Wisdom is better than silver or gold...

"Don't gain the world and lose your soul, wisdom is better than silver or gold..."

Bob Marley's message to the world clearly hasn't hit the financial markets. Gold seems to be acting as the most valuable substitute in the absence of any obvious wisdom. As the financial crisis has unfolded the price of gold has gradually edged upwards towards $1,000 per ounce (from $253 in 1999), as it's "safe haven" attributes have come to the fore. Historically, gold has retained the capacity to act as an effective hedge against inflation, and a declining dollar, and as a general store of value during times of geopolitical and financial market instability. All of the above would seem to fit the current circumstances.

When the US dollar replaced gold as the world's reserve currency, it might have been expected that the trend of using of gold as a store of value would have faded away. After all, gold, despite being useful in prolonging marriages, doesn't actually have much going for it. You can't eat it. You shouldn't drink it - as the Aztecs showed so creatively, and you are unlikely to be able to build a house out of it. Given the lack of attributes, why is it that gold still retains such a position in our financial system? In particular why does it still seem to be the "ultimate" store of value right now. This past week the US dollar has come under pressure as a reaction to plans in the US for potentially hyper-inflationary fiscal policy, and gold has shot up even further. Why?

The dollar is down 4.6% this month against a basket of six major currencies. Gold and the dollar, which have moved in tandem for most of 2009 as investors sought a haven from financial turmoil, have returned to an inverse relationship. There's a growing concern that the US monetary base is expanding - the Federal Reserve bought $7.5bn of Treasuries late last week, its first targeted purchases since the early 1960s. Benchmark interest rates are between 0-0.25% - which if there is any form of economic rebooting should be inflationary. Therein lies the explanation for gold's perpetual rise - the expectation of a falling dollar and increased inflation in the future.

The theory goes: the amount of gold in existence is relatively fixed - around 160,000 tonnes have ever been mined - and the proportion of gold to the money supply according to "the economics" should (in theory) remain relatively constant. Gold adds up to $4.7 trillion at the current $950-odd price per ounce, while notional money supply is at maybe $60 trillion. Consequently, the assumption is that gold must go up in price.

Once upon a time I would have agreed. Unfortunately this 'time' was well before I was born, so it was hard to participate in that discussion. The time that I mean was during the the various periods between the first adoption of the gold standard in the UK in 1717 (£1 was convertible at 7.32 grammes of fine gold), through to a looser international gold standard established by the Bretton Woods Agreements after the Second World War. Under that system, many countries fixed their exchange rates relative to the US dollar. The US promised to fix the price of gold at $35 per ounce. Implicitly, then, all currencies pegged to the dollar also had a fixed value in terms of gold.

Under the regime of Charles de Gaulle in the late 1960s, the French reduced their dollar reserves significantly, trading them for gold from the US government, thereby undermining US economic influence abroad. This, along with the fiscal strain of Lyndon Johnson's "Great Society" expenditures and the Vietnam War, led Richard Nixon to eliminate the fixed gold price in 1971, causing the Bretton Woods system to break down. Since that time, the gold standard has not been used by any country in the world.

Furthermore, many governments have systematically (or moronically in Gordon Brown's case) sold down their country's gold supplies. At the current time, the holdings of gold in direct (bullion) form, and indirect (gold mining companies, derivative contracts) of the world hedge fund community comfortably outweighs the 19% of overall supply that is held by the world's central banks. That seems a bit out of whack to me.

In that context, why has gold remained such a popular store of value, when it has been eschewed by those who run our economies? The truth for me is that it is merely a trend, albeit one that was once based in some form of grounding. Gold goes up in price when people expect inflation, in my view, because that's what people think it should do - it's purely based on expectations. These expectations are somewhat rational, as that is what has happened in the past, but the real economics no longer make any sense to me. If the world does proverbially "hit the fan" then I want to be in possession of "real assets" - food, water, firewood and the like. The usability of gold in those circumstances is not going to be up to much - the real reserve currency will be the items that sustain our existence. Farmland is better than gold for me in that case. If on the other hand the economic outlook improves, the gold price should fall, and quickly.

I would compare the gold price rises since the end of the Bretton Woods system to the "portfolio insurance" debacle that led to the market crash in 1987. Similarly, all very well in theory, but not great in practice.

