“A dynamic economy is one in which human and
physical capital are chasing new opportunities,
not holding onto lost causes.”
– Arnold Kling

5 Minutes on the Couch + 10 Minutes in the Library =
A Plan for the Information Age

LISTEN: Audio mp3 (19.5 min)

Want to put your mind at ease about the current financial turmoil? Here are two perspectives that may help you get out of today’s funk and on to better things.

5 Minutes on the Couch: Letting Go of Present-Event Bias
Here is a brief excerpt from renowned investor Warren Buffett, in his Chairman’s Comments section of the Berkshire-Hathaway 2008 annual report, released February 27, 2009, assessing the economic events of the past year:

“By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A free fall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.”

A “vicious negative-feedback cycle.” Doesn’t that seem to describe all the economic news these days? Bad news causes fear, which leads to more bad news. As Paul Sullivan writes in a February 6, 2009 article in the New York Times, (“It’s Not Just the Money, It’s the Mind-Set”),

“Above all, people’s psyches are being wracked by what behavioral economists call present-event bias. This is the belief that what is happening now will always be. The same thing happens in bull markets — values always seem to be rising until they don’t — but it is clearly more painful when wealth is being destroyed.”

Logically, we all know present-event bias isn’t reality – we know that things, both good and bad, will not stay the same forever. But when you’re in the midst of a trend, it can be difficult to see beyond the prevailing sentiments of the moment. In both good times and bad, there is the danger of allowing the faulty premises of present-event biases to guide our attitudes and economic decisions. When we do, the long-term outcomes are not usually favorable.

In fact, many of the issues at the heart of the current economic crisis have been, to some extent, the result of present-event bias. Because of present-event bias…

• Both mortgage lenders and homebuyers felt they could afford the risk of no-money-down, interest-only loans. After all, “real estate always goes up.”
• Many stockmarket investors were lulled by the mantra “over time, the market always goes up.”
• A union job for a major manufacturer was the gold standard in blue-collar employment, because “General Motors is always going to be there.”
• When politicians began government-sponsored pay-as-you-go social security programs, they were sure that there would always be enough workers to bear the cost of providing benefits for the retirees. After all, said German Chancellor Konrad Adenauer in 1957, “People will always have children.” (Unfortunately for government planners, many developed nations now have fertility rates well below replacement levels!)

If you recognize that making decisions based on present-event bias isn’t productive, what’s a better alternative? Well, for starters, apply Stein’s Law.

Herbert Stein was an economics professor and government advisor to presidents Nixon and Ford (and also the father of entertainer/commentator Ben Stein). He put forward a simple statement about economic trends: “If something can’t go on forever, it will stop.” Put another way, present-event status will end when something can’t be continued. If banks can’t expand their lending because there aren’t reliable borrowers, they will stop lending. If people can’t afford over-priced housing, they will stop buying. When big corporations can’t be profitable in a competitive marketplace, they will cease to exist. And if there aren’t enough workers to pay the cost of Social Security, it will go broke.

In hindsight, it’s relatively easy to apply Stein’s Law to explain how and why past events changed from boom to bust. But can you use the same logic in a forward-thinking manner, to determine how and why the bust will end and prosperity will return? If you break free from the group psychology that creates present-event bias and take a broader view of history, some possibilities emerge.

10 Minutes in the Library: Going Post-Industrial in the Information Society
More than 30 years ago, some historians, economists and sociologists began questioning whether the current economic realities could continue, and if not, what would happen when they stopped.

In 1973, Daniel Bell analyzed the contrasts between the industrialized economies of the USSR and the United States in The Coming of Post-Industrial Society. Bell not only saw the centrally-controlled collectivist Soviet model as unsustainable, but also correctly predicted the attributes of a post-industrial U.S. economy: globally interconnected financial systems; international trade imbalances; and the decline of the manufacturing sector.

Peter Drucker, in his 1989 book, The New Realities, highlighted what he saw to be the major cultural shifts in the 20th century. In 1900, farming was still  the largest part of every nation’s economy, even though the Industrial Revolution had begun 100 years earlier. By the end of World War II, manufacturing had completely supplanted farming. This was the culmination of economic change in the twentieth century, and was the basis for America’s supreme position in world affairs. But Drucker also saw a “post-industrial” world coming, where manufacturing would be less prominent.

