are a prelude to more fundamental changes to come

Part One

By

Thomas Schinkel

January 25, 2010

That there are stresses and strains on American society is clear for anyone to see. These stresses and strains are the result of changes that include the country’s demographic composition, but more importantly, fundamental changes in the way value has been created during the last decade and a half.

As these changes are now making their impact felt, many thinking people struggle with the question of what will happen to American capitalism. My own take on it is driven by a simple distinction that I find helpful in trying to understand what is going on. That distinction is between “Culture” and “Structure.” For example, the American business culture has always been and continues to be informed by a spirit of innovation and entrepreneurship, and a willingness to take a chance.

The structure of our present model of capitalism is another story. There is no doubt in my mind that a large part of today’s societal frictions is the result of the fact that several important industries have morphed into what can be labeled as “Oligopolies”. An oligopoly is a market system dominated by three or four major players and in which everyone else operates on the periphery. Today, we find this condition in such sectors as, financial services, automotive (the domestic portion, anyway), the health insurance industry and pharmaceuticals. One of the more salient characteristics of an oligopoly is that the leading participants try to avoid competing on price in as many ways possible.

At the same time, you will find that large corporations, including those operating under conditions of oligopoly, are not exactly stellar creators of jobs. To the contrary, it is a well-established fact that job creation occurs mostly at the bottom of the pyramid, where the millions of smaller and medium-sized companies reside. Those players operate under conditions of “Free Enterprise”, where many players compete vigorously on price and all other ingredients of the competitive landscape. Free enterprise of course, is merely a different shade of grey within the entire spectrum of capitalism’s organizing principles.

Culture over Structure

So here’s my take on the tug of war taking place within American capitalism as we begin the second decade of the 21^st century. Ultimately, I think “Culture” will win out over “Structure. It will take a while, but the oligopolies will either be broken up, severely restrained or forced to modify their behavior in some other way. If some of the brands at the pinnacle of the Corporate pyramid must disappear, so be it. But the culture that represents the heart and soul of American capitalism – independence, entrepreneurship and a spirit of innovation – will prevail.

I see this playing out already in numerous small ways among friends, colleagues and clients. It will take a few years to get our bearings straight, as we move away from the delusional mantra of America being the “consumer of last resort”.

Homeless in America

Speaking of independents, the Massachusetts electorate’s rebellious and successful attempt to put a Republican candidate in what many thought was Kennedy’s seat in the Senate lays bare an interesting phenomenon and that is that half the State’s population appears to be homeless. Not physically, but homeless in the sense that they think of themselves as Independents, not as Republicans or Democrats. The red-blue divide means nothing to them. And the political duopoly that the Democrats and Republicans have become leaves them homeless and powerless to make their voices hears. This phenomenon of “rebellious independents” is not limited to Massachusetts. It exists throughout the country. If this group of independents continues to grow, and my take on the situation is that it will, there is even a chance that within five years we will officially have a third political party, fully registered and participating with seats somewhere in between both sides of the aisle.

From Caterpillar to Butterfly

There’s no question that this struggle will cause and is already causing hardship while the transformation is taking place. Allow me to liken this transformation that is taking place in the realm of economic, social and cultural dimensions to a unique one observed in nature, the process through which a caterpillar changes into a butterfly.

The changes that will need to come about, either by default or by design (the latter being the preferred method to be sure), will encompass an overhaul of American society in the most profound way. These changes will come about, in some cases by borrowing from the European and Asian models of capitalism,  but mostly by arriving at our own conclusions.

Specifically, as the voice of the independents gains strength, over time we may witness real reforms being made in such areas as re-regulation of the financial industry, fiscal policy, energy and international trade.

Stimulus Plan Phase II

And the next Stimulus Plan, if and when it comes, will look very different from the one passed in 2009. Above all, it will need to include a gameplan for “new value creation”, a gameplan that gets us away from the delusion that the financialization of the business sector was an effective way to create wealth among the population at large.

All along,  the top bankers had wanted us to believe that their booming industry was driven by innovation.

But listen to what Paul volcker, former Chairman of the Federal Reserve has to say on the very subject at a recent conference in London:

“The only innovation that has taken place

over the last twenty years in the

financial services industry is the Cash Machine!

Paul Volcker.

Wow! Needless to say, for business leaders in all walks of life, monitoring and anticipating the transformation of our economy and society is extremely important, because the impact on the business environment will be profound In my next article in this series, I’ll discuss how in America we can kill three birds with one stone by embracing a method of taxation that has found its way into all major economies of the world, except ours. As always, thank you for your interest in my writings and regardless of whether you agree or disagree, feel free to share your thoughts by e-mailing me at thomas.schinkel@gmail.com.

Thomas Schinkel

by

Thomas Schinkel

January 18, 2010

It is now almost a year ago that US Treasury Secretary Timothy Geithner ordered the largest financial institutions to conduct so-called “stress tests” to make sure they could withstand worst-case scenarios.

At the time, many felt that the program was a comfort measure with the primary purpose of bolstering confidence in the economy, and [?the worry was that it would become] an exercise in window dressing. One of the bankers, Wells Fargo & Co. Chairman Richard Kovacevich, criticized the government and called the administration’s plan for stress-testing banks “asinine.”

Asinine or not, what I advocate for the business community is an altogether different kind of stress test, one that is designed to prepare companies for a smorgasbord of events likely to happen by default or by design, but whose timing remains as unpredictable as a Florida hurricane.

In an earlier article, we looked at a paradigm shift in the making, one that shifted senior executives’ focus from planning for growth to preparing for the unpredictable. During the years ahead, the likelihood of a combination of unpredictable events happening in the realm of currency risk, cluster risk, and global fiscal and monetary upheavals is fairly high (see figure, below). These events will have a profound impact on the business models of all but a few corporations around the world.

To get a handle on these issues, I encourage my clients to conduct a specific series of stress tests that ultimately test the vibrancy of their business models in the wake of various combinations of events. One of the most significant challenges companies face is in the realm of value chain management. The globalization fever of the last decades has invited a culture of creating longer and longer value chains, all based on assumptions of cheap energy, cheap labor and free markets.

