The following article was part of a presentation made to the California Farm Bureau Federation in December of 2011.

The looming shortage of freshwater is not unique to farmers here – it’s rapidly going global. Many farmers will choose to see the problems ahead with water as a crisis, but it could, instead, become a significant opportunity if they play it properly. Let’s start with the fundamentals of the emerging crisis.

There’s no shortage of water on Earth: three-quarters of the Earth’s surface is covered with it. However only 2½% of Earth’s water is fresh water, and most of that is not where it’s needed, or available when it’s needed. In fact, of that 2½%, more than 2% is frozen, mostly locked up in the Arctic regions (for the moment). That leaves less than ½ of 1% of usable freshwater, the vast majority of it is contained in aquifers. Unfortunately, many aquifers are largely non-renewable resources, being, in effect, fossil water laid down over periods of hundreds, thousands, or millions of years, but which we are depleting in periods of decades. When they run dry, problems will multiply very quickly.

Now, given where we are right now, there are seven major factors contributing to coming water shortages, and they will have differing levels of effects on farmers:

• Population growth here at home will produce modest, but steadily increasing pressure on supplies. Meanwhile, population growth elsewhere, especially in places like India and other developing countries, will be a major source of freshwater difficulties. By the third quarter of this century, it’s estimated that there will be another 3 billion human beings, all of whom will need water. Yet, short of technological breakthroughs (which will come, but not cheaply, and not soon), there are no major new sources of water available.

• Increases in the standard of living will be largely neutral here (unfortunately), but another major cause of stress on water sources in the developing world.

• Agricultural intensification (especially using irrigation in dry areas) will moderately increase water shortages here, but again will be a big cause of water shortages elsewhere as almost 70% of the world’s water is used in agriculture.

• Urbanization will be one of the major causes of shortages of water everywhere as rapidly growing cities ratchet up the demand for an increasing share of static or dwindling water supplies.

• Pollution will be pretty well neutral here, which means it’s not going to get much worse even if it doesn’t get much better as we’ve already done most of our polluting. The same isn’t true in the developing world, where farmers are looking to increase yields by using more fertilizers, and the run-off will contaminate water sources and aquifers.

• Depletion of aquifers (fossil water), which can destroy an aquifer, or at least reduce its long-term capacity, will be a major issue here and everywhere else, particularly as much of the damage to aquifers comes as the levels get low. Worse, predictable as aquifer depletion may be, virtually no government, agency, or voting public ever thinks that the aquifer they’ve exploited for years will ever run dry – until it does. They are then caught by surprise, and completely unprepared. This is one of the most surprising things about the coming water shortages – there should be no surprise at all, but there inevitably is.

• Climate change (which changes where and when water is available) will also be a major issue. While people can argue over whether humanity’s at fault for climate change or not, there’s very little real argument left about whether climate is changing, and farmers are among the first to notice and feel the changes. Moreover, the changes that do occur are more likely to be negative than positive.
For these, and other reasons, the shortage of water is going to force itself on global consciousness. You’ve all probably heard water referred to as “the new oil”, but I say that vastly underestimates the problem. There are substitutes for oil, but there is no substitute for water. Water shortages are going to be felt to varying degrees, but at a rapidly increasing rate all over the world, and are going to affect what farmers can grow, where industries can flourish, and how fast economies can expand.

Likewise, you’ve all heard about carbon neutrality, now you’re going to start hearing about water neutrality. For example, Coke & Pepsi were required by the Indian government to put 1 liter of water back for every liter they withdrew from community sources. If you think about what they sell, you realize how difficult this was for them to accomplish this – but they did. So water neutrality and steadily improving water management is something you should be thinking about, even if you’re already ahead of everyone else on this issue, as water continues to grow scarcer.

Meanwhile, political conflicts are going to continue to grow between user groups (e.g., farmers vs. cities), states (Texas vs. New Mexico, for example) and national governments (especially the U.S. vs. Canada and Mexico). Perhaps the two coming conflicts that will get most attention here are the conflicts between cities and farmers, which are going to get steadily worse, and the conflict between water-rich Canada and water-seeking America.

Yet, while farmers here think they know about water scarcity, I think we’re just scratching the surface on this problem, and they would be well advised to look at ways of increasing their water productivity. As water scarcity becomes a worldwide issue, more and more attention will be focused on it, and its perceived value will continue to rise. This will cause more people, groups, and political bodies to try to grab more control over it. It will also attract attention from financial players, like sovereign funds and pension funds, who will start buying water sources to control and toll, which will further escalate the conflicts.

But there’s an upside, too: Those farmers that improve their water management practices can benefit from the water problems of other parts of the world through increased demand for the agricultural products they produce.

One of the big changes to come is that countries, like India, that were self-sufficient or even net exporters of food are becoming net importers simply because they don’t have enough water to grow what they need. This kind of importing of “virtual water” through crops will increase the opportunities for farmers who are proactive in learning how to manage water supplies even more carefully than they do now. I’m not suggesting this will be simple, but there are more water-efficient technologies out there that can help, like those from Israel, and forward-looking farmers should be actively seeking out new techniques, new technologies, and new, possibly GM crops that allow them to grow more with less water.

In summary, water shortages are inevitable, they are going to become increasingly high profile, and they offer real opportunities to those who can be proactive in managing supplies. You know that there will be problems with water, you know that agriculture is a big user of water, and you know that those who are prepared for a problem while their competitors are still struggling to catch up can prosper from difficulties.

So take the plunge – exploit the future of water.

© Copyright, IF Research, February 2012.

The year ahead is going to be a tumultuous one, challenging in political, economic, and financial terms. Despite this, there are opportunities for those prepared to take advantage of them, because uncertain times mean that market share is up for grabs. And no, it’s not a coincidence that there are 12 trends for 2012. I discarded a bunch more, but it’s such a catchy title I couldn’t resist.

I’m going to approach these 12 trends with three objectives: What is important? Why is it important? And what does it mean to you?