Very simply "portfolio insurance" was where Phd. Mathematicians started to meddle with the worlds financial system. A group of 3 such "rocket scientists" formed LOR Associates in the early 1980s, and started selling a computer modelled trading strategy that helped big asset managers protect their gains on their large equity portfolios, in the event of market drops. The strategy worked by using a hedge - selling S&P futures, for example. If the portfolio increases in value and moves above a desired minimum floor value, the hedge is reduced, allowing the portfolio to enjoy a greater fraction of the market gain. If the portfolio declines in value, the hedge is increased, so that finally, if the portfolio value falls well below the floor value, the portfolio is completely hedged. The clever bit that these geniuses were selling was their model's output, which would tell the asset manager when, how much, and at what level to execute these hedges. In the early years the strategy was incredibly successful - and the business of portfolio insurance started to grow exponentially.

Between the period 1982-87, the Dow Jones Industrial Average almost tripled in value. As a consequence lots of asset managers had big gains that they were keen to insure against losing if the markets started to fall. By 1987 portfolio insurance was the driving force in trading decisions, with more than $60bn of assets being hedged with this technique. When the cracks started to appear in US equity markets in October '87, portfolio insurance based hedging started to kick-in. In the run-up to the market crashing more and more futures were being sold on the various equity indices that were being insured. These indices were usually relatively liquid - as in it was possible to do lots of these trades without moving the price. However as more and more hedging was required, as the markets fell, there was a tipping point where the liquidity in the system could not sustain the selling pressure, and the market capitulated. The Black Monday decline of October 19th was the single largest one day percentage decline in stock market history, with the DJIA dropping 22.6%.

To complete the comparison with gold - those who are using gold as the "perfect" hedge, aren't seeing the full picture - just as the portfolio insurers didn't see that liquidity in the futures market wasn't endless. In the case of gold, it may well appear to be a good "safe haven" because the price of gold continues to rise. For my money, though, that is only because of a trend, or expectations. If we really do hit the wall that the gold buying is protecting against, we will be in a completely different paradigm and gold won't have any "real" value. Hopefully we won't get there, but in that circumstance I'll take guns and butter every time thanks very much.

The real AIG scandal...

This week the American insurance conglomerate, AIG, has been center stage in the US political arena for the trifling by current standards $165 million in retention bonuses that have been promised to staff who are "helping" to unwind the shambles that they themselves created. Galling on many fronts.

In the context of the $170 billion (and rising) government bailout of AIG, however, the bonus issue is virtually inconsequential. The $165 million in bonus payments is less than one-tenth of 1% of the total amount of bailout money given to AIG in one form or another. It's a scandal, but there is a far bigger one here. Far too little media attention is being paid to the really serious stuff, which is where the big money in the bailout is going - the payments of AIG's obligations to its derivative counterparties. Some of these counterparties, will now (or already have) receive multibillion dollar payments owed by AIG. Most significantly in the US, Goldman Sachs will receive $12.9bn, Merrill Lynch $6.8bn and perhaps more outrageous for US taxpayers is that foreign banks like Societe Generale and Deutsche Bank will receive close to $12bn each. These payments are virtually direct from the US taxpayer, albeit with the AIG stamp on the cheque. Personally, I think it's absolutely outrageous that these institutions are getting out of this situation in this way. These are professional risk takers, and they cocked up. That the US government doesn't even haircut them in the payments they are now receiving sets up all sorts of false incentives, and moreover penalises the US taxpayer in a way that makes the bonus scandal look pretty trivial.

In deciding to rescue AIG, the US government was understandably worried that if it did not bail out the company, its collapse could lead to a cascading chain reaction of losses, jeopardizing the stability of the worldwide financial system. Goldman Sachs could easily have become the next Lehman Brothers, if their capital base was eroded by the full expected loss on their counterparty exposure to AIG (i.e. the $12bn mentioned above). Ben Bernanke, was quoted this week saying: “Of all the events and all of the things we’ve done in the last 18 months, the single one that makes me the angriest, that gives me the most angst, is the intervention with AIG” He went on: “Here was a company that made all kinds of unconscionable bets. Then, when those bets went wrong, they had a — we had a situation where the failure of that company would have brought down the financial system.”

