The rise of high-end finance work in India

Until recently, outsourcing by global financial firms to India conjured up an image of commoditised low end services outsourcing: call centres, peripheral systems programming, and testing and maintenance. However, in recent years, there is a new rise of more sophisticated work. This reflects supply and demand factors. Global financial firms are keen to cut costs. Capabilities of operations in India — both captives and independant firms — have grown for many reasons:

  • The individuals involved in this field in India have gained experience (”learning-by-doing”) and credibility.
  • New management practices and improved telecommunications technologies have improved the extent to which teams and projects are handled in a more non-local way.
  • The Indian diaspora has been rising to senior management levels in global firms, and is better able to envision what can be done in India and to obtain execution.

A European investment bank was among the first to experiment by bringing in teams in India into critical projects. This was a landmark change as a lot of inertia about confidentiality was overcome. Other banks followed suit. New management practices, higher pay, greater meritocracy came in, which helped Indian teams make the transition from low-end work where the HR and management techniques used are quite different. Demand for high skill labour has helped induce greater supply, with a lag, as individuals were more inclined to tool up with advanced degrees and high-end knowledge.

Alongside the developments in finance, parallel developments were taking place in the field of offshoring which have driven up skill levels, and helped create a high skill ecosystem in India. Top tier consulting firms launched `centres of excellence’ in India, hiring grads from IITs, IIMs, IISc, statisticians, economists. While education in India has huge problems, the raw talent available in India was of good quality, particularly when we focus on individuals who were able to read on their own and reinvent themselves (”never let your school come in the way of your education”). This process has been helped by globally recognised certification exams such as the FRM and the PRM.

IT firms have have been evolving from core development and maintenance to an entire gamut of IT strategy and consulting for financial firms. Many smaller KPO firms with specialised domain knowledge in finance have emerged, who cater to smaller hedge funds, trading houses, not just outsourcing increasingly complex pieces of work, but also advising them on the entire outsourcing strategy. All this has helped create a pool of high skill labour which is moving between multiple employers in India and able to build knowledge through diverse kinds of experience.

The most impressive development of recent years has been the growth of offshore trading units of global brokerages and trading houses, where people sitting in India take independent trading decisions in international financial markets based on their own skills and judgement. In some ways, this is the highest level of transfer of decision functions to India, albeit at relatively low monetary stakes.

In this fashion, within a period of 15 years, India had graduated from doing repetitive low value tasks to Knowledge Process Outsourcing (KPO) for the global financial system. While these activities are primarily in Bombay, they are also taking place in Gurgaon and Bangalore. The number of high-end finance workers in Bombay has never been greater than it is today. It is estimated that there are now 50 individuals working in Bombay doing work for global financial firms who have Ph.D. degrees in quantitative fields. This is starting to become a big enough number for them to talk with each other and get network effects going. From an employer’s point of view, it is now possible to shop in the labour market in Bombay and recruit a 10-man team all with Ph.D. degrees so as to get a new group going. This is a sea change when compared with conditions just a few years ago.

To appreciate this change a little further, it was interesting to take a look at some of the capabilities of finance focussed KPOs, divided mainly into 4 broad categories, catering to Sales and Trading, Middle office and Back office:

  1. Quantitative Research and Analytics Support:
    1. Equity and FICC Analytics: Model Validation, Price Verification jointly with clients: these are pretty quant heavy functions which require in-depth understanding of products.
    2. Technical and Fundamental Analytics.
    3. Index and Portfolio Analytics: Index maintenance, design, construction, operations and after sales, Portfolio tracking, decomposition and correlation analysis, performance measurement and attribution support.
    4. Derivatives and Risk Analytics: Measurement of derivatives Greeks, Value at Risk, Tolerance checks.
  2. Research:
    1. Equity and FICC Research: Company research, Credit Research, Economics research etc. to augment senior analysts in money centres.
    2. Trade idea generation and back testing: Sales pitches for clients and internal trading desks.
    3. Country, Sector, Company profiling, trends, news and projections: Pitch book generation and support.
    4. 24×7 weather patterns tracking for global energy trading outfits
    5. Overnight trade and market tracking to feed in summary reports, Market Dashboards, news letters, morning meetings and agendas
    6. Market Research: Pre-entry market research and positioning survey for bank’s clients.
  3. Data Analysis and Modelling:
    1. Data sourcing from multiple heterogeneous sources, refining and maintenance: Static data, Live and Historical market data maintenance. Data research and statistical studies feeding into trading strategies.
    2. Data Mining solutions.
    3. Data modelling, smoothing: Providing data solutions for Algo trading desks.
  4. Operations and Control
    1. Derivatives trade processing and documentation: Trade review of structured trades and complex documentation. End to end life cycle management of trades e.g., matching, broker confirmations and fee calculations.
    2. P&L and balance sheet control: Generation and reporting of P&L for vanilla products. Some banks have started moving exotics P&L functions to India. This is quite a significant milestone as such activities require high degree of confidentiality and direct user (e.g., traders) interaction who have zero tolerance for mistakes.
    3. Risk Stress testing, VaR back testing, Risk reporting to senior management.
    4. Auditing: external auditing of valuation marks of trading desks and control processes around it.
    5. It should be noted here that since the funding crisis of 2008, these jobs have become quite complex as most banks have built more sophistication into their analytics. For example, most yield curves would now have multiple basis spreads (like tenor basis, xccy basis) and not just rates desks but even credit and equities desk have been using such advanced discounting curves.)

What’s next

The biggest push probably has been in quantitative middle-office functions with an ever increasing emphasis on valuations and counterparty risk management. Given the way markets have adopted collateral based pricing of derivatives, and the regulatory push on managing counterparty default risk, some captives have started building quantitative teams who will develop and manage CVA, DVA, etc. processes for all trading desks.