And I’m going to start with the bad news, and end with the silver linings.

1)    Declining American influence – America’s absolute and relative influence in geopolitics, economics, finance, and the military is declining for a host of reasons: the rise of competing powers like China, India, Brazil, and others; the very expensive military adventures in Iraq and Afghanistan, which have sapped America’s willingness to engage in aggressive political and/or military action; the Arab Spring, which eliminated Middle Eastern strongmen like Mubarak who followed America’s political lead, and the continued stalemate over the fate of the Palestinians, means that America’s influence over this critical and unstable region is at or near an all-time low; the Great Recession, which has sapped America’s economic and financial clout; and the dysfunctional stand-off between Republicans and Democrats that has frequently led to policy paralysis.

The implications of this are a less stable, more dangerous world. America may have gone back and forth on whether it wanted to be the world’s policeman, even though it truly was the global cop, and it’s inability to fill that role now means that the world is a more dangerous place.

This sets the stage for sticky situations to emerge, such as the twin nuclear threats from a suddenly even less-stable North Korea, and the only slightly more stable and geopolitically ambitious theocracy in Iran. It also leaves more elbow room for the ever-ambitious China to expand its power and influence, notably in south Asia and the South China Sea. It also leaves critical global issues, like what to do about climate change, without essential leadership.

The implications of this is a world where there are more likely to be more, and more serious, geopolitical, financial, and economic crises, and greater uncertainty in virtually every aspect of life. Others may not always have agreed with American policies, but they will miss America’s steadying influence as it ebbs from their lives.

2)    Ho-hum! Just another financial crisis (European edition) – The daily drumbeat of scary headlines dealing with the financial crises in Europe have gradually deadened everyone’s awareness for how dangerous the situation truly is. In particular, Angela Merkel is juggling hand-grenades, and hoping that she won’t drop any, and that none of them will go off unexpectedly. Germany is the only European country with the potential to stop the rolling crises that are affecting Europe, and then only if Merkel acts in a timely basis. To do this, she must let Greece go bankrupt instead of propping it up, shore up the banks, notably German banks, that have bought far too many dodgy EU bonds in the past, allow the European Central Bank (ECB) to become a lender of last resort, with the ability to stop a run on European bonds, and halt the bond market attacks on other European countries, starting with Portugal and Ireland, but extending to the much bigger countries like Spain, Italy, and even France. But Germany doesn’t want to do these things, and German voters are adamant that they won’t subsidize what they see as the lazy, profligate lifestyles of southern Europeans. But if Germany doesn’t act, and in a timely fashion, it may lose the ability to act at all, and come under attack from the bond markets as well. Indeed, German bonds are no longer being bought with as much enthusiasm as they were even two months ago. If Germany doesn’t act soon, it may lose the ability to do so at all.

Remember what happened in the American financial markets in 2008? If Germany doesn’t act in time, we could see the same kind of thing happen in 2012, this time starting with a run on European government bonds. From there a run could spread to those banks – American as well as European – that hold too many of these bonds. And once such a run started, the most dangerous question of all would emerge: “Who’s next?” Investors, frightened by the panic, would look to sell any and every questionable credit, and their attention might turn to the various U.S. state and local governments, like Illinois, California, and Harrisburg, Pennsylvania, among many others, that are struggling with their finances.

The U.S. Federal Reserve has become the de facto lender of last resort to the entire developed world, and would undoubtedly step in and support the banks and markets with everything they had. But this time, remembering the callous, greedy ingratitude of last rescue of the banking industry, American voters and the American Congress would likely tell the banks to drop dead. It was a hard enough last time to get Congress to bail out the banks; this time I suspect it would be impossible, even though failing banks would take the global economy down with them. Moreover, the Fed doesn’t have anywhere near as many bullets today as they did in 2008, and Fed Chairman Bernanke already has some Republicans, notably Ron Paul, baying for his blood over the quantitative easing from the last crisis.

The danger here is frighteningly real, and even greater than the risks we faced in the panic of 2008. Yet, the steady drip of crisis headlines and last-minute rescues has left many people convinced that nothing will happen. If it does, it will catch people flat-footed, not because they didn’t know there was a crisis, but because they have been hearing about it for over two years now, and have tuned it out. We could muddle through, and probably will – but the risks are far higher than most people realize. It will be important to have thought out a Plan B to deal with the unthinkable, if it happens, one that prepares you and your finances for a bigger repeat of the 2008 panic. Again, it probably won’t happen – but it’s better to have a plan and not need it, than need a plan and not have it.

3)    Yes, China’s influence will continue to rise, but…  Napoleon famously said, “China is a sleeping giant. Let it sleep.” Well, China’s very much awake now, and throwing her weight around – although cautiously. If I were (God forbid) Emperor of China, I would require my minions to tread cautiously, to smile a lot at our trading partners and neighbors, and to make our gains slowly, one salami slice at a time, never appearing too greedy or overreaching. I would practice soft diplomacy, offering aid and comfort where I could do so cheaply, loudly proclaiming our respect for other countries’ internal policies, taking leadership positions in things, like climate change, where I knew I was going to have to make changes anyway, and generally trying to look like a good global citizen. I would act, in short, as if time were on my side, and I was going to be the next Big Thing.

And generally speaking, that is precisely what China is doing – except that every once in a while the mask slips, and the avarice and aggression shows, as with the boundary disputes with other countries, especially as related to the South “China” Sea, which China (the nation) seems to be trying to interpret literally as being a Chinese lake.

But China has an Achilles’ heel – several of them, in fact – and does not have (much) time on its side. Its biggest weakness is that it is aging faster than any other significant country on Earth. Because of its One Child policy, China’s population is expected to peak, and begin declining, sometime around 2020 – within the next 10 years. And its labor force is already in decline, even as the demands for higher wages push its cost structures higher.

Meanwhile, although there is a great deal of pride in China’s new affluence among the Chinese, that affluence is not evenly spread, and there is unrest among those who remain poor. Add to this the widespread corruption of Chinese officials at all levels, which often provokes revolts, like the one in Wukan, which leads to simmering dissatisfaction among many Chinese.

