the risk economy and a gamble society

An essential reason behind the current financial crisis is the crash of the risk economy. Insurance and the risk economy is supposed to bring more security into our regular life. Many of us, however, forget the other side of the coin---when we valuate safety higher, our society is actually less in secure.

In about 500 B.C., the great Chinese philosopher Lao Tzu wrote the following statements.

大 道 废 ， 有 仁 义 ﹔ 智 慧 出 ， 有 大 伪 ﹔
六 亲 不 和 ， 有 孝 慈 ﹔ 国 家 昏 乱 ， 有 忠 臣 。

Raymond Blakney, in 1955, translated the words.

"The mighty Way declined among the folk
And then came kindness and morality.
When wisdom and intelligence appeared,
They brought with them a great hypocrisy.
The six relations were no more at peace,
So codes were made to regulate our homes.
The fatherland grew dark, confused by strife:
Official loyalty became the style."

The translation is fine in expressing the plain meaning. It does not, however, well reveal the deeper thoughts Lao Tzu wanted to tell. By my understanding, I then revised Blakney's translation a little bit.

大 道 废 ， 有 仁 义 ﹔
Now you see that in a society everybody tells the greatness of kindness and morality; it is only because that the might Way has declined among the folk.
智 慧 出 ， 有 大 伪 ﹔
Now you see that in a society everybody appreciates the true wisdom and intelligence; it is only because that a great hypocrisy has been among them.
六 亲 不 和 ， 有 孝 慈 ﹔
Now you see that in a society everybody looks for regulation in their homes; it is only because that the six relations have been no more at peace.
国 家 昏 乱 ， 有 忠 臣 。
Now you see that in a society everybody is grateful to official loyalty; it is only because the fatherland has grown dark, confused by strife.

In additional to the four, I, hereby, add another one:

Now you see that in a society everybody demands insurance; it is only because the nation is fond of gambling.

How much does a particular risk really worth? This is a truly hard question. The economics geniuses at Wall Street believed that they had figured out the answer. Based on a few very complex mathematical equations, the geniuses built the foundation for the investment banking. If we pull off all the complicated and intentionally sophisticated layers wrapping the investment banking, the core is indeed surprisingly straightforward: to inject the motion of gambling into the society. The more people are found of earning money through gambling their money, the higher valuation the risks can be; the higher valuation the risks are, more people then join the force of gambling their money through risk investment. The cycle thus forms until one day the valuation of risks becomes truly ridiculous. Therefore, financial crisis comes as we have it now.

The more insurance we implement in our society, the less possible we may avoid this kind of financial crisis in the future. This is what Lao Tzu had told us 2500 years before.

The Credit Crisis video

The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

This is a brilliant video that visually explains the present credit crisis. It is worth of your time if you have not watched it before. The video tells that the crisis is actually rooted by capital itself. the current presentation of capital indefinitely amplifies the greedy side of human nature. We truly need to invent a new presentation of capital (in contrast to manipulate any economic theory) in order to avoid this type of disasters in the future.

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.

The financial crisis: who will be the winner?

The financial crisis at Wall Street seems to become more and more severe with the plunge of Dow Jones in recent days. A question is, however, generally overlooked by many people---who will be the winner in this financial crisis?

Some people may answer by no winners and we are all losers. But it could not be true. Whenever there are losers there must be winners. For example, is Warren Buffet a winner? Many people may say so since Mr. Buffet is likely to gain more than he loses in this crisis. So will the winners just be a small group of the Buffet-like people? The answer might be surprising to many people. Believe it or not, United States of America as a nation could possibly be the biggest winner of all!

A private Chinese economist, Junluo Liu (Chinese: 刘军洛) published recently a brilliant analysis on the eventual effect of this crisis. If you may read Chinese, I would strongly recommend you going to read the original article yourself. Otherwise, I am briefly introducing his analysis here and add a few of my own comments at the end.

Crisis: rebuilding the foundation of USA

Crisis, its Chinese translation says "danger and chance" (Chinese: 危机). Unlike the western tradition that favors precision and strictness of the meaning of words, the oriental tradition (especially the Chinese tradition) respects broadness and thoughtfulness of the meaning of words. Hence when we translate the English "crisis" into Chinese, it becomes "extreme danger but with lots of chances." This is exactly what Junluo shared.

