Tuesday, October 28, 2008

Third Order Economy

'So the last will be first, and the first last.' (Matthew 20:16)

In his highly insightful book 'When Markets Collide', Mohamed El-Erian attributes current financial woes to the rapidly changing economic realities in today's world. He points to several germane factors such as trade and account deficits, national debt levels and GDP growth. He makes the case that world economy is undergoing a reconfiguration phase. The new players are high productivity (in terms of real goods) nations such as China and India, and natural resource rich nations such as Gulf oil producers and Russia. Highly consuming nations such as the USA and the UK are bound to suffer significant standard of living readjustment until they return to savings and productivity.

Although GDP growth and net account and trade deficits are neat quantitative indicators, they may mask deeper indicators that are more qualitative in nature. Economies are dynamic systems whose basic components are human agents and transactions. As such, they tend to undergo anthropomorphic cycles. To a poor individual, activities pertaining to basic needs such as food, shelter, personal safety and procreation seem to occupy the majority of the individual's attention and most of his resources. These are, therefore, first order priorities. The economic activity of a poor nation focuses primarily on the provision of such first order needs. Agriculture, construction, and textile and garment production tend to represent the majority of economic activity of such economies. As the individual's financial standing improves, he starts to value second order priorities such as health, looks, wealth, and leisure. A nation, whose average citizen is in that category, tends to favor economic activities in medicine, pharmaceuticals, sports, cosmetics, architecture, transportation, banking, and time-saving gadgets. In this phase of the economy's cycle it is most productive and flourishing. It is also the most exportable phase, since the basic needs of the local population have already been fulfilled.

A second order economy is a maturing economy that tends to handsomely rewards its agents. Bank accounts start swelling. Standards of living rise. And a general sense of euphoria prevails. Near the end of this phase, with a lot of time to spare, the individual shifts to third order desires; desires that are neither palpable nor necessarily useful. Rather than participate in sports, in this phase individuals watch sports. Rather than work to increase wealth, individuals spend their time thinking up get-rich-quick schemes. A sense of entitlement and invincibility prevails. A third order economy is an aging economy. It is dominated by entertainment, marketing activities, financial bubbles, luxury products, and frenzied non-productive activities. In a second order economy, lawyers are agents of protection. In a third order economy, they are agents of extortion. In a third order economy, a class of extreme elite citizens is born. Its function is primarily organizational, and its compensation is stratospheric.

A prolonged third order economy is possible given it manages to maintain an outward appearance of health. As long as second order economies do exist, and are willing to deal with a third order economy, such economy can manage to stay in business. At the earliest signs of trouble, however, trust is lost as the 'Emperor's New Clothes' are fully exposed for what they really are.

China, India, Brazil and a host of other developing economies are second order economies. Germany, Japan, Switzerland and a host of other developed economies are borderline second/third order economies that can easily revert to a second order economy. The USA and the UK are full-fledged third order economies. Natural resource rich economies are economies whose nature is different from the nature of their individuals. More precisely, such economies may have individuals who live in a first, second or third order lifestyle, yet the economy itself is a first order economy by virtue of what it produces and exports.

Thus, the current tectonic realignment is more fundamental than can simply be explained away via deficit and debt figures. Tectonic shifts of this size and nature are usually painful to all involved. The final outcome is often hard to predict. One thing is certain, however. As a third order economy crumbles under its unsustainable appetite, it has to revert, depending on the skill set retained by its citizens, to either a first order or a second order economy. For us in the USA, let's hope it is the latter.

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