This will further be exacerbated by the fact that China’s factories are automating almost as quickly as those of the developed world, which threatens to slow the rate of job creation, productivity, and affluence markedly over the next 10 years. Yet, China dare not automate; to do so would mean a loss of competitiveness, which would produce even worse results as industries would move elsewhere.
So, with that in mind, what would I, as self-appointed Emperor of China, do? Worry about a future I couldn’t control, and for which I could not see a clear path forward. The next 10 years will mark the beginning of the end of China’s ascension, and if I were Emperor, I’d think about retiring to some warm, cushy haven before the revolution came. Chinese Spring, anyone?

The implications are for China to step up its attempts to increase power and influence, and throw its weight around even more actively before that power starts to wane, but as quietly as possible. Look for China to try to make this the China Decade, especially in finance, trade, and geopolitics, as it attempts to pull in as much as it can while it can.

4)    American Spring? Meanwhile, closer to home, while those on the political right like to dismiss the Occupy movement (e.g., Occupy Wall Street), the fact that the movement happened at all is the most significant part of it. Indeed, Time magazine made protestors its “Person of the Year”, and that’s not restricted to just the Arab countries. The Occupy movement and protests against cut-backs in many developed countries had many of the earmarks of the Arab Spring: protestors saying that their governments serve an elite clique and not the people; lots of people, especially young men, who cannot find work despite months or years of trying; and a belief that the political system is neither representative nor responsive. Just because winter has fallen, and the Occupy settlements have been disbanded does not mean that the dissatisfaction has gone away. And with increasingly dysfunctional government in America, the potential is there for a much stronger protest movement against the System, however that is defined. American Spring, perhaps? It sounds unlikely, but not as unlikely now as it did before, and it won’t be restricted to America for discontent will grow in all developed countries.

This is especially true as the boomers move towards retirement, only to find that their either don’t have the resources to retire and that no one is going to donate them, or that the civil servant pensions that they were promised are unaffordable.

The protest movements have only just begun, and they are going to be acrimonious, disruptive, and at times hijack the political process.

5)    Mixed signals for both weaker – and stronger – economic growth.  Europe and its prospects are dragging the global economy down. The uncertainty in Europe, combined with the painful budget cuts in Greece, Ireland, Portugal, Italy, Spain, and the United Kingdom, mean that Europe is now in recession and a drag on the global economy.

Meanwhile, China, which had been concerned about inflation, and hence was hiking interest rates in a bid to slow it, has now reversed itself, which I can only interpret as concern that growth will slow more than they want. That’s a potential positive, as it will add stimulus to the global economy.

Canada, which has to date seemed to skate above most of the problems of the rest of the developed world, now seems to be experiencing slower growth, with an unexpected jump in the unemployment rate, while its housing market is looking pricey, frothy, dangerous, and much like America’s prior to the collapse in 2008, especially in condo development in its major cities like Toronto, Vancouver, and Calgary. Moreover, its consumer debt levels are exceeding the levels of American consumers in 2007, and no less a figure than Mark Carney, the highly respected Governor of the Bank of Canada, has warned consumers and banks alike to cut back on consumer borrowing. Canada could be arriving late for the financial meltdown of 2008 – but if its consumers don’t mend their ways, they will get there.

And yet, America, which until 2008 was seen as the world’s engine of growth, seems to be picking up for no specific reason. Actually, this was almost inevitable because of the natural dynamism and entrepreneurship of the American economy. What has prevented America from rebounding earlier, or more strongly, has been the housing market, which is still in horrendous shape – but slowly improving.

So how will this balance out through 2012? Assuming that Europe doesn’t crash and burn, and drag everyone else down with it, and that Iran doesn’t precipitate a significant war in the Middle East, then America will continue to recover, its jobless rate will continue to decline (slowly), the world will lick its (economic) wounds, and things will slowly get better.

Accordingly, while I continue to counsel my clients to have a Plan B in their back pocket if things do go bad, my primary advice is the prepare now for better times ahead. There are problems – big problems – ahead, and the American election in 2012 is not going to help, but for 2012 we are likely to see an improving environment, and opportunities re-emerging for those with the courage to grasp them, as I outline in Trend #7 below.

6)    Climate change accelerates – and the consequences will multiply. The most significant and portentous climate news of 2011 was the discovery of methane gas bubbling up in the Arctic Ocean off the north coasts of both Siberia and Alaska. Methane is a far more potent greenhouse gas than carbon dioxide, and the melting of the Arctic ice cap, combined with the rise in the temperature of the Arctic Ocean, has started to release methane from the ocean floor. As well, as temperatures rise in the northern polar regions of Siberia, Alaska, and Canada, the permafrost melts, releasing even more methane into the atmosphere. The amounts of methane that could be released by both sea floor methyl hydrates and permafrost are staggeringly huge, and could dramatically accelerate the rate of climate change. If this trend continues, not only will the debate over climate change be over, but humanity will be forced to race to keep up with the potential changes.

As it happens, the vast majority of climate scientists – something approaching 95% – now agree that climate change is happening, and that humanity is at the very least a significant contributor to it. Since I speak to lots of different kinds of audiences, I can tell you that most groups now accept that climate change is happening, even those that have been among the most vocal doubters. The doubts they now raise are more along the lines of whether humanity is to blame. But from my point of view, it no longer matters: if your house is on fire, you don’t throw gasoline on the fire, regardless of how it started. That’s roughly the position we’re in now.

In 2012, we will get more information about the release of methane, and can only pray for good news. Meanwhile, brace yourself for more strange, and increasingly extreme weather. And because climate is a chaotic system (where chaos theory is a branch of mathematics), it is literally unpredictable. This means we can’t tell whether we will get floods or drought, hurricanes or tornados, or something else unforeseen. But it won’t be business as usual, either.