At that time, “post-industrial” was a vague term used by economists in that it told what was passing, but didn’t identify what was coming in its place. Since the mid-1990s, a consensus phrase arose for the coming new economic era: The Information Age.

James Davidson and Lord William Rees-Mogg authored several books on the seismic economic changes they felt were likely to occur in the coming decades. In their 1997 book, The Sovereign Individual, Davidson and Rees-Mogg stated that from its earliest beginnings until now, there had been only three basic stages of economic life in human history:

1. hunting-and-gathering societies;
2. agricultural societies; and
3. industrial societies.

“Now, looming over the horizon, is something entirely new, the fourth stage of social organization: information societies.”

With the microprocessor and the Internet as the technological drivers of this new economic age, the forward-thinking commentators saw several trends arising from the emergence of these new technologies.

There would be a transition from goods production to the provision of services. This didn’t mean manufacturing would cease, only that fewer people would be employed in manufacturing. (This mirrors the changes that occurred in farming over the previous century. Today, less than 1% of Americans list farming as an occupation, yet the general wealth of the farming sector has not deteriorated. These few farmers produce much more food than their predecessors of the previous century, and both individual farmers as well as the broad population are better off today.)

With the move away from manufacturing as a core economic activity in developed countries, the importance of blue-collar, manual work (e.g., assembly-line manufacturing) would decline, with much of the lesser-skilled work outsourced. Professional and technical work (lawyers, computer programmers, etc.) would come to predominate. Although this service emphasis was predicted to impact a wide range of sectors, health, education, research, and government services are seen as the most decisive for an Information society.

This “Information Age” perspective isn’t new. Remember, a number of economic and sociological commentators saw this economic shift coming three decades ago. In various ways they said, “the industrial society cannot go on forever. Things will change.” And while it’s rare for economists to accurately predict the future, it’s not like other people haven’t seen the same things over the past 30 years. The decline in manufacturing jobs, outsourcing, and the increased globalization of companies are not new trends. The inevitable conclusion is the industrial society, and many of the economic features that embodied it are quickly fading into the past.

The economic ramifications for the individual are significant. Some of the mainstays of the industrial economy like lifetime job security, company pensions, and government benefit programs are no longer financial certainties. In varying degrees, change is shaping new financial realities.

The Plan For the Politicians & the Individual
When faced with change, there are two fundamental responses: resist it or embrace it. The chosen response often depends on how much one has invested in the existing program, and how much benefit is offered by the newer approach. For those whose livelihoods are connected to the American automobile industry, the change away from manufacturing is threatening. Workers who have paid into Social Security for 40 years don’t relish the thought of seeing the benefits diminish or disappear just as they reach retirement. On the other hand, for providers of Internet search engines and on-line content, change probably can’t come fast enough.

The Political Response
Since many politicians have decided the economic crisis requires government intervention, they also face this resist-or-embrace dilemma. Because many of their constituents remain heavily invested in the industrial society, many politicians promise to “save” jobs, Social Security, and the American way to capture their vote. As Arnold Kling, an ex-economist for both the Federal Reserve and Freddie Mac, said in his November 12, 2008 commentary on www.econlib.org, “…I can see where a bailout is a winning policy. The threatened industry is organized and visible. The alternative(s)…are diffuse and unseen.” But while such an approach makes for good politics, Kling says political intervention may not be the best response to the reality of a changing economic society.

“My guess, however, is that in a post-industrial economy, the necessary adjustments are too subtle and complex…In theory, wise technocrats could help guide workers in declining industries to appropriate re-training and career development. In practice, technocrats are not that wise. But it is much worse than that. Instead of giving the technocrats the mission of making the adjustment process more efficient, politicians will give them the mission of delaying the adjustment process and resisting the signals coming from the market. Thus, the expectation that government should help could have an ironic effect: the more that the public asks government to relieve the distress in labor markets, the longer it may take for labor markets to adjust.”

