible – took a different approach. They “created jobs”. Italian labour costs rose by 34% during the same period mentioned earlier. That is, the state borrowed in order to keep people in activities that are not needed, or could be done more efficiently. (It is estimated that each job which was created in recessionary Britain in the 1970s cost the state around ten times nation average income.)

Job creation appears often to have been related to populist and partisan politics: essentially, to electoral bribes. It can hardly be an accident that the heartland of the British labour party had around three quarters of all paid work funded by the state after their last period in power. Nevertheless, the heroic scale with which his was done in countries such as Greece, the insouciance with which poor tax collection was regarded, the laxity of the controls on potential corruption and the false or non-reporting of important statistics are breathtaking. Much as the sub-prime issue came to a head in the US, so sub-prime states are the characteristic of the Euro region.

Once again, titanic sums are being discussed. There are two conceptually straightforward options that are available. First, to bail out the debtor countries and so save the Eurozone. This is expensive, and expansive with no end in sight. It will require intrusive machinery in order to enforce the disciplines that will prevent a repetition.

The second option is to let these countries go into default, repudiate them as members of the Euro and protect EU banks from exposure to the results of this. The first satisfies EU political instincts but has the risk of being interminably and vastly expensive, whilst the latter raises both of issues of execution – how to avoid a run on the banks? - and finite risk of much worse skeletons stalking out of the Italian and Spanish cupboards.

The key player in exercising this choice is Germany, followed by France. Germany has the required funds. The French have huge exposure to sovereign and private debt from the unstable nations. French banks would need the bulk of any support fund that might be forthcoming. Germany and France have been the key movers of the Euro project, and Germany in particular is unwilling to be seen as precipitating its demise. In addition, it has operated with an artificially low exchange rate as a member of the Euro, which has served to promote its exports, but has also raised the cost of living for its people. It has certainly gained market share for its exports by this, but whether that has translated into greater foreign earnings than a higher exchange rate would have granted would need detailed study.

Three outcomes seem to present themselves:

First, that the Euro is saved by the donning of intense sackcloth by the nations in difficulty, accepting a degree of governance from the EU itself, and benefiting from extraordinary and chronic German generosity. This is the "official future" that the EU projects.

Second, the entire project may unwind, either due to Germany abandoning the project unilaterally – extremely improbable, but conceivable – or if the sackcloth model is tried, but fails. This would be the worst possible outcome, with chaos and recrimination dominating finance for perhaps a decade, with only lawyers getting fat.

The third option is a "core" Euro and a peripheral structure akin to the pre-Euro ERM mechanism. Europe stops trying to protect debtor nations and instead concentrates on underwriting its banks, France effectively nationalise its banking system, or de facto sells its banks to the Germans or to a chiefly German-funded intervention via the European central bank. In the periphery, nations would have separate currencies ("The Greek Euro") but would agree to accept common disciplines and to offer transparent national accounts. Membership of the non-core, wannabe-Euro currencies would serve as a training ground and apprenticeship area, where nations have to prove themselves for a prolonged period before admission to the core.

The key issue for the overall system is, however, when the Euro crisis is settled, and not how this is achieved. The first of these cases boils down to "never", at least in the time frame of financial markets. The second is, as noted, disastrous and leaves a long-lived legacy of chaos. The third could be achieved in a short space of time and in an orderly manner. It would be embarrassing, but is the only solution that seems internationally acceptable.

The future

The future

The variables that define our collective future – pleasant surprises and shocks aside - reside in two areas.

First, the degree to which the sovereign debt issues around the Euro can be settled into a predictable framework, and how acceptable that may look. The issue is not whether this or that country fails, but whether the European banking system collapses or is saved. The survival of the current Euro is not synonymous with the return to equilibrium of Europe’s economic affairs.

Second, the economic outlook for the US and its non-EU trading partners, notably China. The darkest scenario is that growth falters seriously, precipitating a mass default on consumer debt. The sums involved mean that no conceivable intervention could rescue such a situation, save hyperinflation; or else would likely lead to that. Setting such extremes aside, China is seeing considerable weakening as demand for its exports falter. The Chinese state has indicated that it needs at least 6% per annum to keep the population compliant, given the myriad discontents that very fast growth has generated. If China stumbled, the consequences for the US (and everyone else) would likely multiply current difficulties. Therefore, we see a horizon level at which the US has to keep operating, below which a variety of extremely unhappy feedback mechanisms begin to operate. A successful EU outcome would greatly assist the US in achieving this.

