Economic Decision-Making in a Changing World

40 years ago from the time of writing it was 1948. Of course it would have been too good to be true if that year had appeared very special with respect to our subject, economic decision-making. But the 1940s as a period indeed are very special in this respect. Not only had John von Neumann and Oskar Morgenstern published their book Theory of Games and Economic Behaviour in 1944, but also the articles by Abraham Wald on statistical inference and uncertainty appeared in 1947, while moreover in that same year the first national Modernization and Equipment Plan for France was completed.¹

Economic theory has a long tradition of interest in risk and uncertainty. The relevance of these concepts for the understanding of entrepreneurship and the analysis of market mechanisms was recognized as early as 1921 in the famous book by Frank H. Knight on Risk, Uncertainty and Profit. In line with the neo-classical tradition Knight stated:

If all changes were to take place in accordance with invariable and universally known laws, they could be foreseen for an indefinite period in advance of their occurrence, and would not upset the perfect apportionment of product values among the contributing agencies, and profit (or loss) would not arise. Hence it is our imperfect knowledge of the future, a consequence of change, not change as such, which is crucial for the understanding of our problem [Knight, p. 198].

It is a world of change we live in, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little [Knight, p. 199].

After a careful and interesting analysis Knight concludes a distinction between measurable uncertainty and unmeasurable uncertainty.

Let me introduce what I consider to be a major challenge of the 1990s for executives in both private and public organizations with a paradoxal observation on the 1970s and 80s. On the one hand the past decades may be characterized as an era of accelerating technological progress. In particular information technology (IT) — the basic, all-pervasive innovation of the third quarter of this century — has progressed quite spectacularly, offering unprecedented opportunities for raising productivity rates in both the private and public sector and, consequently, for also raising macro-economic growth rates.¹ On the other hand, in contrast with the accelerating technological progress, growth rates in all Western countries have declined quite dramatically in this period. In the European Community the growth of GDP/employment declined from 4.4 per cent in the 1960s to 1.4 per cent in the 1980s (in the OECD from 4.1 per cent to 1.4 per cent). In the USA the decline was somewhat less pronounced, from 2.6 per cent in the 1960s to 0.7 per cent in the 1980s; Japan tumbled from 8.8 per cent to 2.9 per cent.² The challenge of the 90s is to do better, that is, to capitalize on IT’s potential to increase the effectiveness of individual organizations and, consequently, to increase productivity growth on the macro level.

Many misunderstandings exist concerning management information systems and artificial intelligence. It is a misunderstanding, for instance, that ‘attaining competitive edge’, ‘strategic information’ and ‘executive information systems’ will lead to sustainable competitiveness. It is, furthermore, a misunderstanding that negative experiences with management information systems (MIS), decision support systems (DSS) and Expert Systems (ES) could be ignored. The key issue for achieving competitiveness is to improve the performance of information-workers in organizations via the exploitation of information technology. Information Management (IM) has to provide ways for task-improvement at the job-site of an individual or a group, using their knowledge and experience. It has to present better ways of task-coordination, meeting the demands of flexible organizations and at the same time flexible information systems. It has to realize information infrastructures between and above organizations. Management is facing a challenging design activity, requiring a lot of intelligence and MIS-understanding

The close and ever-increasing involvement between the economies of the western industrialized countries creates a great need for the coordination of economic policies if the world economy is to function smoothly. The world economy is today dominated by three large economic blocs: the United States, Japan and Europe.

In the past two decades, Americans have become much more conscious of international economic and financial interdependence. The oil shocks of the 1970s brought home to citizens of the United States their dependence on that particular import. But the perception has been more general. As both imports and exports of goods and services have increased relative to GNP, more and more Americans are aware that their well-being is tied up with what happens in the rest of the world. Similarly the increase in financial interpenetration among the industrial countries, as capital has become much more mobile, has made Americans realize that what happens to interest rates and other financial variables at home depends to a significant degree on policies and events in other countries. Thus the perception of interdependence has grown with the increase in actual interdependence.