One of the drivers behind the financial crisis of 2007-2009 was the entire notion – embraced by just about every mainstream economist and financial expert – that real estate markets would always go up. Nobody was prepared or preparing themselves for the seemingly unlikely event that a downward trend might occur suddenly. In the meantime, the list of unresolved issues in the global economy is getting longer, not shorter.

To help my clients with these stress tests, I have prepared ten categories of questioning with numerous subheadings that probe the business model in a three-dimensional way.. This framework of ten categories, including several that address cluster, currency and credit risk, allows us to systematically probe into a business model’s ability to respond to rapid  changes in the environment.

The primary benefit of conducting the stress test is that it prioritizes the key issues where a company needs to strengthen its adaptability requirements. In many cases, stress tests will point to an urgent need to reverse engineer the value chain as it is currently configured. Sometimes stress tests of the type outlined here bring to the surface specific areas in which a company can shine with disruptive new approaches to business.

The outcome of the stress test is different for each company. However, chances are that the test outcome will help senior managers charged with the custody of their companies’ assets to create a smarter, leaner, and more flexible business model that helps them cope more vigorously with the challenging conditions of the second decade of the 21^st century.

Later this month I will be at the Paperworld in Frankfurt. There, I will be meeting with several clients addressing the topics outlined above. If you’d like to learn more about how a stress test could help your company strengthen its business model for success in an uncertain world,  contact us:

Thomas Schinkel

42 8^th Street, Suite 1523

Charlestown, MA 02129

e-mail: Tom@thomasschinkel.com

Business Success May Depend on a Subtle Shift in Mindset

by

Thomas Schinkel

December 2009

What can we expect in 2010? Pondering what the immediate future will bring is a popular pastime, especially at year’s end. There are plenty of prognosticators out there who will tell you with the utmost certainty that one group of trends or another will prevail. Economic growth, unemployment, housing starts, the condition of real estate markets, the stock market — the targets are too numerous to begin to list. It serves no practical purpose to parrot any of those predictions here.

Does 2010 have a malaise in store for us or will it be the beginning of a Renaissance for America? My own sense is that there are so may unresolved issues that it is too early to tell. In other words, not much of a forecast!

But I do want to draw attention to something more subtle, less tangible and definitely not measurable by the sort of mainstream metric that economists love. It has to do with a subtle shift in thinking about business and strategy, the traditional domain of the Chief Executive Officer. How to structure the organization, how to allocate capital, innovate in house or acquire knowledge from the outside, etc. – in the traditional paradigm the CEO is in charge of planning for the company’s growth, especially long-term. This mindset is captured in the following drawing:

But the crisis of 2008/2009 has shaken up many conventions and traditions, and today

especially going forward into the next couple of years, another mindset altogether is required. This new mindset has to do with coping with uncertainty of a new magnitude. The crisis has exposed many vulnerabilities in the global economy and, while a collapse of the entire global infrastructure has been avoided, unfortunately many of the unpredictables are still out there.

In view of this persistent condition, I have a different prediction to make: The crisis of 2008/2009 will have an overhang into 2010 in that it will have triggered in the minds of more senior business executives an urge to refocus their attention on something different from what they have been accustomed to during the last twenty years.

A Paradigm Shift for Business Leadership

Post-crisis management preoccupations at many a corporation will have shifted from the traditional realm of planning for growth to preparing for unpredictable events, as depicted in the following:

Many a business model has been affected by the crisis in ways that would have been unimaginable even a few years ago, and not always in a positive manner. To the contrary, the crisis has exposed weaknesses in even the largest and seemingly invincible corporate enterprises.

Since many of the factors that provided the underpinning for the crisis are still there, the timing of this paradigm shift is perfect. For example, during the next few years, it is not unreasonable to think through scenarios of inflation and deflation, combined with obsolescence and cluster risk.

Vulnerable Value Chains Present the Greatest Challenge

In my view, the greatest challenge facing many corporations is the issue of trend reversals in the value chain. Most value chains have become global, and the crisis of 2008/2009 has proven that these value chains are vulnerable to “black swan” disruptions. Preparing for and anticipating these disruptions is a sensible exercise – just as sensible as installing hurricane clamps in your house if you live in Hurricane Alley. In this context, some companies are better prepared than others. The French author and publicist Jean Jacques Servant Schreiber noted in 1967 that the American model of competition distinguished itself not because of its access to technology but more because of its manner of organization, combining resources and talent in new ways that made it so competitive and disruptive.

Today, forty years later, the world has changed many times over, and globalization has transformed the American economy into something unrecognizable the 1967 model. Many of the industries Schreiber identified as powerful soon entered a steady trajectory of decline, including the giants of the automotive industry, such as General Motors.

Prepare for the Unpredictable

But many countries — and especially specific companies — have taken a lesson from Schreiber’s observations, and today there are hundreds of companies spread all over the globe that distinguish themselves not because of their technology but because of the way they organize themselves, how they handle information, how they learn (from mistakes), how they share knowledge, where they focus their energies and why.

What seems to be a lost art at the national level has taken hold within some of the companies that will make history during the next five years. It has nothing to do with size; it has to do with how they prepare themselves for unpredictable events. Like hurricanes, these events will come, with the timing and intensity remaining unpredictable. The organizations and companies that are prepared will reap the benefits of extraordinary new opportunities that will provide the groundwork for renewed prosperity, distributed unevenly as ever around the globe.

##

by

Thomas Schinkel

November 22, 2009

A simple change in the way the largest retailers source their goods could have a dramatic effect on the United States’ trade imbalance with the rest of the world, and bring a host of other benefits in the bargain.

In America, we have two problems that touch the lives of every citizen, rich, poor and middle-class. These two problems are inextricably linked. The media have done, and continue to be do a poor job of explaining these problems to the American public , let alone describing solutions.

What are these two inextricably linked problems? One is the “Structural Trade Deficit”. The other is the “Triangle of Debt” (Government, Financial Services industry and Households). Here is what these two problems look like in isolation:

Structural Trade Deficit as Pct of GDP

Exhibit One of course, shows the Trade Deficit as a pct of Gross Domestic Product (GDP and highlights the changes that started to take place after the mid-1970’s. The growing services sector creates a trade surplus year after year, but it is never enough to make up the shortfall incurred by the trade imbalance in goods.