The unconscionable bets that Bernanke speaks of are the derivative positions that the likes of Goldman Sachs "advised" AIG to put onto their books. Many of the derivative positions in question will have been types of insurance contracts where AIG has written a policy, and in return receives a premium income from the likes of Goldman Sachs for this protection. Part of the risk of these trades for Goldman Sachs et al is assessing the counterparty exposure i.e. if the provider of insurance (AIG in this case) gets into trouble, will they be able to honour any required payouts. Many of these contracts would have been written on US housing related assets. With the falling value of these types of assets AIG would have been obliged under these derivative contracts to cover their trading partner's losses. Similarly, on the Goldman Sachs balance sheet, these expected "windfall" payments will be recorded in the accounts as trading gains; the $12bn gain mentioned above would have been recorded in the profit statements on the Goldman books. If they were managing their risk properly then some "counterparty risk" against AIG would have been acknowledged in their accounting process. When AIG failed, Goldman Sachs should have been expecting to only receive a fraction of their expected windfall on the basis of the "recovery rate" achievable on the assets that were protected by the insurance contract. It's not dissimilar to the notion of buying house insurance, have your house burn down, and then finding out that the insurance company can't pay - which happens in the real world. In that situation you would not have your insurance paid, unless some helpful soul bailed them out - which would be unlikely because they wouldn't come under that favourite category of "too big to fail".

As Goldman Sachs saw AIG slide further into trouble, there is no question that they would have been lobbying both Bernanke and Congress along the lines that if AIG goes bankrupt then Goldman would quickly follow, and we would see the armageddon situation that Lehman Brother's collapse created all over again. So far they have been successful in arguing that cause.

While AIG has thus far been able to cover derivative losses using government funds, the possibility of large additional losses is not out of the question. AIG recently stated that it still has about $1.6 trillion in "notional derivatives exposure". If AIG ends up with losses equal to 20% of this exposure, for example, that is $320 billion. Assuming that the value of AIGs current assets, including the shares in its insurance subsidiaries, is $160 billion. In this scenario the government's full backing of AIG's obligations would produce an additional loss of $160 billion for taxpayers. Should the government be prepared to do so?

I accept the argument that a complete failure of AIG would have unacceptable consequences. The relevant question the US government and the media should be asking, aside of dumping all of this on taxpayers, is what combination of parties is going to absorb the losses. For me, any reasonable answer to that question would include Goldman Sachs, Merrill Lynch, Deutsche Bank and Societe Generale (to name a few), who were major contributors to this situation and should be contributors to this particular collateral-damage minimization relief fund.

If they are to contribute, the plan must be something other than simply doling out another $100bn every few months to try to keep AIG going a little longer. I would advocate splitting AIG into a core business that the US government wants to protect, with enough equity to be a viable operation, and a derivatives business that is going to be systematically liquidated in large part by rescinding outstanding contracts. In this case, AIGs creditors, including its derivative counterparties would obtain the company's assets and suffer whatever recovery rate on their claims that the market would allow. To clarify further - AIG is a holding company, conducting most of its business through insurance subsidiaries organized as separate legal entities. The Financial Products subsidiary, where the large derivative contracts and their losses sit, is also a separate legal entity - but thus far AIG has guaranteed this subsidiary's obligations, using taxpayers funds to do so.

AIG recently stated that failure to meet all of the company's obligations could lead to a "run on the bank" by customers seeking to surrender insurance policies and "would have sweeping impacts across the economy". Insurance policyholders, however, wouldn't be at risk if AIG failed to meet its obligations. The insurance subsidiaries aren't responsible for the debts of their parent company AIG, and insurance policy claims are backed by the subsidiaries specific reserves and state insurance funds.

Returning to the question of concerns that losses to the derivatives counterparties would substantially deplete the capital of some of them - that concern would be best addressed by the US government (or foreign governments) infusing capital directly, in return for shares, into the banks that require it. There is no acceptable reason to back AIG's obligations as an instrument for infusing capital (with taxpayers getting nothing in return), into the likes of Goldman Sachs or Deutsche Bank. It is true that the collapse of Lehman Brothers last September led to a crisis of confidence in the markets, and in particular among depositors in banks and money market funds. Letting AIG's derivative counterparties take a significant haircut, however, should not lead to a similar crisis. AIG's obligations are to derivative counterparties, who are professional risk assessors, and not to depositors. While there may be a run to sell shares in these institutions if forced to take a haircut, there would be no bank run as such. It is only reasonable to expect these guys to assume some of the financial burden of AIG, and it certainly isn't reasonable as has been the case so far, to place the full burden on those who had nothing to do with the situation.