The new regulatory climate (Dodd Frank, Basel III etc) has lead to a substantial increase in costs due to additional checks and reporting requirements e.g., centrally cleared OTC trades, real time trade reporting to regulators, exhaustive risk reporting – all of which can are leading to fresh volumes of activity in offshoring.

All high quality banks have a team of techno-quants who work closely with the sales/trading desk, risk managers etc, on their day to day needs as well as on strategic projects. It is now feasible to move such high impact roles to India. It would be possible to have “extended front office teams” where dedicated staff support traders in money centres, doing real time risk analysis and client profiling, while the trade is being dealt overseas.

For a back-of-envelope calculation, if we think of internal billing rates of $100,000 per person per year, and if there are 10,000 persons at this average price, then this is services export of $1 billion a year, which is a sizeable amount. It appears that the early beach-head is in place, and this area will grow dramatically now.

This blog post reflects my experience, which is in investment banking and money management. A similar escalation of complexity of work in India is taking place in retail banking, insurance, etc., reflecting similar compulsions and opportunities.


There is a certain tension between the push towards offshoring to India, and the activities that regulators consider `key in-house activities’ that cannot be outsourced.

There are serious constraints with education in India. The top institutions are producing some quantitative skills (e.g. fluency with matrix algebra, fluency in numerical computation). On one hand, there are weaknesses of broad intellectualisation that shapes cognition, creativity and malleability. On the other hand, there is essentially nothing in place by way of a finance education in India. A small amount of high-end finance research is taking place (example) but for the rest, there isn’t much capacity in the existing academic campuses. New approaches to learning and training need to be devised through which high quality individuals, with strong quantitative skills, can be converted into full fledged participation in high-end global finance work. A mix of public and private initiatives are required in order to jump to the next level.

There are strong synergies between the sophistication of the Indian financial system and the work that is done for global financial firms. There is a two-way feedback loop here: Better domestic capabilities will help do sophisticated offshore work, and the brainpower built for offshore work will strengthen domestic capabilities. The best example of this is found in the equity derivatives market, where India has a world-class market. The individuals with a domestic background here are ready for offshore jobs in fields like algorithmic trading, and individuals with capabilities built in offshore work are useful in the domestic setting. This is where India can set itself apart from Malaysia and the Philippines. To the extent that Indian financial reform makes progress, this will fuel the rise of high-end outsourcing to India.


I am grateful to Anand Pai, Paul Alapat and Gangadhar Darbha for useful discussions.

International financial centres: Peering into the future

I did the SIGFIRM Quarterly Lecture at the University of California in Santa Cruz recently:

Also see: Mumbai as an International Financial Centre, a project led by Percy Mistry.

You may like to subscribe to the NIPFP MF channel on youtube.

Fire This Clown

Paul Krugman demonstrates his irrelevance yet again:

What was Mr. Rubio’s complaint about science teaching? That it might undermine children’s faith in what their parents told them to believe. And right there you have the modern G.O.P.’s attitude, not just toward biology, but toward everything: If evidence seems to contradict faith, suppress the evidence.

No, Rubio apparently believes that parents—not the state—should determine what their children are to be taught. Now, the logical way to go about this is to homeschool your kids. However, I can’t think of a single good reason why state-run schools in a democracy educate citizens’ children according to the desires of the citizens.

Anyhow, Rubio’s complaint is not that science contradicts children’s faith; his complaint was that public education was teaching things contrary to the desires of the parents. Since parents are citizens in a representative democracy and also pay taxes, it is right for the government that claims to represent the parents to obey the wishes of the parents when educating their children. To put it in terms that hopefully even a statist clown like Krugman can understand, Rubio apparently believes that children belong to their parents and not the state.

The most obvious example other than evolution is man-made climate change. As the evidence for a warming planet becomes ever stronger — and ever scarier — the G.O.P. has buried deeper into denial, into assertions that the whole thing is a hoax concocted by a vast conspiracy of scientists. And this denial has been accompanied by frantic efforts to silence and punish anyone reporting the inconvenient facts.

How soon we forget East Anglia. Now, when even the head scientists at the East Anglia Institute itself admit that the data is faked, fraudulent, and highly massaged manipulated, then perhaps we can conclude that the data is not trustworthy. And since a goodly amount of working papers and policies are actually predicated on data released by the East Anglia Institute, then it is quite fair for most, if not all people to be somewhat skeptical or even highly skeptical of the case for man-made climate change.

Furthermore, since there has been little research on how the sun—you know, that big ball of fire in the sky that only heats the entire world every day—impact long-term global temperatures, then perhaps all of us would be justified in being a little more skeptical of anthropogenic global warming.

We are, after all, living in an era when science plays a crucial economic role. How are we going to search effectively for natural resources if schools trying to teach modern geology must give equal time to claims that the world is only 6.000 years old? How are we going to stay competitive in biotechnology if biology classes avoid any material that might offend creationists?

I don’t know, division of labor?

Both my parents are public school teachers. You know what they don’t teach to fourth-graders in public school? How to search effectively for natural resources. Know why? Because that subject is not something that most fourth-graders are able to grasp.

I attended public school for my last two years of high school. Know how many biotech classes my school offered? Zero. Know why? Most high school kids don’t have the intellectual chops for biotech. For crying out loud, most college kids don’t either. Come to think of it, a good number of adults probably can’t wrap their heads around it.

Now, maybe Krugman should retake Econ 101 and read up on the division of labor. This is a fairly well-established concept, having been around since at least 1776 (in Smith’s The Wealth of Nations), that states that production can become more efficient when labor is divided up into various roles and sectors. Not everyone is going to take a job searching for natural resources, nor is everyone going to take a job in biotech. Those who do go into those industries will likely require some training beyond mere public school. Thus, it makes little sense to complain how creationism will take away from future biotechnicians’ budding careers, since most kids won’t need those classes, and those that do won’t need them until college.