As mentioned earlier, low skilled people in the IW have been greatly affected by changing commercial practice, "globalisation" and the related factors that have, primarily, led to massive wealth generation. However, some have seen their wages static or shrinking, as previously discussed. They have been shielded from this both by welfare spending and by their previous capacity to borrow. However, it is clear that those days will not return. The IW has, for the most part, an aging population and limited pension provision, further dented by recent events. Welfare subsidies for able bodied low skill individuals will not be forthcoming, and real wages will contract, unemployment will grow and social tensions will increase. This is almost unavoidable, and completely unavoidable under conditions of long run economic stringency.

This would not matter if employment was readily available. However, as we have seen, whilst there are skill shortages and high wages on offer for people with high skills and considerable experience, there is much less on offer for low skilled people and those without experience. This is the intensification of a process that has been running for some time. The figure shows how US employment has recovered more slowly with every recession, and how particularly slow it is in the current situation.

Labour participation rates have been slower to recover with each successive recession

This provides another and rather sinister feed back mechanism that might come into play. We already see the growth of populist movements, some plainly claimant, some ostensibly of the Right, such as the Tea Party movement. That these will begin to acquire political traction is an inevitable feature of the next decade: too many received ways of behaving have been trashed by political events for this not to be reflected in populist, decidedly non- or anti-analytical, divisive and hate-fuelled political movements.

The affect of these on delicate accommodations is to make them that much harder to achieve. Current US legislators are, for example, trying to make life harder for China. This is unwise, but debate is conducted in shrill tones, with the pseudo-patriotic terms of reference of the debate predicating its outcome.

This brings us to scenarios. For dimensions, we have chose the following:

The Eurozone issues drag on interminably, with the permanent danger of a major shock; versus a dramatic settlement, of the sort outlined above.

The US and its trading partners achieve a gradual transition back into growth, such that dissenting voices in the US are kept to a manageable level; versus the social friction generated by poor economic performance is sufficient to deter commercial investment, leading to a self-reinforcing cycle of poor US performance, weak global leadership and general loss of prestige, coupled to partner performance and instability in China.

Two axes defining three cases

The result of doing this is shown above. The self-reinforcing cycle of decline starts in the brown-tinted zone at the foot of the matrix. The impossible combination – Euro instability and a return to fast growth - is also shaded in brown, in the top right. (We consider this impossible for political reasons, as continued cross subsidy on the scale and lengthy time scale that would be needed is extremely demanding on the wealthy donor nations.) The present ("2011/12") is marked with a red button.

Three cases reach out from this.

The brown case finds Europe unable to take difficult decisions. This is one important reason for why the overall situation becomes worse. Deep in the danger zone, the Euro fragments and in the resulting economic turmoil, a variety of sources of friction are swept away, As examples of these, unstable exchange rates are forced to alter, labour markets are forced to clear, firms are in effect forced to redistribute or invest their cash reserves. A tentative return to growth appears at the end of the decade.

The green case begins with a series of conclusive deals around the Euro which sees it restructured in ways that reflect the economic realities of the individual constituent nations. This may entail some nations leaving altogether, or the creation of a two tier structure, as discussed earlier. We discount a "dual" Euro, however, and believe that the creation of an ERM-like outer circle of hopeful entrants seems more appropriate to the issues. A long period of paying down consumer debt and managing state deficits ends after five years, with a return to modest growth appearing thereafter.

The blue case begins with a cosmetic "fix" for the Euro, somehow assuring markets that the system will be able to muddle through. Major stimulus packages, coupled to taxes and incentives that in effect force companies to invest or distribute their surplus cash, produces a modest return to growth; but this is a reprise of the 2008-09 stimulus, and the contradictions show through. A third set of challenges to the Euro emerge, and this time states have no possible way of meeting the sums that are involved. The response is authoritarian and populist, restricting the power of markets and taxing the wealthy. Unpleasant political movements gain momentum. The global system plunges down the matrix towards the danger zone.