Prosperity makes friends, adversity tries them...

"The economy in Ireland has been rampaging ahead for the last 15 years. Barring an international, political or natural catastrophe, things can only get better for the Irish." This was the US comic Eddie Murphy's 'insightful' take on Ireland a few years ago. Amidst its silliness, there's a funny sort of accuracy. Until the current financial crisis, Ireland managed to dodge international, political and natural catastrophe quite nicely, and funnily enough the "Troubles" went away. Now there is an economic crisis, and it would seem the "Troubles" are back.

To what extent they are back remains to be seen, perhaps the recent violence is isolated, and not representative of the broader community perspective. For my money, though, the single biggest thing that brought peace to Ireland in the last 20 years was economic prosperity - community and religious lines faded amidst greater opportunity, and would-be terrorists were given the chance of economic independence; a home and a reasonable standard of living to support their families. Not all took the opportunity, but more and more did. Belfast in particular grew into a confident and prosperous city. Billions of pounds of investment has been pumped into the city. The Victoria Square shopping complex, boasts the most successful House of Fraser in the UK and the soon to be completed £85mm Obel Tower Complex, which overlooks Belfast Lough, had all of its 180 apartments reserved within 48 hours of going on the market.

Undoubtedly, Belfast's middle classes have benefited from the "peace dividend". Some areas have experienced unbridled growth and prosperity, which albeit on the wane currently, won't be any worse affected by the global financial crisis than other prosperous parts of the UK. Other less fortunate areas, such as the Drumbeg Estate in Craigavon are destitute, however. Among rows of grey, pebble-dashed, terraced houses, the rates of suicide, drug abuse and unemployment are high, and there is likely a pervasive and growing sense of hopelessness, as what existed of a local economy falters. The disaffected youth whose prospects are pretty weak, provide excellent recruiting material for dissident Republican or Loyalist groups. It's scary to note that one of those being questioned in Craigavon about PC Stephen Carrolls murder is only 17 years old - he was only 5 when the Good Friday Agreement was signed. His formative years were relatively peaceful years in Northern Ireland, so why has he fallen by the wayside?

Many political commentators would like to suggest that political will, and effective negotiation were the most important tranquilizers in Northern Ireland. It certainly suited political needs to say so. While the Good Friday Agreement was an amazing political achievement, taking people off the breadline by creating real jobs and the opportunity for personal and family prosperity I think was the biggest catalyst in the peace process.

With economic prosperity failing, I can't help but associate the recent violence with diminished prospects for potential troublemakers. The Northern Irish economy is expected to fall in size by 4% this year, and while unemployment at close to 6% is better than the UK average, there is no real job creation in the region outside of public sector work. The growing fear of social unrest as the economy falters isn't isolated to Ireland. Across the world age-old hatreds will sadly be reproduced and falsely blamed for hardship and diminished opportunity.

Despite inch-by-inch progress, community divisions were never truly removed in Northern Ireland, only that their relevance became less pressing when greater opportunity was prevalent. To show how much has stayed the same in the region, it's interesting to note that as of 2009, 95% of children in Northern Ireland still go to religiously segregated schools. Cross religious or community divides were faded by prosperity, but not truly addressed. The "catchment" age for many of the Unionist or Republican terrorists in Ireland, or anywhere else for that matter, is likely to be between the ages of 15 to 25. If prospects are low for this age group, there is an increased likelihood of "taking up the Cause", and entering the armed fray. The killings of three members of the British security forces in Northern Ireland last week has brought back memories of some very bad times in Irish history. At an official level there has been a concerted push to suggest that the killers are isolated have no support from the community.

In an article in the Independent this week called "Real IRA, Real Life" there is an interview with 'Mark', who is an officer in the NI Police (PSNI), who suggests that at ground level this just isn't true. "Not a single person at ground level really believes it. Everybody knows there is support for them." He points to the walls of the housing estates in County Down close to where PC Carroll was shot on Monday. The stencilled images of gunmen right by the murder scene provocatively flanking the words "Still at War". In Craigavon, where Constable Carroll died, the local newspaper said people "joined together to speak with a single voice" in opposition to his murder. Politically sound words, but fundamentally not true. There was a candlelit vigil, and flowers were laid, but after a 37 year-old man and a teenager were arrested there was also trouble. Wheelie bins were set on fire, and memorial flowers were vandalised. The "unsaid" is that there is strong community support for what has happened.