7)    Innovation as Steve Jobs’ legacy.  Jobs didn’t invent innovation, but he sure popularized it! Innovation has become a corporate religion in recent years, and with good reason: innovation can allow you to disrupt the marketplace, scoop up market share, increase profits, and win friends and influence people, just as Jobs and Apple have done. Yet, innovation is hard, especially because there’s a natural resistance to change and to the real risk-taking that innovation requires.

But if there is a theme for the corporate world in 2012, it is that now is the time to get serious about innovation. As an innovation specialist who runs seminars and workshops for corporate clients, I’m seeing this on a daily basis in genetic and medical research, agriculture, the automotive industry, the insurance industry and finance generally, plus just about every other sector of the economy. And technology itself embodies innovation. Indeed, the idea of a technological company not working hard at innovation seems like recipe for extinction. The world is changing rapidly, and there are lots of new opportunities – and disasters – out there. It’s raining soup, but if you just stand there, looking up in surprise, you’ll drown!

8)    Who dares, wins. Such is the motto of Britain’s fabled SAS – one of the world’s premier commando groups. But their motto applies equally to unsettled times. During such times, it’s easy and very, very tempting to hunker down, conserving cash, and wait for lazy, easy times to return. But study after study shows that companies that continue to market aggressively, and pursue research into new ideas, new products, and better results for their customers make far more inroads with modest expenditures during bad times than spending far more during good times, when everyone else is competing hard. Moreover, loyalty is won when times are bad, both among consumers, and among employees. And best of all, you can often accomplish a great deal with careful planning and foresight rather than lavish expenditures. This is where strategic planning comes to the fore. The time to be thoughtfully aggressive is when your competitors are playing turtle.

9)    The Red Invaders. The emergence of a Chinese middle class not only means upward pressure on food and fuel prices, it also means a vast invasion of Chinese tourists bearing money. For those countries and regions able to attract such tourists, it means a new source of revenue, and a big shot in the arm. And, as with all ethnic groups, it also means serving them the way they want to be served in terms of language, food, and customs. To the winner go the mega-spoils.

10) Haggling returns to North American retailing. Smart retailers are recognizing that it’s no longer enough to post a sign saying “10% off” to attract consumers, but that consumers are more demanding now, and are moving away from the traditional “no haggle” approach to buying. Moreover, haggling offers two additional benefits to consumers: it’s become somewhat of a game where they can enjoy the thrill of the hunt; and it offers bragging rights when talking with their friends. As a result, haggling has been emerging in two different ways, one passive, and the other active.

The passive form of haggling is to wait for sales. You can witness this almost anywhere when consumers see an item they like in a store, and ask if it’s on sale. When they’re told that it’s not, they turn up their noses, and say they’ll wait until it is. This might be described as “temporal haggling”, where the consumer is saying, “I’ll wait until you lower the price before I buy it. And if you don’t lower it enough, I won’t buy it.” Smart stores are responding in creative ways. Some salespeople say, “No, that’s not on sale, but it will be starting next week,” which amounts to a counter-offer. A smart consumer will reply by saying, “Can you put it aside for me until then?”, implicitly offering to buy it if they do. Some salespeople say no, others say “Sure.” The net result is that store and consumer have haggled over the price to agree on a sale/purchase. Yet the smart retailer actually has an advantage in this exchange: they get to name the sale price in temporal haggling.

By comparison, in active, more traditional haggling the consumer takes the initiative, saying something like “What’s your best price on this widget?” If the salesperson replies with the sticker price, the haggle is over and the consumer leaves. If the salesperson names a price, the consumer responds dismissively, and says, “I wouldn’t pay a nickel over $X for that”, and the salesperson can choose to respond or not. This is, as I say, traditional marketplace haggling.

If a retailer wants to capitalize on the re-emergence of haggling into the North American marketplace, they need to anticipate it, and come up with a range of responses. One might be to say, “We can’t discount this item today, but it is going on sale next week. Would you like to put a deposit on it to hold it until then?” The retailer regains the initiative this way, and moves towards a close. Or better still, the retailer should look for a way to add value rather than cut price by making a counter-offer like, “No, I’m sorry, we can’t discount that item. But we can offer you a 50% discount on a matching accessory if you buy it.”

Regardless of approach, though, retailers should be prepared to return to marketplace haggling, and have a range of responses ready to deal with it. Consumers, as always, should decide what they want, and what their bottom line is in getting it.

11) Health care magic blossoms. Putting aside the issue of cost, which concerns everyone, the ability of health care to solve problems is beginning to move at computer speeds, in part because IT is increasingly being used by doctors, nurses, hospitals – and patients – to manage health care, and in part because research is increasingly being done using smart, powerful computer tools to perform research and execute treatments. Among the changes in the immediate future of health care are:

• The rapidly rising ability to repair failing hearts and minds (or at least brains) and other organs with stem cells. Stem cell treatments are starting to move out of the laboratory and into the operating room, and 2012 will see hundreds of people receiving this kind of therapy.
• Similarly, 3D printers, which have been in development for roughly 20 years, are now good enough that they are starting to be used to create replacement organs from a patient’s own tissue. This will gradually move into mainstream medicine, with replacement hearts, livers, and kidneys being at the top of the list.
• Quadriplegics will increasingly be able to interact with the world through prosthetics controlled by thought alone, either through electrodes that interpret brain wave patterns, or implanted chips which interpret specific thought-impulses.
• Retinal implants are starting to emerge that can help blind people discern light, shapes, and some objects. The implication is that we may be able to help aging boomers improve their failing eyesight as they age – one of the biggest complaints of old age!
• Health care is increasingly falling into the hands of the patient – literally. Smartphones, which are fundamentally wearable computers with all the capabilities of what used to be called “supercomputers”, can now work with Bluetooth-enabled sensors to monitor various aspects of health, from the vigor of your workout, to the health of your heart, to the level of your blood sugar. This will lead to a revolution in health management, with consumers sometimes way out in front of practitioner.
• Likewise, as patients become more and more comfortable with researching medical conditions and treatments online; they are demanding an increasing role in their own diagnosis and treatment; becoming active, important advocates for fund-raising and acceptance of treatments; and blunt critics of health care practitioners through social media and word of mouth. Smart practitioners are accepting this trend and rolling with it. Old school practitioners are resisting, but may wind up steamrolled by it.
• Crowdsourcing of tough diagnoses, and novel solutions to the medical and financial problems of health care promise to open yet another front in the health care revolution. This follows on with the success of crowdsourcing in helping leading-edge research scientists in astronomy (galaxyzoo.org) and protein research (Foldit game softwear).
• Sequencing your genome gets cheap. Sequencing the first genome cost billions of dollars and took decades to perform (culminating in the Human Genome Project). Today it costs about $1,000 (although analysis costs significantly more). Within 10 years, it will cost $100, and analysis will cost about $500 more, and will provide you a complete run-down of where your vulnerabilities lie, and what you can do to forestall future health problems. For 2012, we will see incremental advances towards that goal, with major diseases identified, and a short list of things you do – and don’t – want to do or eat prescribed. This is the true beginning of personalized medicine, and it will revolutionize health care.

