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A System of Connections

Summer re-run season has me terribly bizzy.  This is a repeat from eight years ago which informs the basis of People’s Economics.  

The art and skill needed to put knowledge to practical use is more than just what technology is really about – it’s generally seen an increasing share of our economy.    The term “Knowledge Economy” comes from Peter Drucker in his 1966 book, “The Age of Discontinuity”.  It includes this:

In a knowledge economy where skill is based on knowledge, and where technology and economy are likely to change fast . . . the only meaningful job security is the capacity to learn fast.

True enough, since a lot of knowledge applied as an art went to revolutionizing economics itself since that time.  But as many of us have learned, the ability to think fast means nothing without the right connections.

You’re declaring all this income, right?

An economy starts with a marketplace.  People who want something connect with those who have something to sell, prices are negotiated, and money is spent on stuff or services or investments.  Merchants with a stall in a central square evolved into institutions that use systems that make it all work.

Each exchange is a connection, and the larger the market the more connections.  Ancient marketplaces eventually came to be where you could pawn goods or borrow money, not just buy stuff.  By the Renaissance, coffeehouses in market squares became places where people bought and sold investment contracts and gradually evolved into what we’d call the stock market.  One of the things this made possible was the growing Knowledge Economy itself, where companies amassed invested capital to create institutions, corporations, that connected specialized skills into something very new.

What’s the risk?

The problem with investing is always risk – the possibility that your investment will payoff or even be paid back.   Traditionally, the way to handle risk is to specialize in an area of investing that you know very well.  That’s when new knowledge came to the old investing institutions.

Around the time Drucker wrote about a Knowledge Economy, the Black-Scholes-Merton theory was being developed.  This magic equation stated that if you properly insure every investment, you can invest with a decent return risk-free.  The market could price the insurance through a long-term contract called a “derivative”.  Capital could flow to new areas and we’d all be rich.

If this sounds like something from nothing to you, it’s probably because you know how it all turned out.  But there’s some fascinating econo-geek stuff to hit up first because it was actually proven that this is something from nothing – but no one wanted to hear about it.

That’s where Graciella Chichilnisky, an Econ prof at Columbia gets to spoil the fun.  Her work in the 1990s centered on “endogenous uncertainty” – the risk that you take on through your own actions even if you don’t know it.  By spreading your risk around the market you form a network of connections that, in the long haul, make the market itself less stable.

You know who she is.

Any given investment may look perfectly risk-free, and thus more valuable, but it simultaneously makes it more likely that everything will one day come down.  The warning shots were named LTCM and Enron, but as we all know she was proved to be true in a big way in 2008. Cash reserves, or at least insurance, were needed to make the system stable, but that would have stopped the party before it started.

Why didn’t we see it coming?  The more traditional way of managing risk, specialization, meant that many of the investing institutions didn’t understand how the quality of mortgage backed bonds influenced the price of tea in China. What those brokers missed was how heavily connected their investments, their risk assessment, and everything was to the whole rest of the financial world.  They ignored it all so that they could concentrate on what was in front of them because it was what their investment institution paid them to do.

Things got badly out of whack as waves of what seemed to be risk free money washed through the bubbles of tech, housing, and eventually commodities. Obviously, that bubble has burst, which is where Restructuring comes in.  That shouldn’t be a problem for a sharp “knowledge worker” who can think on their feet, right?

Is there a skills gap? Apparently so.

Well, it isn’t working that way.   Specific skills allow a worker to come into a job quickly without a lot of training. Want to be noticed in this market?  You have to network, which is to say make a whole lot of connections you didn’t have before until you find the people that need you.  Companies, as institutions, are focused on getting things done right now.

The promise of a Knowledge Economy hasn’t been fully realized for the simple reason that even management and economy technology is more about skill than knowledge.  It doesn’t come together in the mind of one well-rounded and sharp thinker, it assembles through the connections from one skilled worker to the next.

It’s not as though Drucker was wrong about the role knowledge would play in our economy 43 years on, it’s that he made a mistake that we keep making – people and their skills and their connections are still more important than knowledge itself because that’s where the art is put into practice.

It’s as if we’re living one big “That sure seemed like a good idea at the time”.

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