Junluo claimed that this crisis to USA might be a great chance of reformation while to the rest of the world (especially China) would be a true disaster. This claim is quite a controversy to the present mainstream opinion that China might replace USA being the leader of global economy after the crisis.

Who will be the winner? It would be the United States of America, Junluo answered.

There is one common character between Junluo and me. Both of us like to discover the essence of a present event by historic comparison. This time, Junluo carefully compared the present financial crisis to the financial crisis at the late 80th last century when USA eventually defeated Japan's challenge on gaining the power of economic leadership. Based on the history, by using nearly the same strategy the Wall Street stock market dropped 20% in short time of period. The result was, however, that Japan fell into a 19-year-long recession while USA rapidly regained the power of economic growth after just three years. This history is repeating. The only difference is at this time the victim becomes China.

There are some simple (but easy to be overlooked) facts we must be aware. Everybody knows that the root of this financial crisis is the loss of control on the real estate loan. In short, many low-income, poor-credit people got the loan (which they should not get) to buy houses they could never afford. One consequence is, however, that at USA real estate investors were able to build many houses in these years despite of the fact many of the new house owners actually could not afford these houses.

This story has two effects: (1) the break of the credit system (nearly everyone is experiencing the pain now), and (2) a huge amount of new houses have built all over the United States (few, however, are considering this fact now). If we take a look at the two effects closely, the new houses will be on the land of USA forever (nobody can move them to China) while the whole world (especially China) is now paying for the credit disaster. When Dow Jones dropped 20%, the stock market at Shanghai has dropped over 70%. This fact identically matched what had happened at Tokyo 20 years ago.

If this time USA could execute the successive strategies as brilliant as the last time when handling Japan, USA would recover and gain a even stronger momentum of economic growth in three years. China, however, will be the next Japan, which inevitably falls into a long time recession. The final winner of this financial crisis thus could only be---the United States of America.

My comment

Certainly this summary I shared is oversimplified. Junluo's original discussion is much more complicated and delicate. However, I want to share a few more of my own thoughts by comparing the consequence of this financial crisis to the consequence of the last IT crisis at the beginning of this century.

By studying the dot-com bubble, researchers have found that the optical network built during the hype period had become the foundation of the following economic boom at the Web industry, namely the Web 2.0 hype. Without the investment of these optical networks and without the bankrupt of the original optical network investors, we were not able to obtain the cheap price of network usage which is an essential reason behind the Web 2.0 hype. By this mean, it was the IT crisis that constructed the foundation of the new Web-based industry.

However, such a foundation is still not enough to boost the full-scale rise of Web-based industry. Another obstacle is the price of real estate. In order to boost a new form of industry, we need to have a large amount of small businesses in this type. High price of real estate, however, is a deadly killer for the blooming of small businesses.

This financial crisis solves the problem. There are now more new houses than they could be properly consumed. As the result, the dropping of price at real estate market is inevitable.

Combining the two effects, the Spring of Web-based small businesses at US is coming. In the next decade, we are going to see that USA again becomes the base of innovation and the leader of the new industrial revolution.

In comparison we may watch China. The future is, however, not optimistic at all because of this financial crisis. The deep drop of the stock market will greatly hurt the industrial innovation. Moreover, western investors are going to invade China on its debt market and real estate market to cause severe economic inflation in China. As we have discussed, the high price of real estate in China will hurt the formation of Chinese Web-based small businesses. As the result, the technological distance between USA and China will not decrease but increase. As a Chinese myself, I am quite sad on this prediction of the future. However, be honest I would say that it is the future most likely to happen.

I have predicted several times in this blog that a great economic, technological, and even social transition of our human society is happening right now. USA is actively facing this challenge while many of the rest of the countries are still unaware of it. I have to say that the age of United State has not passed yet.

Wall Street, Fall 2008: crisis, capital, risk, computation, and information

Crisis is an unstable situation of extreme danger or difficulty. This term precisely describes what is happening at Wall Street now.