12) Technology accelerates in 2012. It’s hard to know what to leave out: electronic mind-reading? Glasses that emit sounds and smells to allow you to enhance social media? The proliferating tablets and smartphones with ever-more wondrous abilities? Here’s a partial list of things I think demonstrate trends that will become increasingly important:

• 3D printers – As well as making replacement organs, 3D printers are coming into the price range of consumers, and may mean that you can buy your own desktop factory. Need a replacement screw for a door? Make it yourself. Need to duplicate a key? Ditto. See a nifty device on TV? Download the plans and make it yourself. Of course, who knows what the ink cartridges will cost.
• Near-eye monitors – These look like glasses, but are computer monitors. They’re the lineal descendents of jet fighter heads-up displays, and will revolutionize the way we use computers, particularly smartphones, but have been hampered by high costs. Prices are starting to approach luxury consumer levels, so applications will start to appear in things like immersive gaming, personal entertainment theaters, medical imaging, and augmented reality.
• Augmented reality through your smartphone – Augmented reality is overlaying information on top of the view from your Mark 1 eyeball, much as Google Street View overlays the names of shops on a photo. You’ll be able to hold up your smartphone’s camera and have your phone overlay directions, stores, infrastructure views, or whatever else might be useful to you. This gets better when you can view the results in your near-eye monitors.
• Cloud computing explodes – Owning a computer is so 2010. Cloud computing is rapidly placing the resources of today’s supercomputers in your hands for pennies a minute. One researcher used one of the commercial clouds to try to break his password to a social media website by brute force, just to see if he could do it. Using the cloud and standard code-breaking techniques he did it in minutes, and it cost him 39¢. As the tools to harness this power get more powerful and easier to use, the potential of the cloud will be adapted by more and more users.
• Siri & copycats + babbling to your smartphone – Siri is an application of the iPhone 4S that allows you to speak to your iPhone and get it to do things for you. This might be setting a count-down timer, converting milliliters to fluid ounces, finding an address and directions from your present location, or looking up a phone number (all of which I’ve done). Apple is offering this technology as a beta version now, but every Siri request goes through Apple’s servers. This means the potential exists to assess what people want to do, and come up with solutions, improving the results really quickly, making personal avatars (also called PDAs, butlers, or assistants) much more valuable in short order. And that means everyone will rush into the field. This will lead to lots of really bad copycat applications, but ultimately a revolution in how we use technology.
• Biometric passwords – Our world is becoming so full of passwords that need to be foolproof (meaning our tendency to forget them) that biometric passwords are almost inevitable, and they are beginning to appear. They will be expensive at first, but gradually retina, fingerprint, voiceprint, and other means of making sure you are you will become cheap and commonplace, and then you will become your own password, no memory required.
• Robots – Everyday robots are here, but they are clunky, expensive, or just plain cute. That’s changing very quickly, and 2012 will see more and more of them appearing in more and more places. Typically these will be commercial settings, but health care is one place where robots make sense and will be used. Rosie the Robot won’t be washing your dishes this year, but she’s coming – if you’re willing to pony up the equivalent of the price of a luxury car.

The Occupy movement is most significant not for what the protestors say, but rather that the movement is happening at all. It demonstrates significant unrest, and the greatest dissatisfaction with the capitalist system that we’ve witnessed since the fall of the Soviet Union. But where is it headed? That’s a much more worrisome question.

The fuel that powered the Vietnam war protests was the draft. There were many other issues – objections to the military-industrial complex, objections to American foreign policy, objections to the money misspent on the war, dislike and disagreement with McNamara and Johnson, even objections to war per se – but without the draft, the protests could not have been as sustained or as widespread as they were.

In the same way, the fuel that powers the Occupy movement is jobs – or rather, lack of jobs. In America, and most other developed countries, the official unemployment rate is high, but the true unemployment rate is obscenely so. In the U.S., for instance, the official rate is 9%. But if you include those who have stopped looking for work, and therefore are no longer counted in the official unemployment statistics, then add those who are underemployed, the true rate approaches 20%. And if you look at the rate for young men, particularly among minorities, it approaches 40%. There is immense frustration with the lack of opportunity, and the smug, self-righteous people who look at the protestors and sneer, “Get a job!” only reveal the vast depths of their ignorance.

It’s true there are many issues embraced by the Occupiers, but without the lack of jobs, the movement would never have developed into much of anything. Americans are not generally a jealous people. If people were prospering, the middle class was expanding, and young people were able to find jobs and start their careers, they wouldn’t really have cared what percentage of total wealth is held by the top 1% of income earners. What rankles is that the rich continue to get richer through a perceived manipulation of “the system”, while the vast majority of other people suffer economically. It leads to the belief that the game is fixed in favor of those who can afford to buy the politicians. Whether this is right or not may not matter – it’s the perception that’s important here. And that perception may be explosive.