The story told by the Northern Ireland tourist board to those who are coming for this weeks St. Patrick's day parties is one of great economic success and transformation. Peace and prosperity have lasted longer than a decade, and it's clear to see. Great old buildings have been restored and new ones built, money has poured in from across the European Union and the US, jobs have been created and cafes and swanky new restaurants opened. All of this very real prosperity is at risk though, as it is in most places on the planet currently. Much of this new wealth is unsustainable in the same way it is elsewhere.

When the tourist board markets destination Belfast, it fails to mention, unsurprisingly, the high concrete and steel peace walls running through the town, which are not historic attractions but very practical obstacles to people fighting each other. The city has 40 peace lines, which is almost twice as many as when the Good Friday Agreement was signed in 1998.

As the prospects for teenagers in Belfast diminish, so does the likelihood that the recent violence is an aberration. As the disillusioned and unemployed look for a place to vent their anger about their misfortune, they will more and more likely revert to the ways of old. "We have a hot-blooded youth here in Northern Ireland" says Daniel O'Sullivan, a Belfast youth worker. "They only see the glamour of the olden days. They want to identify with something that is rebellious. The older people will tell you that history repeats itself: that the original IRA became respectable, and the Provisionals arose out of that. There is a very real danger that it is happening again. The difficult economic environment is making it more and more likely, as the alternatives for the young are diminishing."

The recent violence in Ireland is synonymous with other politically charged violence elsewhere in the world. The consequences of the global financial crisis stretch considerably further than diminished pension funds or distressed banks. The social consequences of increased unemployment, and a sense of reduced opportunity stretch far and wide. It may be coincidental that cross community tension is increasing in Northern Ireland, at a time of economic distress, but I don't think it should be surprising. Throughout history, the correlation between economic prosperity and rates of social dischord is extremely high - and I don't think it will be any different in the current economic crisis. Prosperity makes friends, adversity tries them.

It's not rocket science. It's social science...

"The great advantage of the mathematical sciences above the moral," wrote David Hume in 1748, "consists in this, that the ideas of the former are always clear and determinate."

For example, Hume went on, an oval is never mistaken for a circle, nor a hyperbola for an ellipsis. Yet for the moral sciences, which in the 18th century started to embrace the investigation of the mind and society as well as questions of right and wrong, there was no such precision. "Ambiguity," Hume said, "is gradually introduced into our reasonings."

With that passage the fat Scotsman waddled off to join the wildest wild-goose chase in the history of western thought, which is the attempt to capture for the various sciences of humanity the precision and prestige of mathematics. This desire for universal mathematical laws to govern the behaviour of human beings has burdened the Western world with all sorts of harmless and less harmless nonsense, from astrology to economics.

In other words, mathematical and statistical physics, as the thinking goes, has attained such a sophistication that its insights into the behaviour of particles of matter can be transferred to the mass behaviour of human beings, whether investing in the stock market or racing for the exits after a fire at a football ground. Maybe it's a pathological part of human behaviour to seek certitude and avoid ambiguity at all cost, but the results of this quest tend not to be so hot. The requirement for certainty created the environment that led us to believe that a new economic paradigm had been created over the past 20 years, that would be forever sustainable. Monetarism worked very well, and we thought we had the economic equivalent of the Laws of Thermodynamics. Similarly as economic policy-makers look for the silver bullet solution to the worlds problems, they are probably mis-guided. Human behaviour is far more ambigious than the Natural world.

I'm currently reading a book called "Critical Mass - How one thing leads to another", by Phillip Ball. In this book Ball provides the very latest applications of "social physics" to urban planning, the movement of pedestrians and motor traffic, stock price movements, trade, the rise and fall of corporations, diplomacy, political alliances, voting patterns, the composition of city neighbourhoods, criminology, matrimony, the transmission of culture and fashion, circles of acquaintance, the internet, sexual epidemiology, weapons of mass destruction. In short, it's not far off an attempt at the concept of a "Theory of Everything".

Whether the experiments concern pedestrians crossing the campus of Stuttgart University or Brazilians electing their state governments, the book presents patterns and distributions which apparently resemble those identified by physicists, such as the Ising model of how atoms magnetise or the sudden "phase transitions" that occur when water melts or freezes. The experiments in political or social organisation produce results that "parallel" or "look exactly like", patterns in experiments in natural science.