Frankly, Krugman has turned into a caricature of his former self. I don’t know what happened to him, but his critical thinking skills—not much to brag about in the first place—have just gone down the toilet. Does he have Alzheimer’s or something? If so, I think it’s pretty safe to say that his mind is about gone, so maybe the New York Times might to go ahead and let him go already.

Doug Casey Predicts Day of Economic Reckoning Is Near

Doug Casey It is a deal with the devil: Governments churn out more and more cash for the promise of continued prosperity. But the day of reckoning is near, according to Doug Casey, chairman of Casey Research and an expert on crisis investing. As the epic battle between inflation and deflation continues, Casey discusses his predictions for the new world market in this exclusive interview with The Gold Report.

The Gold Report: There will be a Casey Research Summit on “Navigating the Politicized Economy” in Carlsbad, Calif., in September. The thesis behind the summit is that governments have made a Faustian bargain, a pact with the devil, that saves the empire with overspending, but drives it to the brink of collapse by creating fiat currencies. Doug, where in that story is the economy currently?

Doug Casey: It’s extremely late in the day. Since World War II, and especially since 1971 when the link between the dollar and gold was broken, governments around the world have accepted the Keynesian theory of economics, which boils down to a belief that printing money can stimulate the economy and create prosperity. The result has been to create huge amounts of individual and government debt. It’s become insupportable. All it has done is purchase a few extra years of artificial prosperity, and we’re heading deeper into a very real depression as a result.

“We have been consuming more than we have been producing and living above our means.”

Let me define the word depression. It’s a period of time when most peoples’ standard of living declines significantly. It can also be defined as a time when distortions and misallocations of capital—things usually caused by government intervention—are liquidated.

We have been consuming more than we have been producing and living above our means. This has been made possible by 1) borrowing against projected future revenues and 2) using the savings of other people. The whole thing is going to fall apart. A new monetary system of some type is going to have to necessarily rise from the ashes. That’s a major theme in the conference that’s coming up.

TGR: Will more quantitative easing (QE) give us another couple years of artificial prosperity?

DC: Most unlikely. We’re at the end of the story, not the beginning. More QE—I hate to call it that because it’s really just printing money. I hate euphemisms, words that are intended to make something sound better than it really is. Euphemisms, like exaggerations, are the realm of politicians and comedians. Anyway, the next round of money printing is going to result in radical and rapid retail price rises. There is no prosperity possible from this, rather the opposite.

TGR: Last time we spoke, you said that we are entering into a depression greater than in 1933. Can you describe how it might be different?

DC: What we experienced in the 1930s was a deflationary depression where billions of dollars were wiped out with a stock market collapse, bond defaults and bank failures. Inflationary money that was created since the formation of the Federal Reserve in 1913 was wiped out. Prices went down. This depression will be different because governments have much more power. They’ll try to keep uneconomic operations from collapse, they’ll prop them up, as we saw with Fannie Mae and General Motors. They’ll create more money to keep the dead men walking. They won’t allow the defaults of money market instruments. They will make efforts to maintain the dollar mark on money market funds. They’ll attempt to keep building the pyramid higher. It’s foolish, indeed idiotic. But that’s what they’ll do.

TGR: Which they’ve been doing by printing money. The first rounds of money printing have gone into the banking system, but the banking system has not allowed it to trickle back out into bank loans. Does that open the possibility of deflation if money is not moving out into the general economy?

DC: That’s right. The government created trillions in currency to bail out the banks. The banks have taken it in to shore up their balance sheets, but they haven’t lent it out because they’re afraid to lend and many people are afraid to borrow. That currency is basically in Treasury securities at this point. Although money has been created, it’s not circulating.

“I believe that governments have the power to create enough new currency to keep prices from going down.”

At some point, it’s going to move out. One consequence of this is that interest rates have been artificially suppressed so that retail inflation is running much higher than interest rates are compensating for it. At some point, rather than sitting on hundreds of billions of dollars that are going to be inflated from under them, the banks are going to do something with that money. It will go out into the economy. Retail prices will start rising.

TGR: Do we need to see another round of money printing to put us over the brink into a collapse? Or will it happen even if they don’t print more, because it’s currently sitting in the banks?

DC: They actually don’t have to create more money. It’s just a question of whether the banks start lending it and people start borrowing it. Another possibility is that the foreigners holding about $7 trillion outside the U.S. get panicked and start dumping them. I don’t see any way around much higher levels of inflation unless, of course, we have a catastrophic deflation, which we almost had with the real estate collapse.

TGR: How much will Europe play into this? It seems its governments are, at least according to the popular press, more exposed to bankruptcy than the U.S. government.

DC: Europe is a full cycle ahead of the U.S. Its governments and its banks are both bankrupt. It’s a couple of drunks standing on the street corner holding each other up at this point. Europe is in much worse shape than the U.S. It’s highly regulated, highly taxed and much more socially unstable.

Europe is going to be the epicenter of the coming storm. Japan is waiting in the wings, as is China. This is going to be a worldwide phenomenon. Of course, the U.S. will be in it, too. We’re going to see this all over the world.

TGR: If Europe finally does go over the brink, where it’s been headed for more than a year, would that also cause inflation in the U.S. or would you expect to get catastrophic deflation?

DC: This is an argument that’s been going on for at least 40 years. How is this all going to end: catastrophic deflation or runaway inflation? The issue is still in doubt, although I definitely lean toward the inflationary scenario. But will it start in Europe? How will it start? These things only become obvious after they happen.

TGR: When you say “lean,” are you pretty convinced it’s going to be inflationary?

DC: I think it’s going to be inflationary; in the 1930s, it was a deflationary collapse. Governments are vastly more powerful and much more involved in the economy now than they were then. I believe that they have the power to create enough new currency to keep prices from going down. Somehow, moronically, they’ve conflated higher prices with prosperity.