But where is this movement going? What’s next?

The Future of Work

If the future holds more jobs, and greater prosperity for most workers, then the Occupy movement will collapse from lack of fuel, and be remembered as a strange fad that came and went, like pet rocks or hula hoops. That’s not the case, because the future of work is much bleaker than people, even most top economists realize.

There are two forces that are squeezing workers in all developed countries: foreign competition, and domestic automation. One is going to get much worse, and the other is going to get slightly better.

The one that will get slightly better, at least in manufacturing, is foreign competition. There have been headlines for decades about the offshoring of jobs. There was even a management cliché for it in the 1990s: “Emigrate, automate, or evaporate,” which meant move your factories offshore in order to take advantage of dramatically lower wages in developing countries; decrease the labor content of your products in order to reduce the advantage of cheap labor in developing countries, or go out of business. (As an aside, there’s actually a fourth option: innovate, but that’s another story.)

This happened because of the emergence of the global economy. A global marketplace implies a global labor pool. If workers in developing countries can do similar work, but at much lower wages, then the work will naturally gravitate to them, and away from workers in developed countries. This has been going on since the 1970s, and is a familiar tale. It makes headlines, and becomes the subject of learned papers by economists, and protests by industries and unions that want protection. And the offshoring of jobs will continue until there is a rough parity between those producing things offshore, using cheaper labor, and the cost of producing things at home, using more expensive labor.

One way this could happen is through wages falling in developed countries, and rising in developing countries. But wages tend to be sticky; not many people are willing to take a cut in pay. As a result, what has tended to happen instead is that workers here are let go, and their jobs disappear, even as the wages in places like China and India are, indeed, rising.

The mild good news here is that much of this adjustment has already happened. Indeed, there are a few reports of manufacturers moving production back to America as the cost of labor in China, for instance, has risen, and as governments, particularly in the southern American states, have reduced legal protections for workers, effectively lowering their cost. (Whether you view this as a good thing or not is a separate issue. Indeed, it’s a difficult issue: do we want good worker protection, but no jobs, or bad worker protection and some jobs?)

The other way for workers in developed countries to compete is through higher productivity, and many companies have survived and kept their production in America that way. Yet, even when they succeed, the number of jobs required goes down. Businesses survive, but only by shedding jobs, leaving a trail of unemployment in the wake.

This is the past and present. The future will be different.

Increased productivity comes most notably through increased automation, and we’ve all experienced that, as when we go to the gas pump, swipe our credit card, and pump our own gas, all without an attendant. But automation is about to become supercharged.

The rate of change in computing speed and cost-effectiveness is not only accelerating, but the rate of acceleration is increasing. Some technology forecasters believe that computers will increase in power by 1,000 times over the next 10 years. With this growth in computing power available at steadily cheaper prices, automation is going to accelerate dramatically, eating its way up the workplace food chain. Only this time, it’s not going to be primarily blue-collar jobs that disappear – that’s pretty well already happened – but white-collar jobs that are hard hit. Indeed, anyone who uses a contemporary computer can experience this for themselves.

With the Macintosh laptop that I’m using to write this blog, I could (if I had the talent) write a new piece of music, score it, perform it with dozens of (computerized) instruments, record it and release it for sale. I could take videos with my iPhone, download them to my laptop, edit them, add titles and special effects, add in the music that I had created, and then publish the end result on YouTube. In effect, with these two tools, a laptop computer and a smartphone, I can replace composers, performers, and an entire movie making team – and that’s using today’s technology. Very shortly, I could make an entire movie, using technology to create photo-realistic virtual actors and background scenes, dub the voices myself, then change the sound of my voice using technology, and produce an entire movie without anyone else. True, it would be a terrible movie as I know nothing about directing, editing, or acting, and not much about composing or playing musical instruments – but that’s not the point. The point is that the tools we use are becoming so powerful that high-end jobs that used to require skilled people can now be done by ordinary folk.

Likewise, computers will move into medicine, performing research using Genetic Programming, and assisting doctors to do complex diagnoses using smart computers like IBM’s Watson; performing clerical work in almost every conceivable industry, and displacing millions of white collars workers along the way; drive cars, trucks, and trains unassisted; and almost any other kind of routine work. Indeed, computer intelligences and everyday robots will move towards replacing workers in any and every kind of repetitive work, leaving only creative, innovative, entrepreneurial work – and leaving millions, or even tens of millions of people unemployed.

What Happens When Too Many People Are Unemployed?

If you look at the Arab Spring from earlier this year, it wasn’t so much a yearning for the freedom to read newspapers not approved by dictators, or the desire to vote that was the driving force that caused people to revolt, but unemployment, especially among young men – leading the inability to create a life, to feed your children, or even to be able to afford to get married and start a family – that drove the revolutions, and inspired young men to face bullets and tanks. If you look at the protests in Europe, it’s not just the anger that a lazy, luxurious way of life is being taken away from Greek citizens, but a very real fear that they won’t be able to live that drives citizens to the barricades.

Unemployment, the specter of want, and the inability to make a decent living, to have a decent life, is historically a very potent, very scary force in geopolitics, and it’s with us now. The Occupy movement is not just about fairness, but driven by the fear and anger that there is no opportunity unless you are one of the privileged class that has a job. As the number of jobs lost to automation rises, so too will the number of people who will respond to the goad of fear and anger about their future.

Worse, it’s not just about finding a job – it’s also about keeping one. Jobs appear and disappear faster than at any time in history, and someone who is a valued employee and a rising star one day can be redundant and valueless the next. A person in that position can try to retrain and find new work, but they find themselves among the multitudes of people desperately seeking work. Without the in-demand skill that got them a job in the first place, they are reduced to the same pavement-pounding, resuming-producing, faith-sapping odyssey that afflicts so many out of work people today.

I’ve seen this coming for some time. In 1993, I wrote a book called Facing the Future. In that book I wrote the following passage:

It’s an overall decline in the need for work that concerns me, brought about by the increasing capabilities and sophistication of computers.