The framework of the world economy today is being affected by the occurrence of a number of great changes, and I believe it is possible to identify three fundamental trends that characterize these changes. Firstly, the progressive globalization of economic activity and the relative decline in the status of the United States are causing a shift in the world economic order: US economic leadership is giving way to a system supported by coordination and solidarity among the leading industrial nations. Secondly, the progress of technological innovation, which has been described as a third industrial revolution, is changing the pattern of industry away from mass production and mass consumption towards diversified production and diversified consumption. Thirdly, while the industrialized nations are exposed to the dangers of protectionism, they are continuing to seek out a new dimension for the free-trade system.

Europe has a long tradition in activist industrial policies aimed at identifying and at stimulating industrial sectors and firms which are deemed to be important by policy makers. The instruments used in these industrial targeting programs are vast. Credit policies, subsidies of all kind, protection from outside competitors, procurement policies, nationalizations of ‘strategic’ industries have been used to create and sustain ‘national champions’.

What is changing most in our world is the increasing interdependency of national economies. Since World War II, the volume of world trade has grown faster than world output. More recently, international capital transactions have been liberalized in many countries, thus leading to an increasing integration of financial markets. International capital transactions have been growing much faster than real transactions in goods and services. For instance, in the Netherlands gross non-monetary cross-border capital transactions increased from 16 per cent of national income in 1980 to more than 67 per cent in 1987. Financial markets react much faster than real markets to changes in economic policy and fundamentals. Therefore, the worldwide financial integration has enhanced the global interdependence of national economies.

In recent years the banks have experienced a change in their traditional function as financial intermediaries. One major development with regard to this has been that of securitization, a term used to denote the process whereby enterprises increasingly turn directly to the financial markets to meet their financing needs. On the other hand, the banks themselves have also contributed to this development by shifting part of their lending to the issue market in an attempt to improve their balance structure.

Economists understand financial crashes in the same sense as geologists understand earthquakes. They know the underlying processes (the plate tectonics of economics), but if you ask about the exact timing and magnitude of the next economic earthquake an unanswerable question is being posed.

Foreign Direct Investment (FDI) is a fascinating phenomenon. However its importance is widely underestimated. Let me give you some figures. The current level of FDI as a stock can be estimated to be roughly one trillion dollars. At present, this stock is growing rapidly. It could at its present rate of expansion double every three to four years in absolute size. If the assumption is made that this stock of foreign investment supports a turnover which is two to three times larger — which is the average ratio for industry — one arrives at a turnover figure which is close to the total value of world trade. Everybody recognizes the overwhelming importance of world trade for economic life. The awareness of the importance of world direct foreign investment for our economies seems much less, however. This, despite the fact that FDI often have a deeper and longer lasting impact on economies than trade transactions.

The relationship between international investments and protectionism is an evolving one. United States multinational enterprises have traditionally invested in Latin America for import substituting reasons. In other words, the foreign firm came in in order to take advantage of the internal market. In recent years, however, these firms have turned more and more to export markets, due to the collapse of purchasing power in Latin America. Japanese multinational enterprises, by contrast have traditionally invested abroad to take advantage of lower costs for the production of goods then reimported into Japan, and in general for exports on the world market. This tendency has accelerated since 1985, i.e. since the upward pressure on the yen began. There are other reasons for international investments but the two mentioned are the most important ones. International investments occur to take advantage of national markets, particularly when access becomes difficult due to protectionist walls. International investments also occur to take advantage of differences in labour costs as a springboard to conquer a corner of global markets.

The overall situation in the global debt problem has not improved substantially since it was widely recognized in 1982. The total debt of the developing countries increased from some 850 billion dollars in 1982 to some 1250 billion dollars in 1988. Such an increase is, as such, not a problem, if not the majority of these countries would still be in a position not to fully pay the interest and repay the principal and, as a consequence, not be able to attract new commercial and official loans on normal conditions. This will continue to be the case at least in the near future.