“Investors need to look for real, productive wealth and consistent growth.”

If we had a completely free market economy, prices would constantly be dropping. That’s a good thing, because as prices constantly drop, it means money becomes more valuable. That induces people to save money. When people save, it means that they are producing more than they are consuming—that’s a good thing. The way governments have it structured today, however, prices are always going up. That discourages people from saving because their money is constantly worth less, which encourages them to borrow. Inflation induces people to try to consume more than they produce, which is unsustainable over the long run.

TGR: You are saying that if the current value of your money is higher than the future value, that encourages borrowing.

DC: Exactly. I don’t see any possible happy ending to this. We’re approaching the hour of reckoning.

TGR: You have said that the titanic forces of inflation and deflation are fighting an epic battle that leads to extreme market volatility. But I am looking out there this summer and thinking it’s pretty calm. It seems like a very slow recovery. Gold is settling around $1,600/ounce. The S&P 500 index is testing the 1,400 mark. Is this just a pause in the epic battle?

DC: Nothing goes straight up or straight down. I just took a cross-country car trip from Florida, up the East Coast to New York, and then out to Colorado. It was actually rather shocking that many times I had trouble getting a motel room—even in the middle of nowhere. The restaurants were full. The highways were full of cars. It looked more like a boom than a depression. At the same time, our real unemployment, figured the way they used to figure it in the early 1980s, is about 16–20%. People are living off their credit cards. I believe it’s the same in Europe.

TGR: It seems as if we haven’t had much market volatility other than the technical glitch at Knight Capital this month. Do you expect market volatility to come back into play?

DC: On the one hand, some people are going to go into the stock market when inflation reasserts itself because at least it represents real value. They can invest in companies that actually produce things and have real assets. On the other hand, the stock market itself by any historic parameter is overvalued right now in terms of dividend yields, price-to-book value and price-to-earnings ratio.

I have no interest in being in the broad stock market. I feel very confident that the bond market, especially, is going to be very volatile. That’s the one place where it seems that there’s a real bubble, and it’s one of the biggest bubbles in history. It’s the worst possible place for capital right now. It’s a triple threat—higher interest rates, default risk, and currency risk.

Even reading the popular press, you can see investors in a desperate reach for yield. They’re only getting a fraction of a percent in their bank accounts. So, to get some income, they are buying all kinds of bonds, even those of low quality, just to get 2, 3, 4 or 5% in yield. The bond market is trading at insane levels as a result of the government having driven interest rates down close to zero in a vain effort to stimulate the economy.

The bond market is much bigger than the stock market. When interest rates start heading up, trillions in bond values will be wiped out, in addition to causing a lot of corporate bankruptcies—that’s why deflation isn’t completely out of the question. In addition, higher rates could really further devastate the real estate market, which has been making a mild recovery. And, of course, higher interest rates are the enemy of high stock prices.

TGR: One of the keynote speakers at the upcoming summit is Thomas Barnett, author of “The Pentagon’s New Map: War and Peace in the Twenty-First Century.” He’s going to be talking about geopolitics today and tomorrow. From your viewpoint, in today’s age of nationalism and conflicts among nations, is it important for investors to know about geopolitics in order to pick junior mining stocks?

DC: Most certainly. Very few investors are putting any money into the junior mining stocks right now, which tells me that it’s a good time to start looking at them. However, investors need to have a grip on geopolitics in order to intelligently assess which companies to buy. There are 200 nation states in the world and they all have different policies. Investors have to avoid putting money into a location where a company will never be able to develop a mine even if it’s lucky enough to find an economic deposit.

TGR: You developed the concept of the “8 Ps” for stock evaluation. Typically, you say that the people are the No. 1 thing that you look at. Is politics starting to move up in importance as a determining factor?

DC: People are still the most important because good people who are running a company will choose an intelligent jurisdiction to develop. It’s also a question of whether the world at large is becoming more stable or less stable. I think it’s becoming less stable, because all the governments in the Western world are really bankrupt and are, therefore, going to be looking for more tax revenue. Mining companies are going to be in its sights because mining companies can’t move their assets; they are the easiest thing in the world to tax. The good news is that makes mining stocks very volatile, and sometimes extremely cheap. Volatility can be your best friend.

But economically, as things get tougher in the Western world, that will hurt the developing world, too, because it depends on marketing its raw materials. If the Western world is using fewer raw materials, it’s going to put pressure on those developing countries.

TGR: Doug, you’re talking a lot about geopolitical unrest. The world is becoming less stable. In 2010, I heard a lot of discussion about gold going into a mania stage, specifically for many of the reasons we’re talking about now. As we approach 2013, will we run into that discussion of gold mania again?

DC: It’s not likely to happen until we reach much higher levels of inflation and we have something approaching financial chaos—but that’s exactly where we’re headed, and soon. The mania is likely to be fear-driven much more than greed-driven. Gold is still in the climbing-the-wall-of-worry stage. Mania is still in the future. It’s going to happen. I feel confident of that. There’s going to be a rush to gold.

TGR: One of the people you like to quote quite often is Richard Russell. There’s a specific quote I’ve heard you say a couple of times: “In a depression, everybody loses. The winner is the guy who loses the least.” In order to be that guy who loses the least, is it a viable strategy to stay out of the markets?

DC: It’s almost impossible to stay out of the markets because almost everybody has a pension program, an investment retirement account or something of that nature. You have to put the assets of that pension into something—the stock market, the bond market or cash. Most people own real estate or their home. If the real estate market gets hurt, you get hurt there. If you have wealth, what are you going to do with it? It’s not a good option to put $100 bills under your bed. Even then, you’re in the market for currency. That’s one of the biggest problems with inflation: It forces people to direct their attention to gambling in the markets, as opposed to productive business.