Total Debt Outstanding as a Pct of GDP

Exhibit Two shows the rising debt exposure of all sectors of the economy, but especially the household sector and the financial services industry.

How is it that these two problems are inextricably linked? In a nutshell, year after year, we have imported more goods than we had domestic currency to pay for through offsetting exports. The capital that left our country ended up in the hands of overseas governments, which used these excess dollars to create money in their own currencies. Then these governments turned around and lent the same amounts of dollar-denominated capital back to us in the form of U.S. Treasuries (financing the government debt), and other debt instruments, predominantly those issued by the major banks.

In turn, the major banks further facilitated debt accumulation by the American public. While the party lasted, it looked great, at least on paper. Now take a look at Exhibit Three:

This is the view from 35,000 feet and another way of seeing the two problems from a global perspective. For a whole generation, our leaders -domestic and international – have paid homage to this seemingly virtuous cycle. But the party came to a grinding halt when some of our overseas lenders came to the realization that the financial products they got in exchange for the money they lent us were without value. When they called us on it, a crisis of historic proportions erupted.

The only realistic way to come out of this crisis is to address both problems at the same time. At the consumer level this is happening, although not at the rate sufficient to get out of trouble within a couple of years. The banking bailout of September 2008, and the stimulus program of February 2009, have actually hugely increased the federal debt exposure, and the nation’s total debt outstanding as a pct of GDP has increased rather than decreased.

The other crisis, the “trade imbalances crisis”, must be addressed at two levels. One is through regulation and renegotiation of international trade treaties. The other is through voluntary action.

Voluntary Action and Domestic Sourcing

A large part of the trade balance is made up of imported consumer goods. Here is where companies like Walmart, Staples, Target, Office Depot, and indeed the entire retail sector comes in.

If all of the 100 largest retailers in the U.S. would voluntarily adopt a program that redirected a portion of their purchasing budgets away from overseas sourcing to domestic sourcing, and kept doing this for the next three years, it would have a positively magic effect on our trade imbalance with the rest of the world. If these influential retailers took such voluntary actions, the trade deficit would be sharply reduced, if not eliminated, within a three year time-span.

Four Benefits

What would be the benefit of such a retailing initiative? I see at least four. First of all, increased domestic sourcing would help create more jobs domestically. Second, it would result in a reduced outflow of dollars that pay for imports we cannot afford. Third, it would reduce, postpone or completely eliminate the need for draconian regulations on imports, or worse, a default-induced collapse of the dollar. The dollar’s collapse would have the same effect as draconian limits on imports, but in a manner that would be more disorderly and much more damaging to the American economy. Fourth, it would restore a sense of credibility in the global financial system, a credibility that was so severely damaged during and after the crisis of 2008.

How to get there?
The best and most effective way to kick-start such an effort in the retailing industry would be to change the reward structure for purchasing managers and others in retailing organizations who are responsible for procurement of products for resale. A meaningful percent of their bonuses could be made dependent on their ability to meet the goal of increasing the portion of their purchasing dollars directed toward products that are actually made here in the U.S.

Protectionism?

Would this be protectionism? Not really! It would not block trade from any country. It would merely help bring the amount of what we buy from other countries in balance with the amount we sell to other countries. A five percent calibration per year in monetary terms would do the trick, perhaps even less.

Self-reliance is possible

America is a very large economy that should be self-sufficient in providing for most of its needs. A couple of years of trade surpluses that were followed by a couple of years of trade deficits would be the perfect tell-tale sign that things were in order. But that is not how it has been for the last thirty years.

Over the next few years, numerous initiatives will come to the fore that will help us reduce our dependence on imported energy. Both initiatives can fix the trade imbalance and then some. Imagine the consequence if we don’t. Some pundits want us to believe that greater transparency at the Fed will trigger a run on the dollar. That is complete nonsense. What triggers a run on a currency is a structural trade deficit that remains unaddressed.

Fixing our trade imbalances is a win-win situation in return for a few Christmas seasons of belt-tightening in the realm of consumer-spending. It would be a form of voluntary restraint on the part of retailers and the consumer. Balanced Trade: good for America, good for the World!

Thomas Schinkel

by

Thomas Schinkel

October, 2009

A central theme in the financial crisis of 2007-2009 is that many people in high places in the financial services industry assumed they were effective managers of risk. Ever more complex and impressive looking mathematical formulas assisted them in their quest to allocate and re-distribute the many risks associated with their actions. But those “post-modern methods of risk management” backfired and a taxpayer-financed bailout was required to prevent the entire system from certain collapse.

Two Remedies

To remedy the situation, two major ideas have come to the surface. One would place a cap on bankers’ bonuses. The other would prescribe strict limits on how much a bank can borrow against its own equity capital. The first idea is inspired by hopes that caps on bonuses will discourage bankers from taking exorbitant risks in the first place. This is pretty much a European idea, heralded by politicians from France and Germany, but also from the UK and elsewhere. The other main idea, with American roots, is to adopt strict rules on leverage. Leverage of course defines the amount of dollars or Euros banks borrow against their “at risk” capital. Such caps are interesting because several banks, such as Lehman, that got themselves in trouble had built up borrowings at 30 times and more of their own capital. And we are not even talking about the shadow bankers, the hedge funds and the like that saw leverage ratios even much higher than that. Going forward into the Fall of 2009, let’s assume that the Global Community actually can agree on some sort of a consensus and that it will embrace a little bit of both. Would that solve the problem of risk management and would that return the financial services community to a condition of health and stability?

Risk Management

Intuition and common sense seem to dictate that risk must be taken cautiously and the best way to guard against systemic failure would be to spread risk among as many parties as possible. What has entirely fallen off the table is the notion that with all the restructuring and the bailouts that we have witnessed, risk in the financial services community has not become less concentrated; it has become more concentrated! According to the Dallas Federal Reserve, before the crisis, the SIX largest financial conglomerates in the U.S. controlled approximately 50% of all financial assets in the country. With the consolidation that was set in motion since the crisis erupted that number today has dwindled to FOUR.

