Friday, July 24, 2009

The New Now

The current downturn appears to be different from past recessions. For the first time, in a long time, we are questioning the economic models that have been fundamental to how we do business. Conventional economic theories based on “rational expectations” and “efficient markets” do not explain the most important dynamics underlying the economic crises. These theories depend upon people rationally pursuing their economic interests. But, these theories no longer provide an adequate explanation for what is going on. Something has fallen apart.

Keynes offered an explanation. His ideas went much further than his macroeconomic views on government spending in a downturn. He also developed the notion of “animal spirits”. That is to say, much of our economic activities are neither fully informed nor rational, and instead are often governed by noneconomic motives – our animal spirits. These are a combination of preferences, gut instincts, social values, experiences, loves and hates.

The reason for this is that we are operating under so much uncertainty that we cannot possibly make choices based upon the weighted average of quantitative benefits multiplied by quantitative probabilities. As a result, our decisions, frequently, are not rational in the traditional economic sense and, as a consequence, the economy fluctuates as is does. Political involvement or non-involvement in business, consumer confidence, wealth perspectives, the treat of global warming, and so on, all support new theories based on animal spirits, or in modern terms; behavioral economics.

We appear to be experiencing a restructuring of the social, cultural and economic orders. Some commentators have suggested that the changes are more reminiscent of the “vertigo years” of 1900 to 1913, rather than those following the 1929 crash. The vertigo years resulted in a new normal. Those years captured the dislocations that occurred as society and business moved from agricultural and rural to industrial and urban. Today the movement is different, but globalization, neo-Keynesian economic models, reregulation of the financial sectors, changing consumer behaviors, shifts away from manufacturing and industrialization are all pointing to new business models, slower economic growth and labor dislocations.

In a short essay by McKinsey’s worldwide managing director, Ian Davis, he noted some of the broad implications of restructuring the economic order:
• For some organizations - survival
• Significantly less financial leverage
• An expanded role for government
• Regulatory restructuring
• New levels of transparency and disclosure
• Increased financial protectionism
• Global financial coordination and transparency.

All of these changes will impact pension plans and the work and expectations of actuaries.

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