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

How currency imbalances and the price of oil may transform Consumer-centric Economy into an Export-centric Nation

by

Thomas Schinkel

June 2008

The other day I was watching a news program on PBS where several oil industry experts in the oil industry were asked why the price of oil was so high. Very quickly they pointed to the two main culprits. One was the Federal Reserve which had made the fatally flawed decision to lower interest rates, starting in August of 2007. The other was that new wave of speculators, financial institutions that had entered into investing in oil futures but not knowing how to do it. In passing they noted that the dollar was low and that was causing problems for the oil markets too.

What did not get addressed is WHY the dollar was so low. In today’s business environment, anyone charged with figuring out the long term direction of their enterprise has these twin questions at the center of their concerns. And if you are thinking of selling your company, these issues are equally important, since they may dictate who your buyers will be and where they come from.

How important is it? Here are some examples. If the price of oil goes up to $160-$180 per barrel, chances are that:

• General Motors may not survive the ensuing twelve months. As of today’s date their stock price is where it was in 1954.
• Several of the major American airlines and a bunch of international ones will either be gone or merged into larger entities slashing their fleet, their debt, and their retirement obligations along the way. Airlines are preparing for a 10% drop in traffic worldwide.
• Shipping costs between China and the U.S., which have seen a dramatic increase already this year, will go up even further, easily doubling the cost of moving product between the two countries.
• Infrastructure repair costs (i.e. roads and bridges), tightly connected to the cost of petroleum, will rise exponentially, creating a further drain on national, state and local treasuries.
• A slew of familiar consumer brands will disappear from the retail scene.

A leading question in all of this, of course, is whether the high oil prices and a low dollar are structural and therefore lasting in nature, or just a temporary condition that may fade away with a few clever policy decisions that the Feds could implement with the stroke of a pen.

Here is how I discuss these twin questions with some of my clients for whom planning ahead is crucial for their survival and prosperity. Keep in mind that these twin questions are line items on top of a laundry list of issues and questions that ultimate drive the opportunities that may present themselves during the years ahead.

Take a look at the following exhibit, which provides a long-term historic view of some of the most fundamental trade imbalances in the American economy.

Prepared by Thomas Schinkel from publicly available data provided by the U.S. Department of Commerce

The yellow curve shows the decades-old trade imbalance between the U.S. and the rest of the world. In nominal terms it does not mean much whether you have a trade deficit of $100 billion of $500 billion. What matters is the size of the deficit in relation to the total economic output of the country. Therefore, the yellow curve shows the trade deficit relative to the U.S. Gross Domestic Product. For example, from 1989 to 1991, the trade imbalance between the U.S. and the rest of the world actually declined from 2% of GDP to 1% of GDP. Later during the 1990’s it went up again to approximately 4% of GDP. But throughout the next decade, it ballooned way out of control to 7% of GDP in 2006, more than tripling in the short time span of ten years. The two main drivers were energy imports (mostly petroleum products), and manufacturers accelerating their shift of manufacturing facilities from U.S. shores to the Far East, with China being the major beneficiary.

Indeed, in the short term, this shift to outsourcing has proven to be a quick and sure-fire way to drive down costs and in some cases, I am sure, improved margins. But throughout the last twenty years a small band of independent economists and analysts from time to time would point to the flaws in this seemingly virtuous cycle of cost control, connecting the dots to jobs, pensions, insurance policies, health care, education and other civic issues. Invariably these voices were moved to the side lines, with the deadpan statement that the American economy was different and that small deficits did not matter to such a large and vibrant economy.

The blue and magenta curves refract the U.S. Trade Deficit into two major components, magenta showing the Energy Deficit between the U.S. and the rest of the world and blue showing the U.S. Trade Imbalance with China. The Energy Deficit means the U.S. is importing so much more of its petroleum and natural gas needs than it exports, again not just nominally, but relative to the size of its economy.

The magenta curve shows that in 1991, the energy deficit was the single largest component of the U.S. trade deficit with the rest of the world. That year, it mushroomed to 60% of the total trade deficit. But throughout the 1990’s there was a sharp correction in this imbalance and by 1999 it stood at a mere 20% of the total trade deficit.

As an aside, this favorable turn of events with the reduced energy imbalance coincided with a government budget surplus during the same period and remarkable productivity improvements throughout society.

Future historians may give at least partial credit to Windows 95 and a host of other productivity enhancing software tools that were widely being embraced by society throughout that period and they may say that this confluence of factors had something to do with the overall perception of prosperity of the late 1990’s.

The blue curve shows that the imbalance in the trade relationships between the U.S.  and China just kept growing and growing, not just in nominal terms but relative to the size of the U.S. economy as well. Today, China makes up in excess of 30% of the total trade imbalance between the U.S. and the rest of the world. Ever since China’s acceptance into the World Trade Organization in 2001, this trade imbalance has widened, again, not just in absolute terms but relative to the size of the U.S. economy.

One of the consequences of this never ending and largely unmanaged saga of growing trade imbalances is that the Chinese and the Japanese governments, and a whole bunch of lesser governments for that matter, are ever more flush with dollars which they routinely re-invested in U.S. treasury bills, with the expectation of steady returns on their investments.