Four Financial Institutions control

50% of All Financial Assets

Before we come back to this challenge of consolidation, let’s take a look at leverage. Taking the financial statements of these four largest financial institutions in the country at face value, as of June 30, 2009 their combined leverage ratio amounted to approximately 11.0 times (total assets divided by total equity), and let’s assume by way of hypothesis of course, that under any new rules it would have to be 9x, a modest improvement.

As you can see from the above calculation, such a new rule would imply that these four financial institutions would have to raise some $147 billion in additional equity capital. Add this to the prepayment of $43 billion the FDIC is proposing to demand from the financial services industry (lest it go broke itself), and you can imagine the challenges here. Even if this could be done within a couple of years, the big question of course remains whether it would fix the problem! The challenge is hidden in the fact that there is no way these financial institutions’ balance sheets should be taken at face value! For years they have engaged in off-book transactions, creating and participating in companies with capital and risk exposures that are impossible to discern from their financial statements.

Off-book transactions

Wait a minute, where have I heard this business of off-book transactions before! Oh yes, of course, I almost forgot, Enron! Back in 2000, they were in a spectacular mess with off-book transactions in hundreds of companies without properly recording not so much the amounts of capital they had invested or how the deals were structured, but WITHOUT BEING ABLE TO DEFINE WHAT RISKS THESE VENTURES REPRESENTED! It seems to me that today, with the top-tier financial institutions we have exactly the same problem. In this context, it is puzzling in the extreme how the other day a firm like Goldman Sachs managed to publish a “buy” recommendation for some of the very same financial institutions we are talking about without saying a word about their off-book liabilities.

Breaking up the Banks

The systemic risk that resulted from the concentration of the bulk of financial assets in the hands of fewer and fewer institutions, would be addressed effectively if the regulatory regime focused on:

• breaking up the largest banks into smaller pieces;
• abolishing the practice of off-book transactions;
• setting specific rules for caps on market share in any specific class of financial activity; and
• prohibiting banks from engaging in combinations of activities that are known conflicts of interest.

In other words, relearn the lessons from the 1930’s, reintroduce the Glass-Steagall Act, a modern version of it anyway, and make sure that the top-tier banking industry does not get so powerful that any one component becomes too big to fail.

Anti-Trust Rules

Breaking up an industry is difficult but not impossible. Given what is at stake here, breaking up the system into smaller pieces should be given much more consideration. In the early 1980’s, Congress managed to break up AT&T’s monopoly in the telecommunications industry, making room for what became known as the “Baby Bells”. Microsoft has been subject to threats of a regulatory break-up for years. And European Competition Commissioner Neelie Kroes is going after Oracle with a vengeance. How come our regulatory bodies are so quiet about this set of tools at their disposal when it comes to dealing with the financial services industry?

Strict New Rules

A return to market segmentation, and limits on market share by product line would be a credible way to reduce the systemic risk that is now concentrated in ever fewer hands. It is such common sense segmentation and separation that would help return the system to stability. For example, the financial services industry could be divided into three groups: Insurance, Banking, and Securities.

A simple rule could be adopted that would prohibit any one financial institution from operating in more than one of these three segments. Companies that take deposits from the public and thereby come under the insurance umbrella of the FDIC would need to abide by even stricter rules. And no bank could have more than a certain market share in any one particular line of business, since it is this very concentration of power within markets that exposes the taxpayer to the mantra of TOO BIG TO FAIL.

Sorry folks, but to my way of thinking, in our capitalist system of free enterprise, no company should ever be too big to fail, and the taxpayer should never have to bail out any corporation (financial or otherwise) ever again!

Smoke and Mirrors

What is increasingly obvious though is that the industry, the regulators and the policy makers appear to have given up on consideration of this very simple method of risk management. It is no longer discussed. Supposedly, if we broke up the banks this would open the door to foreign competition. This of course, is nonsense since foreign banks that wished to operate in America would be subject to the same rules. Unfortunately, instead of providing firm new regulation, the powers that be, both in Europe and here in America, are stitching together a beautiful new wedding gown (in the form of bonus caps and leverage requirements), but it is for the same old, same old bride. Our prime creditors, the Chinese, have become very skeptical of the quality of Washington’s promises and the strength of its Treasuries. In a twisted paradox, these sentiments are increasingly shared with the American middle class. Real reform may restore the trust and faith in our present model of capitalism. It actually may provide the underpinning of an American Renaissance. Without it there may very well be taxpayer revolt, or worse.

may be much more effective as a tool for creating new jobs!

by

Thomas Schinkel

April 13, 2009

Part One of this series of articles about America’s New Deal with Capitalism estimated the size of the hit that the economy had taken as a result of converging forces in the realm of financial globalization. The article concluded that for 2008 alone, it would be in the range of $9 trillion. Now, don’t get me wrong, $9 trillion is a lot of money but it does not throw the entire country into bankruptcy. Yet, it is a big number and it did get the attention of the disproportionately hit middle class!

The second part of this series articulated a remedy to the crisis, in essence suggesting that the government should stop bailing out banks that are supposedly too big to fail, and intervene instead by making direct (once in a lifetime), interest-free loans to those families that had gotten into trouble.

The program would have a rigorous repayment schedule and participants would automatically agree to a higher tax bracket. This way all parties would maintain a stake in the positive outcome of such a program. In other words, no bailouts, but a solid agreement between tens of thousands, maybe even hundreds of thousands of families and their government to prevent an avalanche of problems in credit, real estate and job markets that could throw the entire system into disarray.

All along the position was that this is not just a single crisis; it is a series of embedded crises that are interconnected.  It is the aggregate result of long term failures in the realm of industrial, fiscal, monetary and foreign policy fueled by a strategy of exceedingly aggressive deregulation, a strategy fed by theories and mantras that would cause our forefathers to turn over in their graves.

The third part of this series takes a closer look at the present situation and it articulates some suggestions for beginning to fix our capitalist system, one step at a time.