The Wall Street banks, especially those investment banks, claimed to have produced capital more than (a lot more than) the capital they indeed have produced. This unbalance between the real output and the claimed output leads to an unstable situation. When the unstable situation has lasted for years without proper fixing, it accumulated and finally grew to be extreme danger or difficulty. Hence we have the financial crisis now.

Capital is cash or goods accumulated and available for use in producing more cash or goods. Capital is the trouble maker in this crisis.

Capital represents wealth; and everybody likes wealth, hence everybody likes capital. So far there is no trouble.

In order to produce more wealth, a straightforward way is to produce more capital. Now the trouble starts. The trouble, however, is closely related to another essential character of capital---capital is a type of matter. Both cash and goods are matter. Although by the nature law the total amount of matter never increases, the value of the total amount of mass could increase. In order to produce matter in higher value, however, we have to at the same time consume some matter or energy (by Albert Einstein, there is equivalence between mass and energy). Ideally, to produce the same amount and quality of output matter, the less value of input matter/energy we consume the more wealthy we produce. This normal formula of wealth generation becomes the origin of all the troubles.

The Wall Street bankers have had a brilliant idea. How about we embody risk/security to be a type of mass and consume it to produce wealth? This idea is indeed brilliant because we can barely objectively measure the actual value of the embodied risk. As the result, the bankers may arbitrarily undervalue the input cost to claim a huge amount of newly produced value by subtracting the input from the output. Then the real-world trouble begins---the unbalance-based unstable (seed of crisis) is generated.

Risk is a possibility of incurring loss or misfortune. Risk is the central problem in this crisis.

The opposite side of the possibility of incurring loss or misfortune is the possibility of incurring gain or fortune, i.e., chance and opportunity. Gamblers love chances and opportunities, and so do the wealth tracers, and thus reasonably we have the bankers/capital-producers in the list.

In order to perform the arbitrary undervaluation of risks, the gamblers (i.e., the Wall Street bankers) hired top mathematicians (or they were themselves) to have created very complicated mathematic models of risk computation (such as the one in the right figure) that few people in this world (I doubt whether including themselves) truly understood. There is only one goal in all of these math models---to minimize the value of input (i.e. undervalue the cost of risks) so that the increased value of output is maximized.

However, computational sound does not necessarily represent in-reality sound. This is thus the problem.

Computation is a general term for any type of information processing that can be represented mathematically. Computation is the most tricky part in this crisis.

Computation is information processing. This recognition is critical because we have mentioned a little bit earlier that capital production is matter processing. Then we are facing one of the most tricky questions in this world---is information a type of matter?

The importance of this question in our situation is in three folds. First, if information is matter, the bankers are not cheating us but they do have miscalculated (if intentionally then they must have legal issues) the real value of information as matter. Second, if information is not matter and it could not be measured as matter at all, we are completely deceived by the bankers and all of the bankers should be put into jail since they literally robbed all of us. At last, if information is not matter while there is some unknown equivalence between information and matter, the bankers could be excused (but still need to be blamed).

Personally, I lean to the third facet. It is the unknown transformation between information and matter that causes this crisis. Certainly, however, without human's greed we would have never trapped into it either.

Information is a numerical measure of the uncertainty of an outcome. Information is the hope that may save us from falling into the crisis again.

Because of the crisis, US government has requested the remaining two major investment banks to transform themselves to be commercial banks. Will this political order eventually solve the problem forever? I don't think so.

This crisis happens due to the greedy nature of human beings beyond the danger of risk computation. In contrast to challenge the nature of greed, I would suggest a more pragmatic solution to the problem---start to study the real value equivalence between information and matter. That is, start to research the asset of mind.

Based on Seth Lloyd's discovery, information is actually another fundamental element of the universe that is the same as mass and energy. Hence it is reasonable to assume the existence of equivalence transformation between information and mass as we have proved the existence of similar equivalence between mass and energy. In fact, we even do not really need such a great scientific discovery in order to solve the immediately faced problems. What we are looking for now is only a measurement of the value equivalence (in contrast to the fundamental equivalence) between information consumption and mass consumption. Encapsulating human mind in a way that it becomes exchangeable in the market might be the straightforward answer.