Personally, though, I'm not convinced. There is clearly some value in understanding trends and the statistics that apply to those trends. An over-reliance on these stereotypes, however, can quickly become a dangerous factor when trying to apply policy and governance. The notion of consistency in human behaviour is considerably different to the consistencies we see in natural physics. Gravity is considerably more predictable, than say the reaction of an economy to a rise in inflation, yet many economists would treat them both as constants.

Social behaviours are dynamic, and the problems are moving targets. In particular, to use George Soros' terminology, applying social science to human behaviour creates "reflexivity", where the biases of individuals enter into market transactions, potentially changing the fundamentals of the economy. A current example of reflexivity is that of the debt and equity of housing markets. Lenders began to make more money available to more people in the 1990s to buy houses. More people bought houses with this larger amount of money, thus increasing the prices of these houses. Lenders looked at their balance sheets which not only showed that they had made more loans, but that their equity backing the loans (the value of the houses), had gone up because more money was chasing the same amount of housing (roughly). Thus they lent out more money because their balance sheets looked good, and prices went up more, and they lent more etc. Prices increased rapidly, and lending standards were relaxed. The main issue regarding reflexivity is that it explains why markets are volatile over time, and do not tend towards equilibrium - they tend to overshoot or undershoot.

On the flipside, because "Natural Laws" like gravity are unthinking and generally unreactive, they do not have biases and consequently don't change their behaviour because of past theories that have been applied to them. To clarify further - the main ingredient in economics is psychology, and the workings of psychology clearly can't be fully known, controlled or fixed. In Nature, there are established and agreed First Principles, that by and large are unchanging through time. In the social sciences, there aren't even agreements on First Principles, and although a form of Chaos Theory could be applied, the capacity for a useful mathematical approach to social science is still a long way off, yet many social scientists speak as if they have uncovered universal truths.

Here are some of the current cunundrums, troubling those who are addressing the world economy:

Consumer confidence and spending are weak. We want to stimulate, but we don't want to replace weakness with hyperinflation.

We're willing to drop fiscal discipline in favour of deficit spending, but we don't want to scare away offshore investors from the government bonds we'll issue to fund our deficits.

We're willing to distribute stimulus cheques, but we seem unable to make frightened individuals spend the money rather than save it.

We know consumers got into trouble by spending more than they earned, and now they should build some savings. But whereas in the recent past consumer spending grew faster than incomes, a rising savings rate means spending would grow slower than incomes, just at a time when incomes are falling and spending is needed.

Likewise, with tax revenues down, governments, states and local authorities have to balance their budgets. One way would be to raise income tax and sales tax rates, but this will further depress local economies and increase the burden on their beleaguered citizens.

We want to recapitalize the banks, but we don't want to reward past mistakes and accidentally encourage those mistakes to be repeated.

We're thinking about buying the bank's bad assets, but if we pay above market prices that's a subsidy to the reckless at the behest of the cautious. If we pay at market, or below market prices, that will further erode the capital base of the banks in question.

We want the banks to lend, but we can't let them make loans to non-creditworthy borrowers.

We don't want the depressing impact of auto companies going bankrupt and suppliers and dealers following suit. But we also don't want to pump money into the industry unless it can produce the right cars at the right prices, which they haven't done for years.

We want to curb speculation in derivatives, but we don't want to make it harder for businesses, farmers, insurers and investors to legitimately hedge risk.

We want to prevent excesses on the part of business, but most people don't think it's a good idea to nationalize companies or have the government tell them how to operate.

Each of these issues and many more need to be addressed in some way through changes in government policy. Each are conundrums because they are dependent on the reactions of the people in the world economy, where there is no established "cause and effect" relationship. Each response will likely have some good effects and some bad effects, but anyone who claims to know the long term implications of these policy responses is probably mistaken. As Thomas Friedman put it in the NY Times:

"Everyone is looking for the guy - the guy who can tell you exactly what ails the world's financial system, exactly how we get out of this mess and exactly what you should be doing to protect your savings... but here's what's really scary: the guy isn't here. He's left the building...
There is no magic bullet for this economic crisis, no magic bailout package, no magic stimulus. We have woven such a tangled financial mess with subprime mortgages wrapped in complex bonds and derivatives, pumped up with leverage and then globalized to the far corners of the earth that, much as we want to think this will soon be over, that is highly unlikely"

In an effort to be 'that guy', the "I know" school of social scientists is still making predictions. Statistical comparisons are being made to past recessions and solutions extrapolated from those experiences. There are projections of a stock market rebound based on the average time between past declines and the recoveries therefrom. I am glad that the engineering concepts that apply to the plane I plan to fly in tomorrow are not based on such pseudo-science.