I seem to be very much in the minority on this view, and I may be dead wrong. The conventional view is that as jobs disappear from manufacturing and clerical work, for instance, the steadily rising productivity of workers using increasingly sophisticated automation will create a new prosperity that will increase demand and create new jobs. This is certainly reasonable, because it is precisely what has happened throughout history. But where, I wonder, will the new jobs appear? The conventional view is that new services will spring up, and that higher living standards will allow people to spend money on things they could never afford before, and that much of this will be for personal and personalized services.

I can see logic in this. New services do appear. There were no aerobic instructors, for example, in my grandfather’s day. But how much personal service can we use? Moreover, generally speaking, service jobs pay less than manufacturing jobs. As for being able to buy things that we couldn’t afford before, since manufacturing will increasingly be automated the higher demand for manufactured goods won’t necessarily generate more jobs.

This is not a problem that will burst on the scene in the next five to ten years. Humans are still capable of offering a flexibility, initiative, and creativity that machines cannot duplicate. But at some point, whether it’s twenty years away or one hundred, I’m afraid that the time will come when there will be very few jobs that computers can’t do better, faster, cheaper, and more reliably than humans. As that day approaches, we will be confronted with several problems.

In the first place, we will need a new economic system. Much as it grieves me to say so, free market capitalism may be dying, for it only pays those who are part of the production process. If virtually no one is part of this process, all the fruits of production will belong to those who own the machines – a recipe for the peon-and-aristocracy patterns of Third World economies. But where will the machine-owners find their customers? People can’t be consumers unless they have money to spend. …[1]

In the intervening 18 years, I’ve seen nothing to change my mind. We are, indeed, heading towards a world of aristocrats and peons. Indeed, that is precisely what the Occupy forces are demonstrating against, only they use a slightly different terminology: the 1% and the 99%. Same thing.

So where is this leading us? If I’m right, then even if the economy and employment picks up, and mollifies the Occupy protestors and their spiritual kin, the concerns will return again and again as the long-term rates of unemployment, especially among the young, continue to rise. And that way lies revolution.

What Should We Do About This?

If we lived in Naples in 79 A.D., and saw steam pouring out of the top of Mount Vesuvius, we would try to warn the residents to flee. We are in an analogous situation. This volcano won’t erupt in the next month or next year – but as things are trending, we need to take action, and soon, or we risk precisely the kind of revolution we witnessed in the Arab Spring earlier this year.

It’s no good trying to stem the tide of automation. That smacks of the 19^th century luddites smashing mechanized looms that they felt were stealing their jobs. Moreover, it would be like trying to hold back the tide, and about as successful. It is possible that politicians, under voter pressure, will seek to ban automation and the productivity increases that automation produces in order to preserve jobs. (This is also called “featherbedding”.) All that means is that countries that do not ban automation will see their relative productivity increase, their cost structure decrease, so that the jobs will migrate from here to there rather than being lost to automation.

Instead, politicians, economists, and anyone else interested in our future prosperity and stability should be taking a serious look at how to create new, better jobs that people can do best. These will largely be entrepreneurial, I suspect, and will all be creative, and focus on innovation. This also implies a complete revamp of our education system, away from rote learning and memorization, and towards creativity and individually customized education, to enable each person to emphasize the things they are best at.

None of this will happen quickly or easily. It requires a very different view of “job creation” and a very different understanding of the future of work. The “magic of the markets” won’t solve this problem. Capitalism, left to itself, will emphasize greater productivity through automation, leading to greater profits for the owners of the machines – until profits collapse because there aren’t enough consumers to by the goods and services industry produces. Capitalism will lead to a dead end.

This is not the conventional view, and many will decry my message as “socialist”, although I’ve said nothing at all about redistributing wealth. Some will pillory me for being alarmist, but without attempting to refute my reasoning. And some will just hide their heads in the sand and say “it can’t happen here.”

To this last group, I would suggest that they tell that to Moammar Gadhafi and Hosni Mubarak. They were sure it couldn’t happen there, either.

The Apple iPhone 4S announced last week received generally tepid reviews. The tech press was expecting more, mostly in the external form factor of the iPhone, and was disappointed when the “new” iPhone looked the same as the old.

I completely disagree with the lack of enthusiasm, and think that the tech press missed a truly important development. I believe the iPhone 4S will eventually be seen as a crucial turning point in the history of technology because of its Siri speech comprehension software. Specifically, Siri is going to take a tool, the smartphone, and turn it into a companion. Computers aren’t going to be boxes that we use to do things any more. Instead, they are going to be our friends, allies, and servants that do things for us. They are going to be our protectors, advocates, and alter egos in cyberspace. Technology is moving past its First Era of being passive enablers that allow us to do things while we use them, into a more mature, Second Era where they work alongside of us.

Apple is not the first, but…

Apple isn’t the first company to create smart computer systems. IBM’s Watson computer made its public debut by beating the human champions on the television game show Jeopardy!, which was chosen because of it’s whimsical, very human use of the English language. Genetic programming (“GP”) is a means of creating rules to identify patterns by means of natural selection, and can solve problems that humans can’t, or create solutions that humans might not consider, thereby augmenting human brains. John Koza, one of the pioneers in the field of GP, has used it to create new technologies, including new, patentable inventions. And there are undoubtedly other smart systems of the Second Era out there.

And Apple didn’t create Siri, they bought it from a company called SRI Ventures, which co-developed it with the Defense Advanced Research Projects Agency, or DARPA, an arm of the U.S Department of Defense that, among other things, invented the Internet. Siri was originally sold as an app for the iPhone, starting in February of 2010, with no involvement by Apple. But Apple bought it in April of 2010, and went to work on improving it and making it smarter and more responsive. Moreover, the fact that Apple has made it a significant feature of the iPhone, and calls it a beta version, means that it intends to continue to improve it.

