By

Thomas Schinkel

November 19, 2010

We are living in turbulent times. In fact, we are witnessing a political earthquake that ranks right up there with events such as the collapse of the Soviet Union, the reintegration of the two Germanys, and the collapse of the Bretton Woods Agreement that had served the world from 1945 to 1970 and had resulted in a prolonged period of prosperity for many nations. (In 1971, Richard Nixon disconnected the fixed parity that existed between the value of the U.S. dollar and a certain quantity of gold. During the period of Bretton Woods One, the price of an ounce of gold was US $35.)

Today’s earthquake promises to be more severe than these past events, as it is economic in nature and global in scope. It relates to what is known as the “Washington Consensus”. What is that? During the early stage of the Reagan administration, a series of new mantras and belief systems about the organization of the global economy entered the collective thought processes of economists and politicians in the U.S. and Britain. Both unleashed a series of changes that reverberated throughout the world for the next thirty years. To make a long story short, these mantras and belief systems (propped up by highly dubious arguments of a theoretical nature) included a belief in privatization, liberalization and deregulation. Privatization applied to government-sponsored and owned enterprises. Liberalization applied to the free flow of capital and goods (not people), and deregulation applied to the dismantling of numerous rules and regulations that the proponents of these new belief systems believed to be strangling many Western economies. Vocal proponents of the new mantras included President Reagan and Prime Minister Margaret Thatcher.

After a slow start, the mantras began to take hold of larger and larger groups in academia, which in turn spread the gospel to the world at large. Businesses began to take advantage and after the collapse of the Soviet Union – an event the proponents of these belief systems claimed was directly attributable to their efforts -  there was no stopping the avalanche of freedom. Some scholars  even went so far as to argue that history had come to its logical conclusion and that a new and lasting equilibrium had arrived.

A signature moment in the march to liberty was the signing of the North American Free Trade Agreement (NAFTA), much heralded as the launching pad for a new age of prosperity among the U.S., Canada and Mexico. As more free trade agreements were entered into, it became clear that below the surface something was amiss. Right after the signing of NAFTA, Mexico was thrown into a severe crisis that wiped out the green shoots of prosperity that had seemed to be taking hold of their economy during the early 1990s. I was there when the crisis hit, and it was an ugly scene.

Later in the decade, crises erupted in Asia followed by Argentina, and then the bursting of the dot com bubble which hit closer to home. Whenever these crises hit a country, a standard recipe was rolled out that reflected the Washington Consensus. The recipe was to privatize government companies, open the market to imports, and reduce government spending.

There were plenty of critics, but I won’t review all the trials and tribulations between the forces in favor of and against the Washington Consensus. What’s clear is that the Crisis of 2008 (which originated in the U.S.) removed the underpinnings of any global consensus on world economics. What was lost was the faith that the mantras would actually be effective. More importantly, many observers inside and outside America could not help but notice that the financial crisis was laced with the F-word, fraud. Fraud before, during and after the crisis. Two lonely professors from Kansas University,  who had massive experience in the handling of previous crises, screamed at the top of their lungs about the systemic fraud that is being perpetuated by the financial services industry, yes, the highest echelons of it.

Perverse as it may be, what comes on the heels of this witches’ brew of issues is the Quantitative Easing embarked upon by the Federal Reserve. If the tipping point in the unraveling of the Washington Consensus was reached on September 15, 2008 when Paulson asked Congress for a blank check in the amount of $700 billion, the avalanche happened during the later part of 2010, culminating in the G20 meeting in Seoul. The Chinese are deathly afraid of QE2, fearing a firestorm enveloping their financial system that could trigger a wave of deflation a la Japan of the 1990s. Brazil has taken a beating with sky-high exchange rates that make their exports uncompetitive. They have taken steps to manage speculative capital inflows. Official protests coming out of Germany and the European Union focus on the imbalances within the American economy itself.

Folks everywhere are frustrated, uncertainty is rampant, and sober analysis is in short supply. The Asians want to go it alone, the Obama administration is wooing the largest democracy in the world to join it in the formation of what can best be described as a “Maginot Line of Economic Prosperity”. The Scandinavians remain quiet,  as always going their own, often  well-reasoned way.  Sixty years of a modicum of consensus in the world around themes of economic prosperity has come to an end.

The contours of what is next are already coming into view. Here are three aspects of what seems to be around the bend:

1. The upper echelons of “Global governance,” organizations such as the World Trade Organization and the World Bank, are probably rewriting their business plans as we speak, trying to incorporate the mind shift that just has taken place. If they do, there is a chance they will maintain some level of relevance when the world turns next.

2. In terms of international trade negotiations, expect the Doha round to be another polite manifestation of “agreeing to disagree”.

3. The rest of us, especially here in America, should expect “Import Inflation”. And frankly, that may not be such a bad thing. One could argue that this is exactly what the doctor ordered. If imports are getting more expensive, opportunities will arise for domestic production, which means job creation and adding more value within the dollar-zone.

4. Members of the business community, especially those who are heavily invested in global outsourcing and overseas sourcing, can expect challenges to their business models in various degrees. Some will have to retool the core of what has driven their success for so many years. Others can get by with tweaking one or more aspects of their mode of operations. Others, especially those who anticipated the turmoil, will have a splendid opportunity to reap the benefit of their foresight.

In this context, those of you who have read my blogs before will not be surprised to hear me say that for some there may be  salvation in looking for local solutions with local resources. Globalization may have run its course, the pendulum will swing back. It is a great time for entrepreneurial, disruptive innovation and the development of new business ideas. The more things change, the more they stay the same.

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

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