To the conundrums above, I don't know the answer. I think it would be healthy if more of the "scientists" who helped to create this mess also stood up and acknowledged the likely shortcomings of all responses. I'm not saying that there aren't better solutions than others, but more that it is more art than science, and that ambiguity needs to be embraced as opposed to ignored.

In the film "Charlie Wilson's War", about US covert operations in Afghanistan in the 1980s, a CIA officer played by Phillip Seymour Hoffman tells a cautionary tale about the need for humility in those who make America's moves on a global chessboard. I think it applies similarly to the requirement for humility amongst social scientists.

On his 16th birthday, a boy gets a horse as a present. All the villagers say, "How wonderful!" The Zen master says, "We'll see." One day, the boy is thrown from the horse and is hurt and can no longer walk. All the villagers say, "How terrible!" The Zen master says, "We'll see." A short time later, war begins, and all the young men of the village are taken away to be soldiers, but this boy can't fight, so he is spared, and all the villagers say, "How wonderful!"

And the Zen master says, "We'll see..."

Specialisation isn't so special after all...

Robert Rubin, the former US Treasury Secretary, once commented in relation to economic policy-making that "I wish I could be convinced of something as much as some people seem to be convinced about everything". Modern society is based on economic theories around specialisation, trade and exchange. Employees specialise in given occupations, machines specialise in certain tasks, regions and countries specialise in producing particular goods and services. If people and other resources concentrate on things which they do relatively well, then everyone usually benefits. Specialisation results in an increase in output and well-being. Easy, uncomplicated - so happy days. Well, not really.

Individual specialisation has been pushed as the centrepiece of "how to get ahead", yet the conviction that economists have applied to specialisation seems overstated at best. At earlier and earlier ages children are being tested and pushed to make decisions about where to focus their energies; what subjects to take, what sort of qualification to go for, and ultimately what sort of career path to choose. Specialisation is seen as the way to differentiate oneself from the crowd, and consequently to have a skill that is in demand in an increasingly competitive world. There are obviously some clear upsides to this strategy, but the pressure to define these specialisations at an early stage is also potentially quite damaging. It's not OK, it would seem, to not know what you want to be when you grow up. I tend to keep it quite quiet that I still don't know what I want to do when I grow up.

Simple trade theory suggests that it pays individuals to concentrate on what they do best. If I can earn £10 an hour from writing this website and it only costs £8 an hour to have someone paint my house, then it will make sense for me to sit and write while the decorator paints. (On these terms alone, however, I probably shouldn't be writing this blog, as £10 per hour is £10 more per hour than I get, and there are some who read this who would probably say that I'm paid too much.) While the efficiency gains of specialisation are clear to see, I think there are dangers to this route that typically aren't considered. If the blogging world becomes oversupplied with outstanding work, then my competitive advantage would disappear pretty quickly, and in the meantime I have become inept at house painting. In a globalised world the speed at which competitive advantage can disappear is very quick. There are a heightened number of "circuit breakers" that could make my particular skill, whatever it is, redundant very quickly. In the current environment, these "circuit breakers" are unravelling the premise on which individuals, businesses and countries have established their economic situation. With hindsight in many cases it would have been helpful to have a fall-back, or to not have become "one trick ponies".

The world's farming community are a good case in point. Fifty years ago farmers in the area near to our house in Kent were considerably more diverse in what they farmed than they have been forced to be recently. Farms might have had a mixture of arable and dairy, and considerable diversity even within those two groups, and their export markets were literally within a radius of 50 miles, where they would sell their fare at country markets on a Saturday morning. Nowadays, specialisation, driven by the need to increase efficiency has meant that farms tend to be one dimensional - even just being an arable or dairy farm is too broad to compete. Their export markets are truly global, and they are competing on a global scale, which doesn't just create opportunity. We take it for granted that all year round we can buy bananas from Guyana or carrots from Guatemala in our local Tesco. From the consumers perspective, this is great progress, but the threat to producers because of specialisation can be underestimated, as they are sacrificing flexibility for efficiency. In some cases this is a healthy trade-off, but in many cases not.