There has been way too much concentration on the financial markets over the last 50 years. This is shown by the fact that roughly 22% of the U.S. economy is in financial services, which is basically just moving money around. The financial services business doesn’t weave, spin or sew; it doesn’t produce anything. In a sound economy, the financial services sector would be tiny, just big enough to facilitate transactions. It wouldn’t be the mammoth that it is today. It seems as if everybody is in the business of moving money around, but the money they’re moving around is just paper currency. It’s quite non-productive.

TGR: They are producing new financial instruments. In a way, financial services companies are coming up with alternative methods to build wealth.

DC: I question that. Financial services don’t actually build wealth. Real wealth is created by the production of new technologies, food, metal or products. Financial services serve a purpose, of course, but it isn’t a real wealth creator. Today the sector is more of a moving-paper fantasy.

Even what I do, which is advising people on where to allocate their wealth, has always made me feel a little bit sheepish because I’m not actually building a bridge or creating a new engine or technology. I’m just telling people how to move things around. If the economy were sound, 90% of the people in my line of work would be doing something else. A speculator, basically, is someone who capitalizes on politically caused distortions in the market. If we had a sound economy, the government wouldn’t be causing these distortions—and it would be much harder to be a speculator.

Anyway, the whole financial sector is bloated. By the time the bottom hits, the last thing that people are going to want to hear about is the stock market, the bond market or where to put their money. They’re not going to want to read financial newsletters because they’re going to be so sick at the very thought of those things. People won’t ask how the markets are doing; they won’t even care if they exist. They’re going to get back to the basics. That is the foundation for the next boom. But that time is a good many years in the future.

TGR: But you are still in the business of helping investors move around assets. What would you say to investors now on how they can protect or grow their wealth through the next phase of volatility?

DC: First, it’s very hard to be an investor in a highly politicized environment. Investors need to look for real, productive wealth and consistent growth. Speculators, on the other hand, try to capitalize on the chaos that is caused by the myriad of destructive government regulations, taxes, and, of course, currency inflation. That’s why I look at all markets, in all countries. But right now there are very few bargains. At some point, for instance, real estate is going to be of interest again. Not right now because governments everywhere are going to raise taxes on it.

TGR: Would you put things like technology, pharmaceuticals and healthcare in the category of real wealth?

DC: Very definitely. That’s why we have a technology letter. I’ve always been kind of a boy scientist; technology interests me from an intellectual, as well as a financial, point of view. Technology is the real mainspring of human progress. No question about that.

The problem with the medical industry is that it’s being nationalized. It’s very hard to do anything with the U.S. Food and Drug Administration (FDA) as it is. It costs $1 billion to develop a new drug today. Developing medical devices can be almost as expensive. Even if something is approved by the FDA, if something goes wrong, count on being sued by the plaintiff bar. It’s a very high-risk business, which is a pity. Living longer and better physically is one of the most important things there is; medical businesses should be encouraged, not pilloried. I’ve always said that the FDA kills more people every year than the Defense Department does in the typical decade. But Boobus americanus still thinks it’s protecting him… (Editor’s note: Read more about investing in The Life Sciences Report.)

TGR: Are there other areas for real or productive wealth?

DC: I read science magazines all the time. There are more scientists and engineers alive today than in all the history of the world put together. Hopefully, with the continued blossoming of India and China—where students are generally going into science and engineering as opposed to things like gender studies, political science and English literature, which students idiotically are doing in the West—there will be even more scientists and engineers 20 years from now.

What areas are they going into? Nanotechnology, microbiology, robotics—these things will blossom the way computers have over the last few decades. The problem when it comes to investing in them is that they’re increasingly highly specialized. Investors need at least a sound layman’s knowledge in order to know if they’re barking up the right tree or not, and that’s hard. There’s just not enough time in the day to gain enough expertise for this type of thing. Of course, that’s the value of magazines and newsletters. The editors condense information for readers to give them an intelligent layman’s opinion.

TGR: Now we’re back to the importance of people. You do have to have some sense of the person who is doing that analysis for you. It needs to be someone who’s credible.

DC: Absolutely. That’s the advantage of having a newsletter over a magazine. In a magazine, you don’t always know what’s going into the sausage that that writer of an article is making. When you’re dealing with a newsletter, you can get to know the editor, what he’s thinking, how expert he really is and what is his psychology. You can learn if you can trust his opinion. Although I read both magazines and newsletters, newsletters are much more valuable.

TGR: To bring this full circle, I would imagine attending conferences where you meet these newsletter writers or analysts face to face is also beneficial.

DC: Yes, it gives you a smorgasbord of views. It’s helpful in assessing the validity of the views to be able to assess the personality of the writer and have a better understanding of whether his views are actually credible. And it’s a great opportunity to ask questions.

TGR: Doug, you’ve given us quite a bit of your time. I greatly appreciate it.

Read Doug Casey’s thoughts on the energy sector in The Energy Report exclusive, “Doug Casey Uncovers the Real Price of Peak Oil.”

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Doug Casey, chairman of Casey Research LLC, is the international investor personified. He’s spent substantial time in more than 175 different countries so far in his lifetime, residing in 12 of them. And Casey literally wrote the book on crisis investing. In fact, he’s done it twice. After “The International Man: The Complete Guidebook to the World’s Last Frontiers” in 1976, he came out with “Crisis Investing: Opportunities and Profits in the Coming Great Depression” in 1979. His sequel to this groundbreaking book, which anticipated the collapse of the savings-and-loan industry and rewarded readers who followed his recommendations with spectacular returns, came in 1993, with “Crisis Investing for the Rest of the Nineties.” In between, Casey’s “Strategic Investing: How to Profit from the Coming Inflationary Depression” broke records for the largest advance ever paid for a financial book.

