A Historical Perspective on the Financial Crisis

For quite a number of years, Carlota Perez has been predicting the inevitability of the financial crisis that ultimately engulfed us.  An expert on the historical links between technology and socio-economic development, she is Visiting Senior Research Fellow at the Judge Business School of the University of Cambridge, as well as being  affiliated with the University of Sussex and a number of other institutions,

I first met Carlota - a friend whom I therefore feel comfortable calling by her first name - when she visited IBM several years ago, shortly after the publication of her book: Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages.  In her book, articles and lectures, she eloquently explains (see this excellent video, for example) how the combination of new, disruptive technologies and financial capital looking for the next big thing come together from time to time to usher massive new changes in society.  These changes are always accompanied by a financial bubble and subsequent massive crash.

She believes that the present financial crisis is indeed a “once in a half century event”, but an event that she argues has happened four times before in the last 200 years or so.  While each such technology-based revolution has its own unique dynamics, a lot can be learned by examining their common characteristics.  If you look at the historical big picture, patterns begin to emerge, which serve as a very good guide for thinking about and planning for the future.

Over the past couple of centuries years, we have had a technology revolution every 40 - 60 years, starting with the Industrial Revolution in 1771.  This was followed by the age of steam and coal, iron and railways which started in 1829; steel and heavy engineering (electrical, chemical, civil and naval) starting in 1875; and the age of the automobile in 1908.  Our present information technology and telecommunications age, whose starting point Carlota pegs at 1971, is the 5th such major revolution in that span.

Each such revolution takes about half a century to spread around the world, and is characterized by two distinct periods: installation and deployment.

The installation period is a time of creative destruction, when new technologies emerge from the lab into the marketplace, entrepreneurs start many new businesses based on these new technologies, and venture capitalists encourage experimentation with new business models and speculation in new money-making schemes.  Inevitably, this all leads to the kind of financial bubbles and crash we are now quite familiar with 

After the crash, comes the deployment period, the time of creative construction and institutional recomposition.  The now well accepted technologies and economic paradigms become the norm; infrastructures and industries start getting better defined and more stable; and production capital drives long-term growth and expansion by spreading and multiplying the successful business models.

I first heard Carlota speak shortly after the implosion of the dot-com bubble.  I assumed, as did most of those who attended her lecture, that given the dot-com financial crash, we would soon be entering the deployment period.  She argued vehemently then, and in subsequent conversations, that the real financial crash had not yet taken place.  After a meeting in 2005, where we once more discussed where we were in the cycle, I posted this entry where I wrote that

“Carlota Perez believes that we may not yet have entered the deployment period, as the crash phase doesn't seem to have resolved itself.  She mentions three particular structural tensions that we need still to work out in order to move on: investments continue to be focused on short-term gain, not on long-term production and growth; the social system continues to foster an unstable environment in which the rich get richer and the poor get poorer; and there is too much idle money chasing and inflating assets like housing and not going into expanding the demand needed to soak up all the excess supply being produced.”

Think how remarkably prescient her words are, especially when you consider the number of top economists who were at the time advocating the notion that the world was now safe from cataclysmic financial crises, because of the ability of derivatives and other new financial instruments to effectively distribute risks.

In this recent article, After Crisis: Creative Construction, she explains that

“this time we have had the boom and crash in two episodes. The first was the Internet mania which was truly fuelled by new technology and ended in the NASDAQ collapse of 2000.  The other was the set of easy credit bubbles of 2003-08, when investors were pushed by an abundance of quasi-free money into finding anything but technology as an object of speculation (from commodity futures to securitized sub-prime mortgages).  The enormity of this financial bubble was facilitated by the process of globalization and the capacity for computer-aided financial "innovation" acquired during the NASDAQ boom.  It is because regulation did not follow after 2000 that free-wheeling finance was able to reach such astonishing levels of systemic risk.  It is only now, when all the crooked doings of the casino have been revealed and their painful consequences for the real economy are being suffered, that there is enough political pressure for regulation and institutional recomposition.”

Carlota believes that the financial excesses that keep coming to light are an integral part of the concept of creative destruction popularized by Austrian economist Joseph Schumpeter to describe the process of transformation that accompanies radical, disruptive innovation.  The new technologies and innovations advocated by entrepreneurs and venture capitalists are the force that ultimately sustains long term economic growth, even as this same powerful force destroys the value of established companies.  As Carlota writes 

“Historically, [the Installation Period] has  been the time when financial capital shapes the economy, while the ideology of laissez faire shapes the behaviour of governments.  It is a grand experiment when unrestrained finance can override the power of the old production giants and fund the new entrepreneurs in testing the vast new potential.  Finance then helps the new giants emerge, enables the modernization of the old industries with the new techno-economic paradigm and facilitates the necessary overinvestment in the new infrastructures (so coverage is enough for widespread usage).  Thus the extreme "free market" ideology has a role to play in the early decades of each surge.”