Globalization 2009: A Witch’s Brew of Contradictions

Taking a candid look at our present day state of affairs in the realm of Globalization, one cannot escape the conclusion that the Global Economy A.D. 2009 is a Witch’s Brew of Contradictions. This witch’s brew consists of the following ingredients:

• Fiat Currencies: Ever since President Nixon nixed the gold standard, we have had a global system of Fiat currencies, IOU’s with nothing to back it up;
• Free Trade: We are continuing to preach and pursue that sacred cow of Free Trade among nations without any regard to the severe structural imbalances that have emerged among the largest;
• Interest Rates: We pursue artificially low interest rates to stimulate consumption sectors of an economy without regard to its ability to absorb such growth and pay for it with money that results from productivity improvements;
• Guns and Butter: We are embracing Guns AND Butter economics without any mechanisms in place whatsoever to fund either, except for drawing checks on future generations’ ability to pay down debt;
• Off-shoring: In business, for more than ten years now, we have pursued a mantra of Value-Chain Management that embraces off-shoring of domestic manufacturing activities as a quick, short-term way to achieve lower costs. While the overall economy has grown and grown, predominantly through consumption and expansion of the services sector, capital expenditures in surplus value creating activities have been sidelined from the economic equation.

Exhibit One shows capital expenditures, payroll and value added for the manufacturing sector from 1977 to 2006. These values are presented as a Pct of GDP.

And we know from previous research, that our services economy lacks the international prowess to earn sufficient foreign currency to feed our appetite for imported goods.

Nobody in America, or Europe, or among the leading international institutions such as the World Bank, the OECD or the WTO, seems to have a coherent fix on these contradictions with any level of forward vision at all. Everyone is fighting for the status quo, for protecting their turf, and defending mantras, theories and strategies that were appropriate for yesteryear.

Let me give you an example. The whole world know that America has a huge structural trade deficit and that there is no way we can continue this way without a severe price to pay. During the discussions about the Stimulus Program, the idea came up to say that all this money should be earmarked for products made in America.

This way we would kill two birds with one stone. The ink was not dry on the Program, or the international howling started. The Representative of the European Commission in Washington actually appeared on TV, uttering stern warnings that this was against WTO rules, and that this entire talking about “Buy American” had to stopped. “OK my friend, but how are we going to fix the U.S. trade imbalance that threatens to undermine not only our own economy, but that of the rest of the world? Will you, and the Chinese, and the Japanese and everyone else, continue to lend us our own money to keep the racket going?” Of course, there was no answer to this question.

Through the prism of an independent business adviser such as me, our present world increasingly comes to resemble that of a volcano, rapidly amassing huge amounts of negative energy. For those of you who are not inclined to think in terms of what this means, the following pictures may help stimulate the imagination:

Keeping with that analogy, here are some very short-term developments that may further increase the pressure on this not so imaginary economic volcano:

• Final year-end reports on mutual funds’ performance will be published shortly – the public will not be pleased;
• Batches of commercial (real estate) loans are ready to implode on bankers’ books (this may be the very reason why bankers are not lending. They want to hang on to the tax-payer funded reserves they got during the bailout to weather yet another storm they see on the horizon);
• Automotive sales continue to slump, with at least one major bankruptcy looming, taking down with it an entire infrastructure of suppliers;
• Real estate markets continue to slump, taking another hit of 5-10% before hitting bottom by the end of 2009;
• Unemployment continues to rise and may soon exceed 9.5%;
• Banks continue to tighten credit standards on even their best customers, despite having received billions in Federal aid;
• Major manufacturers tighten credit on marginal players in their distribution channels, setting off a silent contraction throughout the economy.

As the pressure builds up inside that volcano, a release can take place in one of two ways. One way is an organic, uncontrolled explosion that sets off the entire system. If the wrong medication is administered, or the right medication is administered to the wrong group in society, or at the wrong time, like in “too little too late”, or nothing is done at all, the volcano will go off, unleashing centrifugal forces that will make minced meat of the entire political, financial, industrial, trade, social, military and cultural infrastructure that emerged after the Fall of the Berlin Wall in 1989.

If this happens all bets are off. But there is some good news as well, that gets drowned out in the pervasive psychology of fear that permeates from the media:

• The Chinese Stimulus Plan is already showing signs that it is working, creating a new wave of demand for imports from all corners of the world;
• The American Stimulus Plan is getting into action very shortly; <li>U.S. Real estate markets that have shown the steepest decline are indicating that bargain hunters are returning to the market;
• The U.S. Savings Rate is shooting straight up into territory it has not seen in a long while; there is every reason to support the assumption that it will hit 10% of GDP by 2010.

So rather than join the herd of people who believe that the roof is caving in, I would like to develop a different scenario, one that is characterized by “a series of mini-explosions”, and economic earthquakes that each carry their own costs and benefits. In my next article we will discuss this at length.

For now, I want to conclude with comments on the actions taken by government during the last six months.

The Bailout Program of October 2008

In October of last year we had the Bailout Bill, to the tune of $800 billion. It is now clear that this program was and is an example of crass self-preservation, keeping the failing banking giants on their feet. An opportunity missed? And here is my question. For example, instead of propping up the top-tier banks with large amounts of taxpayer provided cash, the government could also have said: To prevent these problems from happening in the first place, we are going to break up the banking system into smaller, separate and distinct components. While it would definitely be “out-of-the-box”, such a way of thinking would have been nothing special. Years ago, the government broke up AT&T, the (very well functioning) telephone monopoly. Also, for years the government has been toying with the idea of breaking up Microsoft. So why not break up the top-tier banks? The Charter of the Federal Reserve Bank, stipulates that its commitment is to the preservation and protection of the top-tier of the American Financial Services Industry. Not to be irreverent or anything, but it is nothing but a cartel that – since its inception in 1913 – has managed to maintain a “very cozy relationship” with officialdom. When you see Ben Bernanke on TV, lest you get the idea he is looking out for you, remember he is on the payroll of the cartel, and his mandate is to look out for the best interests of the top-tier banks. With the help of taxpayer dollars, a break-up has not even been considered. Mission Accomplished, at least for now. From a banker’s perspective, 2008 must have been a year of Great Accomplishment.