Casey has appeared on NBC News, CNN and National Public Radio. He’s been a guest of David Letterman, Larry King, Merv Griffin, Charlie Rose, Phil Donahue, Regis Philbin and Maury Povich. He’s been featured in periodicals such as Time, Forbes, People, US, Barron’s and the Washington Post—not to mention countless articles he’s written for his own websites, publications and subscribers. Casey Research currently produces 11 publications on a variety of investment sectors and maintains two websites.

Higher Order Labor

As demonstrated in this example of mechanization:

I’m in Chicago at my Mom’s place for Christmas, and over dinner last night we were talking about Race Against the Machine and the steady pace of automation (because what else do I talk about these days?). She and her husband Gene told me that the Walgreens in their neighborhood didn’t have any human cashiers any more.

I told them they must be mistaken. I’ve seen plenty of self-checkout stations, but they’ve always been accompanied by at least one human cashier to accommodate customers who for whatever reason — unfamiliarity, techno-fear, the desire to chat, whatever — don’t want to deal with a machine. I assumed the same would be true at this Walgreens. Mom and Gene were adamant that it was 100% self-checkout, so we got bundled up and walked over to get the straight dope.

They were right and I was wrong. There are six NCR self-checkout kiosks at the entrance / exit, and no cashiers at all there. There are human cashiers at the photo lab and the pharmacy and customers can take their purchases to these two locations if they want, but at the main checkout area you can’t get rung up by a person any more.

This goes back to something I wrote about a month ago. The tendency in the free market is for labor to become of an increasingly higher order. Note that this is not an immutable economic law so much as an ex post observation. There is no reason to believe that this trend will continue, save for the purpose of thought experiments.

At any rate, the historical trend demonstrates two things. First, as intellectual capital increases, humans have a tendency to mechanize labor. The cotton gin and mechanical harvester are early examples, and the robotic assembly line and aforementioned cashier are more recent examples. The problem with machines, though, is that for all of their advantages they still aren’t perfect. They generally need maintenance of some sort and occasionally fail. Fixing machines, for the time being, requires human involvement.

This problem is generally solved first by increasing pay for those skilled at maintaining and repairing machines and then eventually simplifying the operation and maintenance of said machines so as to tap into unskilled labor (which the machines initially replaced). Basically, then, machines are a net benefit in the long run because they enable humans to capitalize on a broad set of intellectual capital via higher order labor. As such, one need not be a Luddite for economic reasons, as the market generally does a good job of solving the problem of labor displacement.

Further fallout for us?

If you are not paying attention to the niche news about what is happening within the Nuclear Regulatory Commission (NRC), you probably should be.

There is a bit of mixing different geographies in this, but here is data I pull when I extract data by occupation across all regions in the US with measurable employment in two of the most specialized occupations out there:  Nuclear Engineers and Nuclear Technicians.  Added together and ranked by absolute employment counts the graph below is what I get.  In sheer numbers these are not huge anywhere, but they are the core  and proxies for the far larger establishments that rely on these workers. So you see why any hiccup in the nuclear industry will have impacts here as much as anywhere.

Whatever Happened to On-The-Job Training?

It is a widespread problem: the article reports survey results showing that 83 percent of manufacturers reported a moderate or severe shortage of skilled production workers. The shortages include such categories as machinists. Wages for skilled labor are rising, in some cases at double-digit rates.

Unskilled labor is complementary to skilled labor. If skilled labor cannot be hired, there is no demand for unskilled labor. Some firms report that the inability to hire needed workers is their greatest impediment to growing their business.

Malinvestment in labor markets is the counterpart to malinvestment in capital goods. Higher education is a bubble, and colleges churn out graduates with degrees that have no application in the workplace. Student borrowing to acquire such degrees is malinvestment in the same way that constructions loans to build homes in Las Vegas was malinvestment.

On-the-job training is mostly inevitable in virtually every business because employers do tend to want some core processes done a certain way. Yet, many employers often expect job applicants to be as smart as the person they’re replacing. This seems rather foolish, as careerists generally amass a large amount of very specific information related to their specific jobs. When they retire, they’re going to take their very specific knowledge base, and no other applicant is going to be able to replicate that on day one.

Now, the current college bubble does tend to distort the labor market since those possessing college are nominally qualified for certain careers and jobs. Unfortunately, the college bubble has led to the very unfortunate side effect of dumbing down curricula, and thus graduates, making it more difficult for employers to tell who is actually qualified for certain jobs.

But, beyond that, a highly educated labor market is going to have certain (inflated) requirements for the jobs they wish to accept. For example, college-educated labor market participants are not going to be particularly likely to work as unskilled labor, nor are they ass willing to work for low wages in exchange for job experience and knowledge. (And who can blame them? They’ve been told their whole lives that they should go to college so they can have high-paying high-status jobs.)

As such, the labor market is experiencing failure right now, due mostly to government intervention. The continual and sizable subsidies of college education has for many years encouraged potential labor candidates to avoid learning trades that, though low status, are somewhat easily mastered and decent-paying. The companies that are interested in hiring these sorts of people are finding quite a shortage at this point in time, causing a relative spike in wages to incentivize people to take these jobs.

One thing that companies needing low-status skilled workers could do is recruit directly from high schools by offering a job, complete with on-the-job training, for those who have an inclination for certain skills as well as the ability to learn. The colleges have failed at producing a workforce adequate to meeting the needs of the current labor market. It is therefore time for businesses to bypass them altogether.

Ricardo Hausmann on Economic Complexity

The member meeting at the Media Lab features speakers from within the lab, like César Hidalgo and Joi Ito, and outside speakers – in that latter case, the invited speakers reflect César’s wonderfully idiosyncratic take on networks. One of his major collaborators is Ricardo Hausmann, director of Harvard’s Center for International Development and former Minister of Planning for Venezuela.

