Technology, Venture Capital, Private Equity

For the past few days, I have been mulling over the fallouts and developments post the sub prime crisis in the US, and there are two strong thoughts that emerge – a)Have the global financial markets become too complex for their own good? and b)Is the US on the verge of losing its position of pre-eminence in the global economy?
As you will see, the two are kind of related, but intend to restrict this post to (a). But, before I delve in, let me take a small philosphical digression and try to connect that with the theme here.

It seems to me that the world we live in today has (for the lack of a better phrase) two “layers of reality”. One is what I would call an outer layer of “synthetic reality”. It is the reality of a world that we ourselves largely create. And the other is a deeper layer of a more “fundamental reality”. Let me illustrate that with an example of a game such as “Monopoly” (or “Trade” as it is called in India). As one would know, this is a game where the players are given some units of the Monopoly currency, which the participants are supposed to maximize. There are rules for this game and also skills involved and at the end of it, there is a winner (and a loser). Despite all that, none of it is really “real” because you cannot take the Monopoly currency and buy something in the real world. However, what if there is a Monopoly tournament, and the winner takes home some real prize money. Now, suddenly, all the things connected to this game take on a real world connotation and implication. There is now a “mysterious” connection between the “synthetic reality” of the game and the “fundamental reality” of the prize money. In one sense, this is also what constitutes the core of management education (like an MBA) – to learn the rules of the synthetic world and the real world, the relation between the two with the final objective of maximizing real wealth. Although this is not directly evident in the curriculum, it shows up in various manners. For example, in Economics 101, we learn the difference between capital and money. Capital, we learn, is the right to consume (resources) and can only be earned through labour (technical and not colloquial usage), while money can be increased overnight (by printing currency) without any expenditure of labour. We then delve into each of those connected concepts – capital and money and the interplay between the two. Each of those worlds (viz. world of economics and world of finance) have rules of their own, which we try and understand. But, the end goal is always to maximize real wealth. Similarly, if you talk of marketing, it is about creating certain mental connections in the mind of a consumer for a product or a service. On the one hand, there is the product, which has an intrinsic set of attributes. On the other hand, we have the customer’s image of the product, which may or may not be in consonance with the actual attributes of that product. A marketer is trained in the science and art of taking a real product and creating a synthetic image of that in the mind of the consumer. (Same can be said of the notional and actual value of a stock etc).
Now, coming back to our original point, in the ideal scenario, there should be as little a disconnect between the two worlds as possible. And whenever there is such a disconnect, it will ultimately result in such crises situations or bubble bursts as they are commonly called. Almost seems like a mysterious gravitational force that pulls the two worlds together whenever they diverge too much. However, the problem as I see it is this – our synthetic world (especially the financial one) has just become so complex that the connection between the two worlds is hard to understand at best or questionable at worst. So, while in a simpler world, it would have been easier to make out when the chasm between the two worlds increases to uncomfortable levels, it is increasingly become harder to do so now. I was reading an article on MIT’s Technology Review (registration required, but worth the effort) on the increasing dominance of mathematical wizards on Wall St. It ends with an interesting anecdote. On being asked whether credit spreads would shrink or widen in the coming months, a group of such financial experts were split right down the middle with half feeling it would widen, while the other half feeling it would narrow. Now, if PhDs in mathematics/finance from ivy league institutions don’t seem to have a handle on how things are progressing, can we really blame the “poor” CEOs of the banks if they have been unable to manage their risks well enough? And I guess, with complexity only increasing with time we need to brace ourselves for only more such events in future.