If numerical measure of the uncertainty is the essence of information, we may solve the valuation of risk in the free market rather than handing the issue to the few smart people in dark room. This picture might represent the future of financial production.

New generation business demands new DNA

Due to the spread of financial crisis at Wall Street, more people start to rethink the intrinsic problem in the present business infrastructure. In a recent Harvard Business Publishing post, Umair Haque, Director of the Havas Media Lab, appealed to "building a better kind of business" that would challenge the rot he saw at the heart of the institutions of business.

Among the five steps of resolution Haque recommended, I am particularly interested in his third suggestion (which mentioned by himself to be the "simplest, and most fundamental step"): understanding that next-generation businesses are built on new DNA, or new ways to organize and manage economic activities.

Haque believed the reason behind the institutional flux to be that "the centuries-old institutions of orthodox capitalism cannot support the transition to a hyperconnected global economy." Therefore, a tactical adjustment of the present financial policy might not be enough to really solve the problem. By contrast, Haque asked for a strategical revision of business fundamentals.

Unquestionably bold the claim is, I do agree to his words about "bringing new DNA to a table." This is what we need to do now.

What is the new DNA?

In his article, Haque, however, has not clearly explained what the new DNA of new business is. He mentioned the demand as well as the functions the new DNA must hold in order to "addresses the rot which pervades the economy at every level." But there is no explicit interpretation of the new DNA itself.

Certainly to define such a new DNA is not easy. I would also not pretend to knowing the answer. However, from a Web researcher's point of view (since many business people including Haque believe that Internet is the future of economy), I would like to share a few of my viewpoints.

I believe the new DNA would be mind asset. The crisis happening at Wall Street right now is rooted by the fundamental of capitalist economy. By nature, capital is near-sighted and selfish. As long as the economy is still built upon capital transaction, there is no way to really overcome the problem occurred today at Wall Street. The only possible solution is to revise the fundamental. By saying that I do not mean communism. By contrast, I expect the rise of mind asset and a new form of human society (harmonious society?).

Mind asset, as the name suggests, is property of human thoughts. The term is contrast to capital asset, which is property of all kinds of products and services.

About four months ago, before this financial crisis I have discussed a vision on the rise of mind asset when sharing with Adam Lindemann, CEO of Imindi. This vision is a reasonable derivation by my theory of Web evolution.

Web evolution is essentially a gradual increment of quality of Web resources. Meanwhile, Web resource is the basic presentation form of modern mind asset. Therefore, the eventual formation of modern mind asset is an inevitable consequence of Web evolution. Since mind product (in contrast to capital product) is the essential asset type of input and output of the postmodern industry, saying the Web industry (or Internet industry), mind asset would replace capital asset being the basis of the coming new economy.

To understand why mind asset being the new DNA can overcome the fundamental problem in the capitalist economy, we need to learn another subtle difference between capital and mind. In essence, capital is mass/energy while mind is information. As we discussed earlier, mass/energy cannot compute itself unless it consumes while information may compute by itself without consuming extra energy.

Now back to the current financial crisis at Wall Street. The crisis happens because the greedy Wall Street bankers tried to let capital compute itself to produce more wealth without literally consuming any real-world mass/energy. Fundamentally this thought contradicts to the computational nature of mass/energy. Therefore, this financial behavior itself is a bubble to burst from its beginning. It only matters when (but not whether) the financial crisis would come.

On the contrary, in theory information may indeed compute by itself without consuming any real-world mass/energy. Therefore, by replacing capital asset with mind asset we may eventually solve (or at least greatly eliminate) the future financial crisis when it is in reality impossible to get ride of the financial business at all (and nor might we remove greed from human's heart).

Referenced resources:

• How to Build a Next-Gen Business Now (Harvard Business Publishing)
  
• Who Needs Unfinished Business? (Torch is Wicked)
  
• We are in a new transition, part 1 (Thinking Space)
• We are in a new transition, part 2 (Thinking Space)
  
• Programming the Universe, Part 2 (Thinking Space)

Teach your kids what is happening at Wall Street now

I just read a post by Jason Kolb. It is fantastic. I guess every father or mother could use it as a textbook to teach their kids about money and what is happening at Wall Street now.