In August 1982, Mexico announced that it was no longer able to satisfy terms of its foreign debt commitments. This precipitated similar moves by other developing countries, and set in motion the debt crisis which has affected international financial markets ever since. Debt restructuring, in which governments of debtor and creditor countries, international organizations and commercial banks all played a part, represented the main response to the debt crisis. In the free markets themselves, however, two developments have stood out as the most important new techniques developed as a direct result of the debt crisis: asset trading and debt conversion.

The Scottish moral philosopher, Adam Smith — as economists will know better than I — presented the first complete system of national economics over 200 years ago. His work sheds light on the importance of the institutional framework for individual decision-making processes. Smith’s conclusions are still valid today. What is new is the speed with which the environment in which decisions are made is changing. One field where the change is particularly striking and far-reaching is international financial markets. The role Europe is playing — or can play — in the changing financial markets is the topic of this paper.

Historians will look back on the 1980s as a decade of predominantly Right Wing governments, favouring supply side economics and producing much-needed stability. A decade too of surprisingly high world growth, of controlled wage and raw material costs, of socially unacceptable, but industrially advantageous unemployment levels, and of startling corporate profitability. And they will see a decade where stock market and stock market players attained unnatural ‘highs’. It will be a decade with which favourable comparisons will be drawn because overall it may rightly be described as a decade of success, certainly by the standards of the 1970s. Indeed, since 1982 we have enjoyed a period of ‘slow, sustainable, controllable, non-inflationary growth’. A period also which witnessed some — but not enough — worldwide economic policy coordination and steady hard and soft commodity prices, including gold. However, all this is changing.

There are virtually as many techniques of exchange rate analysis and forecasting as there are currencies. These range from the judgemental or ‘kitchen sink’ approach to highly sophisticated econometric and technical models. This diversity makes life difficult in decision-making regarding foreign exchange. There are probably several steps, however, involved in reaching some practical conclusion regarding currency behaviour. First, it is important to have a clear idea regarding what constitutes a relevant theoretical model of exchange rate determination. Secondly, within the constructs of that model, it is important to distinguish between the ‘equilibrium’ exchange rate and an exchange rate’s dynamic path once it has been disturbed. Thirdly, it is essential to realise that events other than those captured by macro- or micro-economic analysis can influence exchange rate behaviour. It is necessary to have an approach which accommodates this. In many ways, a similar set of remarks can be applied to the analysis of interest rates. This paper illustrates how we, at Goldman Sachs, have approached the issue of decision-making in the foreign exchange and foreign bond markets.

An international investment company, investing in equities, located in the Netherlands but with shareholders all over the world, could have a number of possible goals: In setting its objectives the investment company also has to keep in mind that its investors have different preferences. For instance: should the ‘better return’ be accomplished in terms of a foreign currency or in terms of the Dutch guilder? Should the ‘better return’ be accomplished in the short term or in the long run? Should the ‘low risk’ be interpreted as a low standard deviation of returns, or as avoidance of negative returns, and in what currency should risk be measured?

This article begins with a few highlights of the changes now taking place in our environment. I shall address the issue of appropriate response to those changes from the point of view of an advertising agency. My thesis will be that agencies must help: by anticipating the future more precisely, by reacting more quickly, by maintaining an uncommon amount of flexibility in their structures and in their capacity to analyse, by understanding the altered implications for communication and persuasion more completely and, consequently, by better serving the more proactive thrusts of their clients.

As decision-makers, each of us grapples everyday with how to use information to move a very complex and often stubborn world. You may have found yourself saying: ‘Give me the right information, in the right amount, at the right time, and the right cost, and I can move the world — or at least the part I’m interested in.’ I’m convinced the way to do this is to use today’s information technologies in bold, new ways.

Today’s companies are starting to pay as much attention to tracking their competitors as to understanding their consumers. The growing attention to competition is reflected in today’s marketing concept, the contents of the steps of the marketing planning process and the growing number of analyses developed to diagnose competition. This paper discusses the consequences of the growing attention for competition in marketing management and marketing research. Most attention is given to the application of diagnostic methods to analyse competition using scanning data.