Virtual economy calls for new institution

The financial crisis is an inevitable result of the conflict between the economic form and the economic institution.

A market is a fundamental institution relevant for economic growth. The crash of a market often synchronizes with the beginning of an economic crisis. By contrast, the recovery of the broken market shows the end of an economic crisis.

We are at present experiencing a severe economic crisis whose symptom is the crash of the financial market. At January 2008, George Soros predicted that this crisis would be the worst one since the World War 2. Until now every evidence, unfortunately, supports the claim.

Despite of the human nature of greed, the crisis happens due to the conflict between the virtual economy and the present economic institution that was designed to support the "real" economy.

A comparison may help us understand the conflict better.

Back to the ancient time in the agricultural society, the logic of keeping the stable development of society was to well feed the general public, especially the slaves. The fundamental of the feudal economic institution was to control the level of laborers' consumption to be low. Therefore the landlords could maximize the share of profit from labor work.

This old logic continued to the early time of the industrial society. The newly risen capitalists tried to grasp their greatest benefit by minimizing the wages of the workers. Such a policy suppressed the majority of people's power of spending. The consequence was the economic crisis of overproduction because the general public was lack of enough income to consume the rapidly increased amount of product.

The overproduction crisis forced people to restart with the principle of supply and demand balance to manage the economy. The capitalists realized that to maintain a stable and sustainable growth of economy they need to let their workers have more money. The more money the workers have, the more product they can consume, and thus eventually the more money the capitalists may gain. This new logic constitutes the fundamental of the modern economic institution. A significant consequence of this new logic was the invention and prevalence of credit.

Now we are standing at the door of another great transition. This time the economy is transformed from the "real" economy to the virtual economy.

In this crisis, many people complained the virtual economy and believe it was a poison. Indeed, however, the virtual economy is an inevitable consequence due to the growth of the capitalist economy. In this world, product and service are no longer restricted to be the traditional "real" and tangible ones such as car or in-store customer service. By contrast, now they include new components such as currency and Web services, which are virtual and intangible (explanation shortly later in this post). The percentage of these new components is increasing abruptly. The main body of the economy is shifting from the "real" domain to the virtual domain.

The price of a product/service in the "real" economy is based on the meantime supply and demand market requests. There is an important assumption behind the valuation of a "real" product/service: a "real" product/service has an equivalence to a certain amount of mass/energy. To produce the same quantity of product/service output, people would have to consume the equivalent amount of mass/energy. This hypothesis is crucial because it defines a baseline value for any "real" product/service. The existence of the baseline protects the integrity of valuation in the free market.

Things, however, become very different when entering the realm of virtual economy. No matter are they currency transaction or Web service consumption, virtual product/service mainly consumes information instead of mass/energy. Therefore, it generally does not exist an equivalence between a virtual world product/service and a certain amount of mass/energy. The previous hypothesis fails in the realm of virtual economy.

In the virtual economy, we may arbitrarily overvalue or underestimate the price of a virtual product/service if we perform the same economic institution as we have applied in the "real" economy. There is no bottom line to protect the integrity of the valuation. And this is the intrinsic reason behind this financial crisis.

On currency transaction, we may estimate the cost of risk high or low arbitrarily because there is no equivalence between risk and mass/energy. In similar, on Web service consumption we may value a service in any value because at any time an illegal copy of the service could make it be totally valueless according to the market institution in the "real" economy.

All the discussion discloses one thing: the present economic institution does not fit for the rising virtual economy. It is not that the virtual economy is wrong. It is the present economic institution that is out of date. In similar to that our ancestors had updated the old labor economic institution to the modern market economic institution, it is the time now for us to design a new economic institution that fit for the new virtual economy.