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The Actuary The magazine of the Institute & Faculty of Actuaries

The new economic paradigm

T here has always been a degree of tension between economists and actuaries economists have tended to view actuaries as crude statisticians who assume that because things have happened in a particular way in the past, they will continue to do so in the future; actuaries have tended to view economists as purporting to be scientific but in practice applying very unscientific and largely subjective theories to matters that should be looked at with a much higher degree of scientific rigour.
When the Institute of Actuaries debated the motion ‘This house believes that the contribution of actuaries to investment could be enhanced by the work of financial economists’, one of the opponents of the motion accused economists of being ‘guilty of promoting a narrow-minded stone-age methodology which has no relevance to the financial world in which we actually live’. He went on to assert that ‘the promotion of theories involving linearity, normal distributions, and equilibrium by financial economists is little short of fraudulent’ and that ‘the general methodology of financial economists is unscientific in the extreme’.
On the other side, the recently published review of the actuarial profession by Sir Derek Morris, a distinguished Oxford economist, accused the profession of being ‘insular’ and ‘slow to adopt new approaches and techniques’ resulting in ‘useful inputs from the disciplines of economics, statistics and demography, to name only some, having less impact than they should’. Sir Derek goes on to argue that ‘these criticisms may be thought all the more telling in that actuaries were relied upon as being particularly well qualified to assess such matters’.
With the pensions crisis by no means behind us, it behoves both professions to adopt a more humble tone and to try to see where their different contributions can augment each other.

Going global
One of my current interests is in the structural changes in the world economy that are taking place. It stems partly from the fact that I was brought up in Malaysia and as a result my master’s thesis at Oxford was a study of the first two offshore electronics plants around Kuala Lumpur (Motorola and Texas Instruments). It was clear even then (in 1973) that this was likely to transform at least the local economies. Now that mega-economies like China and India are getting into the act, the effects are not just local but global.
What has happened essentially is that the globalisation of trade and communications has meant that for tradable goods and services, any business’s potential labour force is international.
What makes this particularly interesting is that in areas like China, reasonably skilled labour is available at between 5% and 10% of its cost in the US or Europe. Productivity may sometimes be lower, but even allowing for this the potential unit cost differential is huge, and it is this that is driving the movement of manufacturing to China and the increasing ‘offshoring’ of business processes to India.
Normally, competitive advantage on this scale is only temporary as the regions with cost advantages attract more business, their costs go up and as their exports grow, their exchange rates normally rise. In the case of the emerging economies in Asia this process is being short-circuited by two factors:
– there is still a huge pool of potential employees that has not yet been tapped; as a result there is and will be for a generation or so sufficient supplies of labour to prevent a labour shortage from causing serious wage inflation;
– these economies are deliberately keeping their exchange rates low to keep their labour costs attractive and also to avoid the risk of overvaluation which was associated with the Asian currency crisis in 1997.
As a result, rapid growth is likely to persist in the dynamic Asian economies for the foreseeable future figure 1 opposite shows how cebr forecasts for Asia compare with those for the other regions of the world.

Demand for commodities
One of the effects of this rapid growth is that it is redrawing the world’s economic map. At the moment in cash terms the Chinese economy is about a sixth of the size of the European economy (though much of the differential reflects China’s lower cost of living if this is adjusted for the economies are already much the same size). In ten years’ time we expect it to be about half the size, and in 20 years’ time we expect it to be larger than the European economy.
One of the other effects is that the emergence of new dynamic manufacturing economies is influencing the demand for primary commodities. Between 1975 and 2002 the real price of non-oil primary commodities fell by four-fifths. Since 2002 it has risen by around 40% and the price of oil has roughly doubled. I would expect that the trend for both oil and other primary commodities will be for price rises well above inflation, though this is unlikely to be a smooth process.
There is a problem for western investors and fund managers if world economic growth turns out to be heavily concentrated in Asia, which is that not all of the emerging economies in Asia have mature markets for equity investors for example, most of the top companies in China remain unlisted, like the leading telecommunications equipment manufacturer, Huawei, and so cannot be invested in easily. So pension funds may in effect be largely restricted from investing in the most economically successful parts of the world and may have to confine themselves to the slower-growing businesses elsewhere.

Another major change in the way the world economy works is the emergence of technology as a much more important driving force. Technology is not new, but in the past it was incorporated into the world economy at a sedate pace. The railway was one of the more rapidly diffusing technologies but in most countries took 20 to 40 years to develop. Electricity was much slower even 50 years after it started to be used on a reasonable scale, fewer than half the factories in the US used it. By comparison, modern technologies like broadband are spreading many times quicker the internet has reached about 80% saturation in a decade.
As the world economy becomes more dependent on technology which is after all only a form of information the extent of economies of scale becomes much more important. Information is expensive to produce for the first time but can be replicated at virtually zero cost, which can drive huge scale economies.
Also, modern technology often has what we technical people call network effects where the use of the technology by one user is positively enhanced by the growth in usage by other users. One wonders who ever bought the first telephone and why modern communications technologies require critical mass to be of use.
The increased importance of economies of scale and of network effects are changing the business paradigm from a traditional model which was in effect incremental to one where even the initial investment has to be large to achieve critical mass. This makes business much more inherently risky and probably itself creates a dynamic that encourages high levels of investment in research to try to get ahead of competitors and land a knockout blow to scoop the market and achieve the desired economies of scale think Microsoft and Windows.

Ever-decreasing circles
Most actuaries by now are well aware of the changing demographics of the western world and the implications for pensions. But one issue that is currently concerning me is that if, as seems likely, future generations are going to have to save much more to fund their retirement, the balance between savings and investment will alter. My fear is that we will inevitably find an increasing surplus of savings which could well drive down yields below even the historically low levels that we have at the moment, let alone historical rates. Moreover, the problem can make itself worse, because if savers expect lower returns and still want to have the same retirement incomes, they will have to save even more, which will drive returns even lower.
The driving force behind much technological advance over the past quarter of a century has been electronics, which in turn has pushed information and communications technologies forward.
But most scientists seem to be claiming that we are now moving into a period where biotechnologies are becoming increasingly important.
One of the most important applications of these technologies is likely to be medical, and this could feed back to play havoc with anyone’s demographic assumptions. Currently a male retiring at the age of 65 might hope to live for a further 18 years. The Government Actuary’s Department’s principal projection is that by 2050 this might stretch to 22 years. But if life expectancy continues to rise at the rate that it has done over the past ten years then it might get as high as 33 years. And biotechnology for example stem cell research might make this happen.
Pity any pension fund manager having to cope with this, let alone a corporate ‘sponsor’ supporting a defined benefit scheme in these circumstances.
What we economists spend a lot of time doing is trying to quantify the implications of the sorts of trends that I have been describing. We try to make the process as scientific as possible but sometimes it is not possible and then we have to be pretty subjective, based on our experience and judgement.
I doubt if the majority of actuaries would feel particularly comfortable at trying to quantify the implications of most of the trends that I have mentioned indeed not all economists would attempt to do so. But I think that it is in areas like this where we economists can potentially be of best use working in partnership with actuaries. It is to be hoped that we can both draw from our strengths to yield superior results.