The Stimulus Program of February 2009

Short on the heels of the largest economic rescue in the history of America, now comes the Stimulus Program, again to the tune of $800 billion. That number seems to take on magic connotations. Taking a close look at the component that includes specific cash disbursements in that program (the other component being “tax cuts”), one cannot help but notice that these disbursements are largely being poured into the veins of the entire Federal, State and Local Bureaucratic Infrastructure. In other words, one cannot help but get the impression that here too there is an element of institutional self-preservation at work. Short-term, my sense is that the program may have a mildly positive effect, as it will create and preserve jobs throughout the economy. But what about the Long-Term? Much money will be spent on fixing the old infrastructure, an infrastructure that created wealth during the 1960’s, 1970’s and 1980’s.

What I am missing in this entire conversation about the economy and the society it is supposed to support is the whole question of New Surplus Value Creation. What about Innovations in the private sector in general and in industry in particular? Where is the next Microsoft? Where is the next aviation industry? Where are the next high paying jobs? Where are the next waves of productivity enhancing investments? Waves of new start-ups? New job creation? We have tried hyper-deregulation. We now know, and perhaps should have known all along, that did not work. How about stimulating venture capitalism across a borad swath of sectors of re-industrialization? My own sense is that we need a third leg under the stool of programs to stimulate the economy, and perhaps it should be called:

The Innovation Program of September 2009.

Such a program would have at least four components. One component would allocate large amounts of money to venture capital endeavors of all kinds. Fixing the electricity grid is great but it takes ten to twenty years to produce results. Another component would be addressing all the bottle necks that have formed in our society that stand in the way of breakthrough technologies not just in esoteric industries like bio-tech but mundane ones like aviation, agriculture, distribution, transportation, conversion of shopping malls into business incubation centers. It would also include very attractive prizes for innovations and breakthroughs in 80-100 different areas of industrial endeavor. And it would completely revamp the way federal taxes are collected, no longer based on old ideas supporting old infrastructures but based on the knowledge we have today about the economy, society and the environment. For example, it would include a Value Added Tax Structure that included the services sector, and it would include a much heavier tax on fuel consumption than what we have today. These new companies, the new innovations, the numerous trials and errors of entrepreneurs, some will fail, some will survive, but some will be extremely successful, creating the productivity improvements we saw during the mid 1990’s when a whole family of companies descended upon the community of small and medium size businesses offering inexpensive new productivity tools that pushed them from survival to prosperity.

My point is this: If you can find $800 billion to come to the rescue of a small group of very big banks, you can also find $800 billion to provide funding for thousands, nay, hundreds of thousands of new small companies and start-ups throughout all corners of society.

One thing is clear and that is that we are on the brink of tinkering with an entirely new form of capitalism. The difference between the old form and the new form of capitalism would have to be that the micro capitalists (main street) get protected from the predatory practices of the hyper-capitalists (i.e. eight of nine very large banks and quasi-banks) that seem to have unrestrained access to tax dollars provided by the rest of society.

What is the bottom-line of my argument? Stop throwing GOOD money against BAD! Instead of using another $800 billion to bail out a small band of big-time shadow bankers at the top of our capitalist pyramid, invest all that money at the bottom of the pyramid, thereby creating a culture of renewal and revitalization from the bottom up. Not through consumption but through the creation of New economic Value!

Thomas Schinkel

By

Thomas Schinkel

February, 2009

In Part One of my article entitled “2009 America’s New Deal with Capitalism,” I concluded that the economic crisis that has enveloped us all had a scope in the range of $9 trillion, that this was a lot of money and that it was accompanied by an even more severe crisis, and that was a crisis of trust.

Trust in this context means implied trust among various groups in society such as the middle class, the financial services community and the governing class. Each of these groups has a stake in our present system of capitalism, and without credible efforts to restore this trust, nothing will work to save this system of capitalism from collapse.

In this second part of the series, I will first outline an alternate set of action steps that I believe are necessary to arrive at a solution. Then I will outline the benefits of such a new way of thinking.

Preamble
Instead of focusing all its energies on preserving the top- tier of the financial services architecture, what the Federal Government needs to do instead is focus on preserving the economic integrity of the American  middle class!
Without the top tier of banking institutions the world will function anyway. Competition within the banking community is sufficient for the remaining, more mundane, bankers to pick up the slack in the event that the top ten banks disappear altogether.
By contrast, if you want to know how a world looks like without a middle class, go visit Mexico City or Sao Paulo, and if that does not get your attention, on your way back home make sure to stop over in Port au Prince (Haiti) and take a look at poverty in its ugliest form.
One aspect of the present crisis offers a glimmer of hope, and that is the historically low interest rate that the Federal Reserve is charging the most elite members of the financial community. The Bank of England went a step further, and set the rate to zero, a phenomenon not witnessed since 1650.

The Real Challenge:
With the steep deflation of real estate markets, millions of members of the middle class (especially the lower echelon), are at risk of losing the equity in their homes, the only real connection they have with - and commitment to - our present system of capitalism. This scenario is getting more real by the day.

AMERICA’S NEW DEAL WITH CAPITALISM

An action plan to prevent the real challenge from becoming a reality consists of two components.  Component One is a household debt restructuring program consisting of interest-free “emergency” loans to members of the middle class. It capitalizes on the historically low interest rates charged by the Federal Reserve, but instead of offering it to the banks, it is offered as  a one-time emergency opportunity directly to individuals and households. Component two is a tax burden restructuring program that allows the government to get its own financial affairs in order.

Component One: Household Debt Restructuring Program

Bypassing the Federal Reserve, the Federal Government offers every family or individual the option to enter into a one-time, interest-free loan of up to 50 percent of their reported household income for last year, or up to $50,000 per person and up to $100,000 per household. This loan is directly with the Internal Revenue Service (no middlemen, no fees, no closing costs, nothing). Prerequisites are that applicants have filed tax returns for the last three years and that they are current on their taxes. Conditions are that applicants agree to use the loan for restructuring of their debts only. They also agree to a tax bracket that is three points above what they pay now, for the duration of the loan, a maximum of ten years. The debt restructuring loans are to be used in the following manner (a simple, one page affidavit attached to the applicant’s form 1040 will establish the specific goals of the applicant):

1.      Pay off or reduce the balance on any home equity loans or second mortgages outstanding;

2.      Pay off or reduce the balance on any education debt owned to financial institutions;

3.      Pay off or reduce the balance on any unsecured lines of credit with their bankers;

4.      Pay of or pay down any credit card debt or other forms of consumer debt with financial institutions or equivalent organizations.