Everything changes after the inevitable crash.  “The collapse reveals the need for regulation to restrain financial excesses and to favour the real economy, usually under political pressure for reversing the income polarization and other negative consequences of the bubble times.”  

And she adds, “Once installation has been achieved, however, there is a vast innovation and growth potential that the economy is ready to tap. Unrestrained markets then become a very blunt and brutal instrument; yet markets guided by policies that implement common visions arrived at through a social consensus orchestrated by modern, well informed, realistic and socially responsible governments are more likely to achieve the best results in these circumstances.”

The focus has to now be on the real economy, that is, the economy of production capital, long-term investment, job creation.  Individual pursuit of wealth and power has to now be balanced with achieving the common good.  Her parting words offer a good prescription for what we must do to help bring about this new period of creative construction

“Ultimately, the length and depth of the global recession (perhaps depression) will depend, not on the financial rescue packages but, to a much greater extent, on whether the wider measures taken are capable of moving the world economy towards a viable investment route with high innovation potential.  The technological transformation that occurred during the past few decades has already provided the means for unleashing a sustainable global golden age.  The environmental threats offer an explicit directionality for using that creative potential across the globe in a viable manner.  The major financial collapse has generated the political conditions to take full advantage of this unparalleled opportunity.  It is everybody's responsibility to make sure this possibility is not missed.”

Comments

[Chris Ward]

I think IBM OS/2 and IBM Lotus SmartSuite cleared themselves off the scene just in time to be out of the way of the 'crash'.

But what's the follow-on act to be ?

We have a Internet now. It wipes some businesses out; it grows others; and it's a great levelling force as between universities and corporations, as between the 'older generation' with assets (of uncertain capital value) and the 'younger generation' penniless but with enthusiasm, and as between individuals and their governments.

And it isn't going away.

OS/2 and SmartSuite never had any competition, did they ? Nobody ever made a profit selling personal computer operating systems and standalone office productivity software ? Or ... ?

[Stephen Perelgut]

I'm not sure that the current era is the same sort of change as the advent of automobiles or heavy industry. This is more about how people communicate.

Speech allows for communication from individual to individual. Writing opened the door for persistence and asynchronous conversation. The printing press changed from one-to-one, allowing one-to-many communication. The telephone erased distance and television added video.

Now, the internet, Web 2.0, and the spread of social networking tools has made another fundamental shift from monologues or one-to-one conversation to full-duplex, many-to-many conversations. And the evolution to Web3D is going to make this a fully immersive, fully synchronous conversation.

This isn't just the change from horses to trains and cars, I think it's the same scope as the Guttenberg press or the Industrial Revolution.

And, sadly, that means it doesn't speak to the current economic crisis one way or another.

[Victor Yodaiken]

Technology has assisted corporations to grow in power and size well beyond the ability of people to manage them and to a level where they are harmful to their employees and to the larger economy.

[Leo Boeckl]

I won’t argue the historic reality of technology cycles repeating themselves throughout the industrial era other than to admit my bias and say that I have supported Perez’s model since 2002 when she first published her model in the book. I have used her model to answer the question as to what time it is within the business unit where I work in the maturation of technology which we support.

Perez’s model of refined Kondratiev long waves presents our company with a kind of roadmap for the obstacles which lay ahead of us. The Inflection Point exemplified by the market crash we are all experiencing today, requires all companies to conserve cash in order to survive into the Deployment Period when an oligarchy of competitors will emerge for our industry. I think we should be confident that IBM will be one of those which survive, but how we are positioned within our own industry will be determined by what we do collectively as a company during the unwinding of asset valuations and the resulting stabilization which will follow.

Perez defines the core of this Long Wave to be one driven by the development and maturation of the microprocessor. How are we responding to the most significant developments of the microprocessor and the effects on the programming/system architecture? Virtualization is clearly the last step for the collapse of the entire system stack layers (OSI model). From the HW abstraction layer all the way up through and including the middleware and application layers. How are we positioning ourselves to provide the products and services knowing that the discrete layers which we provide today and which generate tremendous revenue for IBM, will be gone tomorrow?