I find it staggering when flying around over Manston airport in east Kent, to see Egypt Air jumbo-jets landing with great regularity, delivering the next load of exotic fresh flowers from Kenya. These flowers have been picked the day before, flown up to Amsterdam, repackaged and flown across to the UK for delivery onto shelves of supermarkets across the country all within 24 hours. How can it make economic sense to fly a jumbo-jet laden with fresh flowers all that way, to satiate an annual demand for what we no-longer consider a "luxury"? It clearly does make economic sense though - the cost of production in Kenya is sufficiently low, and scale sufficiently high, that this export market works. Nonetheless, the Kenyan farmers have an un-hedged, specialisation that could very easily become unsustainable quite quickly. If an effective carbon trading scheme is put in place, and an appropriate tax applied to the flowers to compensate for the carbon emissions created in their long-haul transfer from Kenya to Stockport, then the market for these fresh flowers could crash precipitously, and we would go back to buying our roses from the farm shop 5 minutes walk from our home. Specialisation, doesn't seem to allow for flexibility, as there is an assumed efficiency cost to that flexibility. It also means that the number of shock points to that market are higher than they would be without specialisation. The good times are good, and the bad times are awful.

In the unfolding mess that the world is suffering through, those who have followed the economic gospel according to specialisation are likely to be hardest hit. High-value added manufacturing is to Japan what financial services are to the UK. Both countries have most of their eggs in one basket. When the good times are rolling, specialisation works beautifully as the high-value-added sectors pull along the less efficient areas of the economy. The price for the high profitability is high volatility. Japan's banks, unlike those in the UK, were fairly conservative when it came to bank lending - being generally too cautious to dance the subprime two-step. Ironically, though they have fared worse on macro terms than the most cavalier of the world's advanced economies. Output in the fourth quarter shrank an amazing annualised rate of 13.2%, which will lead to the worst performance of the Japanese economy since the Enola Gay dropped the atomic bomb on Hiroshima. Japan's dire performance is almost entirely linked with the collapse of exports, which fell 35% in December and 46% in January. The free-spending trading partners for Japan, have suffered and consequently their consumption capacity is diminished, but Japan and others in a similar position, have been hit harder than all, even though they appeared more conservative than their trading partners.

Other "specialisation" basket cases include South Korea, Singapore and Taiwan. Taiwan in particular, is amongst the worst performing of advanced economies. Unlike Japan, they don't have many of their own brands, but were a really key part of the supply chains of other nations manufacuring processes - supplying the microchips and flat screens that Sony or Hitachi would use to make their TVs or computers. When trade is flowing, it has been an indispensible part of the global supply chain. Now that the end user is broke and trade has seized up, its economy is rapidly grinding to a halt. Taiwan's most recent quarterly GDP figures, point to a seasonally adjusted annual contraction of more than 20%. That's not good.

Ironically, it is at times like these that poorer, less sophisticated economies that have committed fewer resources to now-obsolete machinery breathe a collective sigh of relief. Workers in China or India for example can be sent back to their villages, in theory to a more subsistence-based rural economies, while the expensive machinery on a hire-purchase agreement in other countries remains obstinately in place. China is expected to grow at between 6-8% this year as the government piles its substantial cash reserves into make-work programmes. That's a decent drop from the double digit growth rates of the last few years, but certainly a more manageable situation that that of Taiwan. Similarly India, where human capital plays a disproportionate role, could grow by 7% this year. India is considerably less dependent on exports than China, though with less of a cash-pile with which to crank up domestic demand through fiscal policy.

All this is not to suggest that free trade, and the specialization that goes with it, is not in the best interests of all parties. The problem with the economics of it, though, is that the social consequences of specialization, are often not accounted for in the efficiency gain calculations. The urbanization that characterizes the developing world is part of the social cost or benefit that needs to be considered, for example. In India, and China, as the urban unemployed return to their villages the impact on the rural structures that they had left behind may not be that simple. Why should a rural farmer who had encouraged his son to take up his legacy, but was denied because of the appeal and opportunity of the urban environment, suddenly embrace his son now that the has changed his focus again.