Thomas Schinkel and Associates

Fallout from the Bailout

By

Thomas Schinkel

October 5, 2008

Rescue or Bailout? Wall Street or Main Street?

Have you noticed? Less than three days after the deal was done, it is already politically incorrect to call it a bailout plan. The correct wording now is ‘Rescue Plan’, and it is not Wall Street that is being rescued; no, it is Main Street that is being bailed out. What a difference a week makes!

Leaving that one for what it is seems to be, at least for now, here are twelve talking points for the “ME” generation, exploring what can be expected in the aftermath of “Project Main Street’s” approval by Congress last Friday. Keep in mind that as of today it is entirely unsure whether the bailout is actually the correct cure for the problem, as defined.

1. Rising Unemployment

Expect unemployment to rise above 7%. And it will take a long time to get this number down to where it was before 2008. Also expect underemployment to rise. More and more people will look for part time jobs, time share jobs, two part time jobs and any other arrangement to bring in cash.

2. Reduced Consumer Spending

Consumers have been spending well beyond their means for years on end. Low interest rates and the resulting housing bubble merely aggravated what should have come to a halt as far back as 2000/2001. Expect a wave of austerity throughout all levels of the economy.

3. Improving Savings Rate

The flip side of this austerity wave may actually help bring the savings rate back up to where it should be, namely in the 5-10% range. When Sweden had its financial crisis back in the early 1990’s, their official savings rate was 1.5%. Several years later it climbed to five percent, and today it is closer to ten percent. My own rule of thumb is that, across the board, Americans spend approximately 7% too much on stuff they don’t need. Most of this comes from imports.

4. Growing Informal Economy

One of the unique characteristics of countries in Latin America is the large size of their informal economy. What that means is that a lot of people do business in cash, they don’t report their income, many have no bank accounts, and records – if they are kept at all – they are kept for internal purposes only. In some countries this informal economy represents as much as 50% of all economic activities.

In the U.S. – where we have an informal economy as well – this figure has historically been estimated at below ten percent. However, due to the crisis that has enveloped the economy, expect this number to rise to 12%, perhaps even as high as 15%.

5. Inflation pushing out Deflation

Inflation and deflation are dangerous items in our economic vocabulary. For years, we have seen Consumer Goods Deflation, resulting from a combination of factors. First was the shift of production from the U.S. to Low- cost countries. This has been going on for decades, but accelerated during the last ten years. Second was the successful expansion of Low-cost Distribution Channels, including all forms of Big Box Retailing. These organizations managed to do an outstanding job of reducing costs in the value chain and pass on (some of) the savings to the consumer.

In other sectors of the economy, such as health care and education, we have seen the reverse, namely Inflation. In other words, Inflation and Deflation have coexisted with each other for a long time. The energy crisis of the summer of 2008 brought home the notion that rising energy costs can have a dramatic impact on the value chain, especially when that chain covers long distances! Even Walmart cannot stop the costs that slip into the value chain when energy costs rise. Today even Big Box retailing has to swallow the bitter pill of Inflation.

But the most common cause of inflation is when central authorities print money to keep the bills paid. Think of the Weimar Republic of the 1920’s. With the Federal Reserve already having committed hundreds of billions to bail out companies like Freddie Mac and Fannie Mae, there is a high likelihood that the flames of inflation will be stoked from that corner as well.

6. Dollar Devaluation

Currencies fluctuate against each other on a daily basis. One of the most spectacular fluctuations in the realm of currencies has been the U.S. Dollar versus the Euro. Back in 2002, you could buy a Euro for $.80. Today, that figure is closer to $1.40. The underlying cause for the weakness of the U.S. Dollar is its structural international trade deficit.

In the U.S. we simply do not have enough high-quality manufacturing left to offer to countries and consumers overseas, to make up for our appetite for overseas goods. This is a dangerous imbalance which has been left to fester by Administrations of all colors and stripes. Exhibit One shows how this major part of the U.S. Economy has been in decline over a long period of time. The biggest challenge is not between the U.S. and Europe, but between the U.S. and China. The pressure will continue to build until there is either a clamp-down on imports from China or there is a massive revaluation of the Yuan. This has been a contentious issue for years, with the U.S. claiming that China is deliberately keeping a lid on its currency.

All the while, in the absence of a social contract, the American Business Community has been all too eager to drive what they perceived of as problematic production (labor costs and unions?), from the U.S. to China, and this too has been going on for a long time.