Hausmann argues that to succeed economically, humans have learned how to specialize. Someone who’s marvelous in one area is likely mediocre at others – consider Michael Jordan’s ill-fated attempts to play professional baseball. Some tasks require a full human’s worth of knowledge – a person-byte – to carry them out successfully. Others require much more knowledge – building a complex product like a computer might require a kilo-person byte or more – the highly specialized knowledge and skills of a thousand different people. “Modern man is useless as an individual. Making a computer is a team sport.”

By understanding how much knowledge and coordination different economies are capable of, we might understand their economic growth potential. In the US, the average employee works with 100 coworkers. In India, the average employee works with 4 coworkers. Hausmann explains that’s not coincidental – the difference in wealth and income between the nations is closely related to the ability of firms to take on complex tasks. This also helps explain recent disappointment with the limited impacts of microlending – those loans go to small firms that are limited in terms of personbytes. They’ve only got so much knowledge they can apply to producing complex and high value products.

We might characterize economies in terms of those where lots of people do very simple work – he illustrates this with a marvelous Edward Burtynsky photo of assembly line workers processing chicken in China – and those where individuals do complex things in consort, like the players within a symphony orchestra. Hausmann shows us a “map” of the world, a complex graph that represents nations and what products they produce. Most nations produce a few things, and a few produce many different things. Some products are made everywhere, while others are made in very few places.

There’s an underlying pattern to this. The nations that make only a few things all tend to make, more or less, the same things. Basically, we can divide the world into two sets of countries – those that have sufficient personbytes of knowledge to produce a wide range of goods, and those that can produce only a few simple things. The places that make everything make things that few others make. Hausmann explains that products require a specific set of personbytes to produce. When you gain additional personbytes of skill, it’s like getting new letters in Scrabble – you can produce a new set of words, but only within the constraints of the letters (skills, knowledge) you already have.

“Poor countries make few things, and things that everyone makes. Rich countries make unique things. And this is true for municipalities as well as for countries.” He shows a graph of manufacturing in Chile that looks curiously like his graph of the world – on the top is Santiago, where people manufacture all sorts of things… on the bottom “is where there’s nothing but penguins” and capacity for manufacturing is very low.

Global economics, Hausmann explains, is a little like the BCS scoring in college football. It’s not just about who you beat, it’s about who they beat as well. What do you make, and what does everyone else make? What do you make that no one else makes? What new products could you manufacture based on what you already make?

Why pay attention to this idea, the “economic complexity index”? It’s a very good tool for explaining the classic question of “Why are some countries rich and others poor?” Specifically, it explains 73% of the variances of incomes across nations. And where the predictions economic complexity theory offers differ from reality, it’s possible that reality is wrong. The index suggests that India should be richer and Greece should be poorer, which suggests that error in the index is predictive of future growth. If you want to bet on economies that are undervalued, Hausmann suggests you invest in China, India, Thailand, Belarus, Moldova and Zimbabwe. (On the last, he suggests that Zimbabwe’s main economic problem is a single persistent individual, but that there are many personbytes of knowledge ready to produce goods once the political situation changes.)

Is economic complexity actually measuring another phenomenon, like education? Probably not. We can look at investment in education and economic growth, and education appears to correlate more weakly than economic complexity. He suggests we look at Ghana, which has invested heavily in education since 1975, and Thailand, which hasn’t invested as heavily. Ghana hasn’t moved far from a largely agricultural economy, while Thaliand has moved from producing jute and sugar to becoming a major manufacturing center. They’ve accumulated many personbytes even if they didn’t invest heavily in education.

This raises a tricky question – how do you become a watchmaker in a country without watchmakers? The answer is that you move from what you currently produce to products that require only a fractional increase in personbytes, from one product space to a closely related one. The question for economic success may be how close you are to good products from what you already know how to make.

I find Professor Hausmann’s theory fascinating, in part because I’ve had the chance to play with the gorgeous visualizations César has built of economic progress in different parts of the world based on economic complexity. What I still don’t understand is how Thailand kicked Ghana’s butt economically. How do you get from jute to microcircuitry? And why couldn’t Ghana get from aluminum production to more complex manufacturing. Looking forward to reading his papers and understanding a bit more, as the core concept of complexity is a very compelling one.

Capitalism, Socialism, and Scalability

Cohen’s book proceeds as follows. First, he has us imagine a camping trip among friends. Food and goods are shared freely. Everyone abides by (purportedly) socialist principles of community and equality. Everyone does his part. No one takes advantage of anyone else. No one free rides. Everyone contributes. Everyone shares.

After a while, people begin to act like capitalists (as Cohen understands realistic capitalistic behavior). Harry demands extra food because he is especially good at fishing. Sylvia demands payment when she finds a good fishing spot. Leslie demands payment for her special knowledge of how to crack nuts. Harry, Sylvia, and Leslie refuse to share without extra payment. Morgan, whose father left him a well-stocked pond 30 years ago, gloats over having better food than the others.