The Individual Response
While it may be possible for select sectors of the American economy to stave off changes that have been three decades in taking shape, it’s unlikely that the US economy will recover by reverting to an industrial/manufacturing base. And for those who want to step away from the gloom of a vicious negative-feedback cycle focused on present events, it makes sense to contemplate ways to embrace the financial changes that may coincide with the growing influence of the Information society.

In The Sovereign Individual, Davidson and Rees-Mogg suggested several ways in which the Information society will impact individual economics. First, most Information workers will operate as independent contractors; the term “job” will mean “a project” rather than “steady employment with a single employer.” Second, employment opportunities will be global, rather than local or regional – even as the worker never leaves home. Third, the new paradigms in employment “will leave individuals far more responsible for themselves than they have been accustomed to being during the industrial period.”

From these broad predictions, it is possible to make some fairly specific personal recommendations.

Cash reserves are critical. In the typical Industrial-era career, workers could count on steady paychecks and generous benefits. This economic certainty made it possible to operate on thin margins. Financial surprises could be covered by cash flow, insurance or even borrowing, as the repayments could be spread over time.

But when employment may be intermittent, and regularly changing, the need for a substantial cash cushion becomes much greater. The most stable Information Age workers will be those who have the financial wherewithal to comfortably bridge periods of unemployment (or perhaps time to work on entrepreneurial projects), instead of being forced to take whatever is available.

You must own or control your insurance and retirement benefits. Employer-sponsored group insurance and retirement benefits are fast becoming relics of the Industrial past, both for employees and retirees. 401(k)s instead of pensions and employee co-pays for insurance are part of the trend to decrease an employer’s long-term financial commitments. At the pace these employer-sponsored plans are being dismantled, the only people who will have pensions are government employees and Congresspersons.

So…If it’s likely that you will be regularly changing employers or working as an independent contractor, you can’t count on employer benefits – even stripped-down ones. This is especially true during the periods you are “between jobs.”

Given the dynamics listed above, it seems likely that future insurance and retirement developments will move to two extremes – government and individual programs. For those above the poverty line, government plans will offer minimum benefits, with the individual having the choice to add supplementary benefits at his/her discretion. As a result of this universal-individual model, the number of employers offering benefits will likely decline. Anything above the minimum will be the responsibility of the individual.

Since individual coverage (such as life and disability insurance) is often contingent on your health status, it makes sense to secure coverage as early as possible, with provisions to keep the benefits as long as they will be needed. Likewise, retirement accumulation programs should be portable, and allow for deposits from a variety of sources, not just wages.

(Using this universal-individual model, here’s a possible configuration of medical insurance. The rising cry for universal health care can be seen as a direct result of the erosion of Industrial-era employer-paid health insurance, and the increased technological costs of providing sophisticated Information-era medicine. While a government-sponsored plan may provide a base level of coverage for everyone, the likelihood is that individuals will also find it desirable to purchase additional coverages matched to their unique circumstances.)

Change your borrowing habits. The ability to borrow is determined by a lender’s assessment of your ability to repay. For a creditor in the Industrial era, a steady job meant regular repayments. In the Information age, lenders may look more at your assets and less at your employment to determine your suitability for a loan. If your unsecured borrowing exceeds your cash reserves, you may be overextended.

Since you may end up working “everywhere”, live where you want – and rent until you’re sure you’re ready to settle down. The real estate cliché about your home being your biggest asset has changed. For many, after the collapse of real estate values, your mortgage is now your biggest liability. In light of the comments above regarding the changing nature of debt, a large mortgage obligation could be an impediment to seizing financial opportunities.

These broad recommendations are not guaranteed to be the perfect prescriptions for your specific circumstances. But they reflect sound financial thinking in any era, and if nothing else, serve to encourage you to reconsider how many previous financial decisions have been shaped by present-event biases. A measured look at history seems to indicate change is coming, and it will favor those who are the best prepared. Those who make financial plans based on how it has “always been” during the Industrial era may find themselves behind the times.

Is Your Financial Program Structured to Embrace a New Era, Or Is It Still Operating on Present-Event Bias?