Against this backdrop of the growing trade imbalance between the U.S. and the rest of the world and its two main components, Energy and Trade with China, back to the question of why the price of oil is so high and the value of the dollar is so low. If, in August of 2007, the Federal Reserve Bank had chosen to raise the interest rate instead of lowering it, this might have bought some time for the value of the dollar, encouraging these foreign governments to hang on to their t-bills just a bit longer.

This in turn, indeed, might have had a slowing effect on the rising price of oil, which is traded in dollars. The folks overseas who own the oil and want to sell it to us argue simply that if the value of the dollar goes down their purchasing power goes down, and therefore they need to raise their price to make up the difference.

But the consequence of such a rising interest rate would have been an avalanche of real-estate induced bankruptcies throughout the country; far larger than what we have seen to date. In other words, with the trade deficit remaining out of control and with no policies that are credible in the eyes of the creditors to stem the tide, the Feds seem to be caught between a rock and a hard place.

The Pullitzer prize winning author and journalist with the New York Times, Tom Friedman, argues for trying to get a comprehensive fix on the structural imbalances in our trade relations with the rest of the world. More importantly, he argues, we need to get our energy deficit under control.

After all, you cannot have 1) a trade deficit, 2) an energy deficit, 3) a government budget deficit, 4) a wholesale shift of manufacturing jobs to destinations overseas AND a strong dollar, AND low prices for imported energy AND have this go on ad infinitum. Come to think of it, those are the ingredients, not of a virtuous upward cycle but for a negative, downward spiral. And that is what we seem to be in right now.

To break out of this spiral, Friedman argues for a Federal tax on all those conventional energy carriers that make us more dependent on foreign sources. First of, the tax would end up in the coffers of the U.S. treasury as opposed to that of other countries, many of which are hostile to our interests in the first pace. It would help stimulate the introduction and lasting integration of clean energy sources such as wind, solar, hydrogen and other sources. In other words, he argues, now that all else has failed, let’s try common sense and adjust our life styles and work styles to accommodate the reality of the situation we find ourselves in. After all, consider the following:

A prosperous nation like Denmark derives 19% of its energy requirements from .  wind.

• The population of Iceland many years ago made a conscious decision to wean themselves off of dependence on petroleum fuel by embracing hydrogen as their energy carrier for prosperity. They are well on their way.
• German companies dominate the world market for practically all aspects of solar energy generation. They accomplished this by introducing – years ago – a series of well coordinated policies aimed at stimulating and integrating technology breakthroughs combined with creative tax credits that touch the lives of everybody.
• Going against the grain of a thousand voices, the Honda Motor Company of Japan stuck with their guns, pouring millions of dollars into the development of a hydrogen fueled engine that they mounted on one of the world’s most balanced chassis, the Honda Accord. Baptized the FCX Clarity, they ended up with a brilliantly innovative product that five years from now, may be at center stage of what the world wants and needs. Going forward, it turns out, they are the leaders, once again showing the way.

Here at home, taking a first step at the state level, the Commonwealth of Massachusetts, in a first in the nation initiative, recently adopted a comprehensive Energy Law that remakes the electricity market, provides incentives for clean energy sources and introduces a new building code requiring new structures to consume as little energy as possible. At the Federal level, watch the government introduce policies that address the twin questions of our energy deficit and our overall trade deficit in a way that comes across as credible to our creditors.

When the crisis is over, many assumptions about the U.S. economy will have been turned on their ear. One of those assumptions is that seemingly all-important consumer spending without which little would be left of the U.S. Economy, or so the theory goes.

Overseas, watch the European Union’s monetary policies. They are focused on inflation and inclined to raise the interest rate in the Euro-zone, not lower it. This will only add to the strength of the EURO and further weaken the U.S. dollar.

None of this is very good news – at least not from the vantage point of the American middle class – but there is a silver lining in this gathering storm and that is that the opportunities for American manufacturers that have innovative and leading-edge, high quality products have a SPLENDID OPPORTUNITY to gain and regain world markets.

Indeed, my sense is that within a short period of THE NEXT FIVE YEARS we will be going through a metamorphosis from a “Consumer-centric Society” to an “Export-centric manufacturing nation”. Excuse me for the metaphor, but this after all, is the only way towards a new equilibrium in a world economy that has allowed major imbalances to accumulate as part of a set of policy assumptions that date back to the 1950’s and 1960’s and whose validity had evaporated a long time since.

In short, if your manufacturing facilities are still state-side, and you have been thinking of moving off-shore, hold off on the decision for just another bit. The iceberg may be tipping over and many strategic moves towards outsourcing may have to be reversed. Produce Local, sell Local. Keep distribution pipelines as short as you can to keep unpredictable energy costs out of the equation. Also: Work, Live and Play Local.

In the process, the entire country will be turned into a bargain hunter’s paradise for acquirers of all assets, fixed and variable, corporate and individual. If you are an overseas acquirer, now is a great time to start looking for business investment opportunities in this country. It will be “Globalization in Reverse”.

Tom Friedman’s metaphor that “The World is Hot, Flat and Crowded” is right on the mark. The time for quick fixes in our trade imbalances has long since past. Letting these imbalances fester for too long has created a witch’s brew of forces that may set us up for a perfect storm. The opportunities resulting from the crisis that this storm creates will be significant and those who seize the moment will be rewarded for decades to come. At least, that’s my take on it. Thank you and have a good day!

Tom Schinkel