The figure is reproduced a second time, below. The trajectories are removed, and approximate GNP growth figures are scattered across the matrix. Red figures pertain to the IW nations, blue to the emerging markets. The numbers guess at average growth for occupants of that part of the matrix. Plainly, a trajectory involves movement through these zones.

Approximate GNP growth rates at various points on the matrix.

It cannot be stressed too strongly that the cosy world of effortless integration that we have seen over past several decades could side into reverse if the world became a difficult pace. Trade protectionism is always a threat – notably when pressed by populist "save our job" political movements – but the schism of the world into financial zones is all too plausible. Here, "our" capital would be reserved for "us", regulation would be starkly different, transactions would be taxed differently and currencies not allowed to float freely. The driving force behind this might be populism, but might also reflect chronic distrust of other economic and banking regimes. The costs to the global economy would be immense, and the impact elsewhere – environment, energy, security – very clear.



This is a messy situation, and the world is not a tidy place. Nevertheless, the overall engine that got the IW into this mess is now clear, and the routes out both unspectacular and also relatively easy to describe. Specific policy measures that encourage this movement are, of course, less obvious, not least as the primary problems are to do with the balance of trust and wariness, confidence and lack of clarity amongst a very disparate group of players. A central requirement is, however, to bring the Eurozone into a state of economic logic which will be far from the vague aspirations with which it began.

The world is heading for nine billion people, and we have almost certainly touched seven billion at the time of writing. Resources are going to become costly, and hundreds of millions of young people will be looking for a place in the world. Global attitudes will be set by a middle class that owes little to the Western traditions, which has little time for notions of social equality as a birthright and no patience with societies which wilfully damage their own prospects. Environmental and security issues will demand collaboration, and the new centres of power will use these as trading tokens rather than the attitude of noblesse oblige with which the old IW has so far thought about such concerns. It will, in general, be a less comfortable, cosy world. It will be particularly uncomfortable for those who have been brought up to attitudes of claimancy and combined these with an inability or unwillingness to engage with the economy. The rich old world will be aging, and will have little resource and less patience for this.

Against this hard and unforgiving backdrop, technology – and its progenitor, fundamental science – will continue to develop. The amount of useful knowledge to which humanity has access is impossible to quantify, but a variety of guesses bring one to a view that this doubles every five years or so. Ten year from now, we will know four times as much as we do now; and will have access to utterly vast universes of information. Computing power will be omnipresent and will show signs of becoming increasing independently intelligent. We will have profound insights into human and other biology, and a technology will emerge from this that impacts in every aspect of life, notably in the extension of the period in which the elderly can exist as productive members of society, and a diminution of their need for care.

Earlier, we discussed the minimalist style of commerce in the 1990s. Work was modularised, what could be outsourced was, and anything that did not have an internal sponsor or which contributed in a measurable way to shareholder value was discontinued. Total quality management and re-engineering fossilised businesses in a model of what worked a decade earlier. Firms lost the ability to think beyond the immediacy of the next quarter's business, and trained a cadre of people who were unable to see that this was a problem.

Stasis cannot work in the current environment. What is needed is innovation, new products, new ideas, new techniques: of course based on cost control, but fundamentally activity which is aimed to capture new imaginations and to make new markets. A very different, dialogue-based style of management is needed, where the ultimate goal is the long-run renewal of shareholders' assets.

Clarity lies at the heart of such commercial success: clarity about how the operating environment works and permits the firm to make money; clarity about the practical options that are open for change; and a clarity that is shares itself across the organisation, such that everyone knows a potential contribution or innovation when they stumble across it; and, of course, clarity about how to take such ideas forward usefully. New things are always innately unclear and probably unprofitable when people begin to think about them. It takes patient experiment, iteration and experiment to arrive at a success. This is the antithesis of the 1990s style.

Science is globally accessible to those who are prepared to make the effort to do so. Nations that have the infrastructure and insight, the routes to market and the laws to permit the exploitation of knowledge will prosper in this environment. Those which, through populist or know-noting politics reject such opportunities, shut down their imaginations and deny potential will lose, in a world disinclined to forgive weakness or intransigence.

 to the top 

The Challenge Network supports the Trek Peru charity.