I am of the opinion that how we as a company address the next few years, before cloud computing and utility becomes as standard for business computing as web browsers and Internet utilities today, how we respond with both technologies and support for the collapsing layers will determine our vitality an where we stand in our industry for the coming Synergy Phase of the Deployment Period.

[Peter]

Good post.Financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value..

[Tom Foremski]

We have an over supply of technologies, we now need to figure out how best to use them--that's where the innovation will be.

However, I disagree that these cycles consist of fairly regular and equal time periods throughout history. They might be similar to each other but that doesn;t mean they will be of fairly equal length.

When it comes to the microprocessor, its real potential wasn't realized until we were able to create the Internet. This potential is the ability to digitize ever larger parts of the world, including knowledge and skills, and then to easily distribute those bits back and forth.

Internet 1.0 allowed us to publish to any computer screen. Now, in Internet 2.0 (I don't use it in the conventional sense) any computer screen can publish back. We have connected up the furthest reaches of the world into a two way information communications medium. This is incredibly disruptive. We have not yet begun to witness the dusruption ahead, imho.

[victor yodaiken]

WSJ article shows india continues to grow because of long-term politically directed investment in the rural poor.

http://online.wsj.com/article/SB123931787215706747.html

Speaks directly to: "She mentions three particular structural tensions that we need still to work out in order to move on: investments continue to be focused on short-term gain, not on long-term production and growth; the social system continues to foster an unstable environment in which the rich get richer and the poor get poorer; and there is too much idle money chasing and inflating assets like housing and not going into expanding the demand needed to soak up all the excess supply being produced.”

More here
http://www.yodaiken.com/2009/04/venture-capital-short-term-and-india/

[David Chen]

I absolutely agree that Perez's writing is relevant here. In every intro to finance/strategy/KM class, the prof points to the growth in the gap between book and market value as an indicator of the increase in knowledge as a factor of production.
Perez, in contrast, points to divergence of the exponential market value curve from the straight GDP growth curve as proof of a bubble.

[Haarod]

I agree "Technology has assisted corporations to grow in power and size well beyond the ability of people to manage them and to a level where they are harmful to their employees and to the larger economy." that right?

[Haarod]

Technology has assisted corporations to grow in power and size well beyond the ability of people to manage them and to a level where they are harmful to their employees and to the larger economy. I agree with your comment.

[Mansoor]

Perez is without doubt the prophet of techno-economic change. being from a developing nation (Venezuela)she has a good grasp on issues of development and economic catch-up.
her explanations are based on irrefutable facts of history and Freeman and Perez have proven their prophecies since 1980s...
but there are a few problems that still trouble me..
1- we have strong evidence that the technology life cycles have shortened and are shrinking rapidly.. does that mean the probable age of technological revolutions (esp IT revolution) would be shorter as well
2- technological diffusion has hastened, esp in IT.. if the age of a technological revolution is equal to its complete diffusion (both installation and deployment) then this revolution must be smaller
3- all revolutions originated in developed nations, and diffused to developing nations, exhaustion of one technological gold rush leads to the rise of the next wave. but in developing nations even the technologies of the previous revolutions have not been mastered, as the new waves hits and gales of creative destruction shatter the old forms, the developing nations are left with nothing but dependence and acute systemic crisis...
4- as this revolution is different from the past, first due to the nature of information technology itself, secondly due to arrival of a few NON-Western, developing nation players (Asia, BRICKS, etc) how would that effect the new paradigm. the next wave might rise from the east, or west, or both or just get canceled out when two counter currents arise from east and west.
5- the technological changes, financial and economic changes brought about by the waves or revolutions are only the visible aspects, the institutional and conceptual changes also come with the new paradigm, but after a time lag, a delay. how long is that delay,does that aftershock play a role in the 3rd and 4th quarters, how does it affect the rise of the next paradigm?
6- finally the forces of creative destruction do not always destroy the structures of the old paradigm, rather they only affect the exo-structure and are build upon the older foundation, the infrastructure,the institutions, organisational cultures, and peoples tastes and culture developed in a previous revolution, support the rise and mastery of the next. then how could a developing nation that missed a previous wave, ride the next wave?

any takers...

* Im a student of technological change at Chinese Academy of Sciences, and belong to Pakistan

[ดารา]

Thank you. This is one of knowledge.

[โปรเกมส์]

Thank you very much for your explanation,It makes work easier.

[Motorcycle]

I agree "Technology has assisted corporations to grow in power and size well beyond the ability of people to manage them and to a level where they are harmful to their employees and to the larger economy." that right?

[Muslim Social Networks]

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