The fundamental flaw in this argument is that there is an assumption of scalability, which simply means that socialism, which works well on a small scale, should also work well on a large scale. Unfortunately, this assumption is simply incorrect.
In the first place, socialism requires a large degree of knowledge in order to be systemically efficient. When one is dealing with a small number of people (e.g. a family), it is possible to have a large degree of knowledge without necessarily possessing a large amount of knowledge. When more people enter the people, the degree of knowledge necessary remains the same while the absolute amount of raw knowledge required increases correspondingly (e.g. 60% of 10<60% of 100). As the famous Dr. Sowell has remarked, “economic decisions are about tradeoffs, not absolutes.” This principle applies to determining which economic system should be used.
In the second place, socialism requires that actors within a system be close in proximity. It is difficult to ensure that all producers are producing enough if they are scattered over a large geographic area. It is also difficult to determine who isn’t pulling their weight if people are not close in social proximity as well, which simply means that people who aren’t “close” to one another, in a platonic sense, are not likely to know what the others do.
Again, these two factors play a significant role in determining which system to use. For small-scale societies, like the nuclear family, the socialist system makes more sense, for the absolute knowledge demands are low, and proximity is near. This, then, is a very economical way of determining how to distribute production and resources, based on the specific skill sets and desires of the individuals working within the small-scale society. In fact, socialism naturally lends itself to a system of informal barter.
Socialism is not, however, well-suited to a large-scale society. The knowledge demands are simply too great for one person, or even a large number of persons. And since large-scale societies also require large amounts of land for sustenance, there is then not enough proximity to reinforce the necessary social norms, leading to a significant free-rider problem. Capitalism (or, more accurately, the free market) solves this problem through the division of labor, which requires only that system participants pay attention only to those things which are directly related to their interests, thus solving the knowledge problem and, to some extent, the proximity problem.
The break-even point for these systems is unknown, but I am willing to bet that the system size strongly coincides with Dunbar’s number. At any rate, it should be obvious that advocating wide-scale socialism based on the success of small-scale socialism is as foolish as advocating small-scale capitalism based on the success of large-scale socialism.
Note: I use the word “capitalism” interchangeably with “free market” in this post, simply for the sake of syntactical brevity.

Was the Industrial Revolution caused by Bourgeois Dignity or Institutional Change?

Most of Deidre McCloskey’s important new book serves to establish that if we want to explain the industrial revolution we need to explain why so much innovation occurred in England from the late 18th century and through the 19th century. She suggests that we should dismiss attempts to explain the industrial revolution in terms of such factors as thrift, accumulation of capital (physical or human), transport, geography, natural resources, the slave trade, business organization, imperialism, eugenics and even foreign trade.

The style of the exposition suggests, at times, that Deidre may not suffer fools gladly (or has a wicked sense of humour): ‘If someone claims that foreign trade made possible, say, economies of scale in cotton textiles or shipping services she owes it to her readers (as I have already said twice: I wish you would pay attention) to explain why the gains on the swings are not lost on the roundabouts. Why do not the industries made smaller by the large extension of British foreign trade end up on the negative side of the account?’ (p 221).

Well, I’m not sure Deidre, perhaps there is a link between international trade, specialization and scale economies – but you may have discussed that possibility somewhere else in the book when I wasn’t paying attention. In any case, I agree with you that innovation must have been a lot more important than scale economies.

Bourgeois Dignity: Why Economics Can't Explain the Modern World

I was a little more concerned that I didn’t see any recognition of the possibility, as discussed in Eric Jones’ recent book (reviewed here), that clustering of manufacturing in the north of England – as a result of trade and specialization within England – provided an economic environment conducive to subsequent innovations. Perhaps middle class enrichment resulting from trade and specialization could also help to explain why the bourgeois revaluation occurred when and where it did. (The bourgeois revaluation is the greater approval of the middle classes – and of innovation and markets – that began to occur in thought and talk in Holland and England three centuries ago.)

My main concern, Deidre, is that in attempting to clear the field prior to sowing a new crop of ideas (or the old ideas you want to propagate anew) you may be inadvertently slashing and burning some other ideas that are worth preserving. This applies, in particular, to the relationship between institutional change and economic performance as discussed by Douglass North (‘Institutions, Institutional Change and Economic Performance’, 1990). I agree with you that North could not have been correct in attributing the industrial revolution to more secure property rights following the Glorious Revolution. There is, however, more to institutional change than more secure property rights. I reject your attempt to dismiss appeals to institutional change as ‘still another attempt to reduce one of the greatest surprises in human history to a materialist routine’ and to claim that changes in institutions did not have much to do with the industrial revolution (p. 354).

In fact, evidence that you cite in your book seems to conflict with your claim that changes in institutions – the rules of the game – had little to do with the industrial revolution. You acknowledge that ‘the norms of antibourgeois aristocrats and clerics did discourage innovation’ (p. 267). You also suggest: ‘Had the Ottoman or the Qing empires or the Japanese Shogunate admired trade and innovation sufficiently to overcome their worries about the maintenance of state power – encouraging innovation and having a go rather than crushing it – then they, not the Europeans, would have come first’ (p. 371). You note that in France and Spain in the 18th century a nobleman caught engaging in commerce could be stripped on his rank’ (p. 387) and that in France it was necessary to apply to the state for permission to open a factory (p. 395).

I think your true position may be that bourgeois dignity and institutions (economic freedom) are both important in explaining the industrial revolution. This comes through fairly clearly when you write: ‘By adopting the respect for deal-making and innovation and the liberty to carry out the deals that Amsterdam and London pioneered around 1700, the modern world was born’ (p. 397). In such passages you seem to be offering an encompassing theory incorporating both bourgeois dignity and institutional change.

So far so good. I can understand that ideology (an amalgam of perceptions and values) influences the climate of opinion toward commerce and innovation which in turn influences both informal institutions (conventions and codes of behaviour) and formal institutions (regulations, laws, constitutions) which may or may not provide a climate conducive to innovation. Is that all there is to understand?

Perhaps not. The missing element is a sense of personal identity. As you say: ‘In truth, the agent wants to act because she attributes meaning to her life … She is a human with an identity, not a Max U calculating machine like grass or bacteria or rats’ (p. 307).

That gets me thinking again about identity economics – the idea of George Akerlof and Rachel Kranton that people gain utility when their actions conform to the norms and ideals of their identity (which I first discussed here). Even a person with great potential to be innovative might find that difficult if the norms and ideals of their identity dictated that any attempt to innovate would be futile. If we start thinking in terms of identity economics, however, we might have to question the sub-title of your book – perhaps economics can explain the modern world after all.

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