As part of “‘America’s New Deal with Capitalism”, the government mandates from the bankers that any of their customers who participate in this program of debt restructuring receive a one-time, two percent discount on any of the debts they pay off to their banks under this program.

Component Two: Comprehensive Tax Restructuring

The government is already way over its head in debt and there are several fairly painless measures to overcome this challenge of government deficits, as follows:

1.      A nationwide consumer tax on all purchases that are non-food and non-investment. What comes to mind here is  a Value Added Tax such as that in use by practically all other major countries in the world.

2.      A  five percent tax on all services that are performed in the economy. The largest portion of our economy is in services and this sector is under-taxed or there is no tax on services transactions at all. The services sector includes architectural, consulting, legal, and numerous other services that are now under the tax radar. It also includes financial services such as buying and selling shares in publicly traded companies. A tax on this hyper-active trade is long overdue.

3.      A significant increase in the Federal tax on gasoline use.
It is my contention that this simple to understand program not only stands the test of fairness, it is also doable in a very short period of time, and it solves several problems at once, as follows:

1.      It reestablishes credibility to the idea that capitalism is for all citizens, not just for the well-connected and the upper crust.

2.      It gives everyone – young and old – breathing room to restructure the composition of their finances, especially since the tide of the markets has turned against them. People who have bought homes in the last three years can restructure. People who have lost fifty percent of their retirement savings can restructure their finances.

3.      Large cash deposits come into the banks through the front door, not the back door (the way it is done now with the TARPS program) This will unfreeze the credit markets from the ground up, not from the top down. The latter has been tried; it did not work, and no more tax dollars should be squandered in this manner.

4.      After an initial, huge increase in government debt, this debt will rapidly disappear from the additional tax revenue streams that will be created by both components. After all, participants are motivated to pay off their loans early so they can go back to the lower tax bracket. My sense is that with the proper balancing of rates, the government can return to a debt ratio of - say – where it was in 1998.

5.      The collective savings rate will increase from minus 2-3% in 2008 to a positive 3-5% within two years, and it may even climb back to 10 percent in five years (where it should be).

6.      It provides specific tools to help transform the economy to a post-consumer society (a natural next phase in society with the baby-boomer generation entering retirement by the millions).

7.      It acknowledges that the problems we are in now - were created and ignored by the upper echelons of our political and business elites and it would be unconscionable to reward that class for the errors of their ways while leaving the masses behind. After all, if the American middle class disappears into bankruptcy, so goes the upper class and so goes the world.

8.      It is inflation/deflation neutral;.

9.      Its elective nature gives it a surgical precision because only those individuals and households that really need it will opt for it. The carrot for the others is to remain with the lower tax rate.
Most important, the program outlined above incorporates something that is missing from anything else that has been proposed to date. It will restore a sense of trust among the various groups in society, a prerequisite for stability, progress and the achievement of a shared sense of prosperity. As a result, large groups of people will come back into the market (financial and real estate), and the deflationary spiral will be broken before the entire system crashes into the ground. Breaking this downward spiral in the financial and real estate markets will be the ultimate cure that will help the American and world economies regain their footing.

In short, I believe that this is a win-win situation for all. It throws a lifeline to the millions of Americans who otherwise will be kicked out of the middle class. It also reestablishes the credibility of the Federal Government and its institutions, badly bruised by fifteen years of thoroughly discredited mantras about privatization and liberalization. It will maintain the core of our traditions of capitalism and democracy, while renewing an emphasis on responsibility, oversight and accountability; that sharing the wealth creates prosperity for all.

With the inauguration of a new President, this line of thinking may well be in harmony with a new spirit that is emerging in America, a new dawn, a new beginning for our global village. Goodbye Crassus, Caesar and Rome! Welcome Compassion, Hope and Goodwill among all!

By

Thomas Schinkel

January 9, 2009

2008 may very well go into history as the year most everybody wants to forget. What started in 2007 as a seemingly obscure set of problems in the arena of sub-prime mortgage lending morphed into a much larger banking crisis, that culminated in the now infamous $800 billion Banking Sector Bailout Request to Congress last September. Along the way, another equally threatening crisis emerged, with the cost of fuel running amok during the summer, but then rapidly fading during the fourth quarter of the year.

But the crisis of the Financial Services Industry ended up inviting a much larger problem, a massive decline in real estate values, combined with a major retreat of stock markets, not just in America but around the world. Through the fog, it is sometimes difficult to separate one crisis from another, let alone trying to get a fix on what caused one crisis and what exactly triggered the next.

Everybody agrees that this crisis is really big, and that it is a real challenge. But how big is the crisis? Is it $800 billion? Will a stimulus package of $700 billion fix the problem? After all, during the summer of 2008, every family in the country got a stimulus check from the Federal Government and whatever it did – it did not stimulate the economy!

So, let’s start at the beginning and try to get a fix on how big the total group of embedded crises really is. We’ll take a five-year look at Real Estate Markets, at the Stock Market and at the Bailout numbers for the Financial Services Industry. We will look at these three interconnected crises through the prism of the American Middle Class, that rapidly shrinking sector of society that seems to be hardest hit by the crises that are all around us right now.

I. Real Estate

Our first stop is at the U.S. Bureau of Economic Analysis in Washington, DC., an organization that maintains detailed records on real estate market values. Capturing data from this source, Exhibit One shows trends in the three most relevant parameters of the residential real estate market, namely the aggregate market value of homes, the aggregate amount of mortgages owed on these properties, and the net aggregate equity held in those properties by U.S. households. The exhibit shows the trend lines from 2003 to 2008. For years, market values have risen steadily, but from 2006 onward, market values have started to slide.

With mortgages staying at the same or slightly higher levels, this combination of trends morphs into a serious decline in the aggregate net equity values that U.S. households have in their homes.

Even today, there is still significant excess inventory in the stock of residential homes throughout the country, and it is not unreasonable to project another ten percent decline in those aggregate market values before residential housing markets reach a new equilibrium. In all likelihood, this rebalancing will play itself out in 2009. Why is this decline important?