To the best of my knowledge there is not a single government official or anyone else in China who coerced us into doing this. In any event, no matter from which way you look at this particular issue, expect the dollar to weaken against currencies that matter (yuhan), until such time that we have invented and installed a new manufacturing base that offers something of value to the world, in large enough numbers and weight to offset our appetite for overseas goods. In the meantime, through devaluation, overseas goods will become more expensive, adding to the inflationary pressures that are coming at us from other directions.

7. Foreign Ownership of U.S. Assets

That unique wave of globalization that was set in motion after the Fall of the Berlin Wall was accompanied by a wave of international and cross-border investments, thereby altering the ownership picture of assets in many countries. For decades, the U.S. has been an active investor in numerous countries around the world. However, foreign companies and investors have done the same in the U.S. Exhibit Two illustrates the scope of these asset ownership flows between the U.S. and the rest of the world.
What is interesting is that the net-capital-investments have favored foreign ownership of U.S. assets.  Expect this trend to continue and if we do not get a fix on our economy really soon, it is likely to accelerate.

8. Tax Rates and User Fees

The Federal government’s budget has been in negative territory for years on end. After an episode of government surpluses during the 1990’s, we have not seen such surpluses for a decade and there is a modicum of probability that a serious effort will be made to fix this as we move into a new administration in 2009. Either way, a fix will come in three forms:

• raise taxes,
• raise user fees, and
• reduce services.

Chances are we will see a combination of all three. An additional stiff tax on the price of fuel – if enacted – would be something of a blessing in disguise, although such a move would meet with strong opposition from the usual interest groups. It would work if it were part of an overall consensus as to the direction to choose for the economy.

9. Mobility

All aspects of mobility will be affected by the crisis we face. People will look to reduce their commuting, through shorter distances between work and home. They will look to change their mode of transportation by shifting to public transport. This is already happening on a large scale. It affects work, shopping and leisure.

If my hunches are right, we are on the verge of entering a Post-Consumer Society, and retail business models of all stripes and colors will be affected. Expect mobility related life style changes throughout all layers of the income spectrum.

10. Imports and Substitution for Imports

The multi-dimensional characteristics of the crisis at hand will place a damper on imports of “unnecessary” consumer goods, and an opportunity will present itself for import substitution. Products that can be made locally will be sold locally.

11. International Trade

Trade relations between “rich” and “poor” countries have been strained for years. The World Trade Organization is trying to put a positive face on this condition, but the latest round of trade negotiations held this summer ended in failure. The embedded crises that followed have done nothing to alleviate the situation. Most dramatically, expect a change of who sits at the head of the table the next time these negotiations resume.

12. Neo-liberal Capitalism

For the last decade and a half we have lived through a rapidly accelerating form of capitalism that had at its core the triple mantra of

• Privatization,
• Liberalization and
• Free Trade.

Privatization was propelled by the belief that government was supposed to be incompetent to run any enterprise. Government’ role as a balancing mechanism among groups of people and companies gave way to Liberalization. International trade was supposed to be free, unfettered by government interference or by any urge to balance what you bring in against what you take out.

If the summer of 2008 has been an “Education of America and the World”, it has been that this triple mantra appears to be flawed at the core. Going forward, whoever tries to defend these beliefs and values, may find him or herself have to dodge softly ripened tomatoes!

Entrepreneurial Innovation

All in all, this is a nice list to ponder the implications for your business model. It is also a reminder that this is the perfect scenario for the introduction of entrepreneurial ideas that zero in on new and emerging needs of the population at large. Present conditions provide fertile ground for the creation of new combinations, whether it is in manufacturing, in distribution or in the services sector.

Innovations typically are combinations of ideas that not everyone had thought of before. A different interpretation of the value chain, a simplification of choice, a cost reduction that was not obvious to the naked eye, all fall within the realm of innovations people need today.

A New Common Prosperity?

In closing, allow me to express the hope that sometime really soon we can have a series of sensible, fact-based public discussions in this country that address the question of How we intend to create Prosperity Together, as we move forward into uncharted territory. Questions should include how to perform triage on our economic and social imbalances without undue favor to the privileged and well-connected? Is there a need for a new social contract? What should the dimensions of such a contract be? Who should be parties to it? What does it take to get there? What is America, Inc.’s collective business model going to be? And  these questions are only the beginning!

Meanwhile, with no time to waste, how is your business affected? What is YOUR response to the multiple challenges we face? Have you prepared for innovations whose time has come? Thank you for your interest!

Thomas Schinkel

Business Adviser