Traditionally, households have looked at the equity in their homes as an economic cushion, an invisible savings account that provides security for the long term. During the last five years, many families had started to borrow against that security cushion. Egged on through aggressive advertising by the very financial institutions that are now in trouble, families borrowed against the value of their homes in the form of lines of credit or home equity loans. With market values in retreat, and their perceived equity cut in half, families’ appetite for borrowing against their home equity has come to an abrupt halt.  The aggregate value of this net loss for U.S. Households amounts to approximately $4.3 trillion.

II. Stock Markets

Our next stop is at the Stock Markets, where another dimension of the Financial Crisis of 2008 is playing itself out. Beyond the widely published indices, it is difficult to measure exactly how much money investors have actually lost in the stock market as a result of the markets turning bearish throughout the year. But there are some reliable sources in the private sector that shed light on at least part of the problem. One such source is the Investment Company Institute, a trade organization that monitors the mutual funds industry.

Capturing data published by this source, Exhibit Two provides a five year perspective on the Combined Net Assets held by Mutual Funds, Exchange Traded Funds and Closed-end Funds. This, after all, is where many middle class families park their savings for retirement and for a rainy day. From 2003 to 2007, net assets under management grew at a steady pace. 2008 reversed this trend, with the total net assets held by this group of funds declining by a whopping $2.6 trillion!

III. Banking Bailout

Now is a good time to take a look at the third dimension of the crisis, the Bankers Bailout of 2008. In September of last year, Congress appropriated an amount of $800 billion earmarked to free a select group of financial institutions of the “toxic assets” they had so eagerly sold to buyers around the world. Look at this Bailout as the “Largest Product Recall” in the history of mankind, except that this is not about traditional products such as automobiles, but about financial instruments such as “mortgage- backed securities”.

Another big difference is that product recalls usually are funded from the coffers of the industries that created the problem in the first place. In this case of the Bankers, it was the American taxpayer (U.S. Households) to the rescue. How do we get a fix on the scope of this problem? The official website of the U.S. Federal Reserve provides a glimpse at the size of the bailout.

Capturing data extracted from the Federal Reserve’s official website, Exhibit Three provides a five-year perspective on the Reserve’s liabilities. From 2003 to 2007, its total liabilities steadily increased by 3-5% per year. But then comes the last quarter of 2008.  During the last three months of 2008, the Federal Reserve managed to increase its liabilities three-fold, an unprecedented increase to a whopping $2.2 trillion!

Without the slightest hesitation it can be said that such an increase has never happened before in the history of the Federal Reserve. The money is earmarked for a bailout of the likes of AIG, Bear Stearns, J.P. Morgan, et al. Where did these new liabilities come from? The bulk of these new liabilities came from the U.S. Treasury and from other sources, predominantly foreign.

First of all, the new amounts of debt created here are much larger than the publicly acknowledged $800 billion bailout money requested from Congress immediately after Labor Day. Granted, the moneys are used in part to acquire preferred equity in the companies that need to be bailed out. If things go perfectly right, some day these preferred equity positions may be worth something. But for now, I cannot help but think that it looks suspiciously like borrowing short term to pay off toxic obligations that are worthless regardless of economic recovery in the near future.

In other words, sooner or later, a large chunk of these newly created liabilities may end up as debt held by the public (the same U.S. Households that already got whacked twice). And if the government decides to get cranking with the printing presses – a scenario closer to reality than we might think today – U.S. Households will pay through inflation.

So in review: Exhibit Four summarizes the results of this brief inquiry into the financial crisis of 2008:

Exhibit Four

Financial Crisis of 2008

Impact on Aggregate Equity Position U.S. Households

Prepared by Thomas Schinkel from official and non-official sources of

Information – 2009

Our inquiry into the size of the Crisis of 2008 results in a finding that it amounts to approximately $9.0 trillion. Yes, Nellie, that is a lot money, but how much, really? Here are some comparisons to give you a sense of how much $ 9.0 trillion really is:

• It is almost as much as all of last year’s aggregate disposable income of $10.5 trillion;
• It is 180 times the size of the Madoff Scandal, estimated at $50.0 billion;
• It is 450 times the cost of Boston’s much maligned Big Dig, which was approximately $16.0 billion (spread out over a period of ten years!);
• It is 3 times the total lifetime costs associated with the War in Iraq.

With all this wealth either disappearing or debt being added to the already sizable public debt, it is no wonder the American consumer went on strike this Christmas! Now, in its on-going effort to deal with the crisis, the Federal Reserve did something else that is unprecedented, it lowered the discount rate charges to almost ZERO, as shown in Exhibit Five:

The discount interest rate is the rate charged to “eligible” depository Institutions. The purpose of this lower interest rate is to allow banks to lower the rate they charge their customers such as U.S. Households. But U.S. Households are not borrowing. Why?  Well, beyond the numbers – however staggering in their dimensions – there is something else happening that helps explain the nature of the problem. During 2008, something very important happened to the intricate web of business dealings between the public (U.S. Households), and their financial institutions, and that was the disappearance of TRUST!

U.S. Households are not borrowing, not only because they saw the equity in their real estate evaporate, but also because they are not sure what tomorrow will bring. Will the real estate market go even lower? It is very possible with the excess housing inventory still amounting to a full year of absorption. More importantly:

Why should one trust the bankers who have so thoroughly discredited themselves?

• Why trust the politicians who have so severely discredited themselves?
• Why trust the regulators and system supervisors (i.e. The Securities and Exchange Commission et al), who so thoroughly discredited themselves?

What else may come out of the woodwork? Will we see a repeat of Hank Paulson on his knees again in front of Nancy Pelosi pleading for yet another $800 billion taxpayer funded bailout without strings attached?

The larger question of course, is: what to do about this crisis and how to get out of it without throwing the entire world into a tailspin. News reports suggest that the new Administration is thinking of a stimulus package in the range of $800 billion over two years. Of course, these additional amounts are not included in the above table. Also, they expect government deficits of $1 trillion per year for the foreseeable future.

In my next article on the subject, I will address this question and suggest a bailout plan for the American middle class. It is a suggestion with a twist. For now, we learned that we are dealing with a $9 trillion problem and that without restoration of TRUST nothing will work to fix it. Stay tuned. Happy New Year!

Thomas Schinkel

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