But what Apple has done, and the reason why Siri will be so significant, is that it has created an entrancing user interface for a powerful technology that will entice people into using it, and it is this that is going to be a game changer. I suspect that Apple sees Siri and related developments as the way of the future: a computer that acts as if it’s your intelligent assistant or personal genie in cyberspace. Assuming it works reasonably well, and isn’t laughed off the stage, it will change the way we use technology forever.

Avoiding the mistakes of the Newton

Apple had a new technology laughed off the stage in the late 1980s with the much-maligned Newton, one of, if not the first tablet computer. Apple’s marketing people, in the absence of Steve Jobs, billed it as a handwriting recognition computer, but the handwriting recognition software wasn’t good enough to live up to the billing. As a result, the Newton was ridiculed, and deemed a flop, even though it was building a solid, even rabid following among organizations that needed computing power with graphic capabilities outside the office, like the U.S. Census Bureau and Boeing. Had Apple billed it as a powerful hand-held computer that had some handwriting recognition ability, it would have become a smash success, and we would be years ahead of where we are today. Unfortunately, when Steve Jobs returned to Apple in 1997, he found the company in dire financial straights, and killed the Newton as not immediately important to Apple’s mission. Instead, he focused on revitalizing the Macintosh and less ambitious new products, like the iPod, that could rebuild the company’s position and cachet. Having done that, Apple is now ready to radically change our relationship with technology – a fitting memorial to Steve Jobs.

Apple is not about to allow the kind of embarrassing failure that happened with the Newton to happen again. Indeed, in my view, this development has Jobs’ fingerprints all over it. As Jonathon Ive, who is Senior Vice-President of Industrial Design at Apple, said in a September, 2011 interview with the Los Angeles Times, Apple’s goal is always to “make something that looks like it wasn’t really designed at all because it’s inevitable.” Siri fits perfectly with that goal. If early reports are right, Siri works just the way you’d want a computer assistant to work – if you had thought about it.

Speech comprehension, not speech recognition

Earlier I called Siri “speech comprehension” software as opposed to “speech recognition” software. The distinction was deliberate. There’s a big difference between recognizing what word has been spoken, and understanding what the speaker means. Most speech recognition systems run off menus that seek to match a recognized word with one of their listed answers. If you step outside this menu, such systems are lost, useless, and infuriating. Siri, on the other hand, goes far beyond that with context-sensitive capabilities, and will undoubtedly get better and better as time goes on, and as Apple continues to improve the software’s IQ. This is the critical issue with Siri: it may not be the first smart computer system, but it’s the one that will make the computer-as-companion desirable, even enjoyable. It represents Jobs’ and Apple’s genius at integrating technology into our lives in ways that we enjoy and find natural.

I’ve been thinking about, and expecting, this development to happen in one form or another for more than 20 years. In The Next 20 Years of Your Life, which I wrote in 1996, I used the following vignette to illustrate this kind of human-computer relationship:

 Marc is late, he hasn’t been able to find a parking space near his destination, and he has to walk through one of the seedier, more dangerous parts of town to get to his appointment. Even though his concern about the interview ahead occupies most of his thoughts, he also has niggling doubts about his safety on the mean streets of Toronto’s inner city.

But Marc is a 35 years old software engineer specializing in adaptive computing software in the year 2017. He was a technologically sophisticated teenager, keen on the latest computers and an avid Net surfer even back in the communications Stone Age of the 1990s. As a result, he has eagerly and nimbly shifted from change to change as new communication technologies have appeared, and as companies have come and gone in the industry. He now prepares to use this skill to protect himself from potential danger.

“Shields up, Mr. Sulu,” Marc mumbles to his genie, whom he has named after a character in the classic 1960s television space opera, Star Trek. The “shields up” command triggers a sequence of events. First, Mr. Sulu pinpoints Marc’s exact geographic position from the Global Positioning Network of satellites. Next, Mr. Sulu contacts Marc’s security provider, Minders Inc., alerting the monitoring genie that Marc is currently safe, but has concerns about his welfare. This commlink will remain continuously open during the “shields up” alert, and if trouble arises, or if the link is cut, Minders’ genie will immediately call the police and give Marc’s last known location.

Finally, Mr. Sulu turns his attention to monitoring Marc’s surroundings. Tapping into the satellite network again, Mr. Sulu calls for a live video picture of Toronto, tightly focused on the area immediately around Marc. This is relatively expensive—it will probably cost Marc four or five dollars for the ten minutes he will use it—but it gives Mr. Sulu the opportunity to examine all the buildings and people around Marc, and to warn Marc of potentially dangerous situations or ominous groupings of people.

“Cross the street here,” Mr. Sulu says to Marc. “There’s a group of five people in the alley on your right up ahead, and only one of them has a phone address. From their dress and size, I would guess they are street kids. Move to the far side of the sidewalk opposite, and put some other pedestrians between you and them.” Marc does as suggested. Sure enough, as a woman walks by the alley, the group emerges and starts to hassle her under the guise of asking for spare change.

“Video feed to the police,” Marc instructs. He has ordered Mr. Sulu to forward the satellite image of the group, along with his own video images captured by his LCD Looking Glasses as he walked by, to the police.

Thirty seconds later, a police cruiser and van pull up, and two officers get out while their drivers watch alertly, hands on riot control weapons. The police don’t arrest the loitering kids, but the kids leave, muttering about invasions of privacy, and casting about angry looks as they try to determine who might have called the cops.

“Try to sell the images,” Marc tells Mr. Sulu, even as he hurries away from the scene. Local news retailers are not interested in an assault that didn’t happen, but a sociology professor in Wichita, Kansas who is researching street youth offers to reimburse Marc for his costs for the clip. After a brief negotiation, Mr. Sulu accepts the offer, and the credit transfer is made.

Marc arrives at his appointment in time to catch his breath and cancel the shields up alert before being ushered into the interview. As the conversation between Marc and the interviewers goes back and forth, Mr. Sulu reminds Marc of the things he has said in his proposal to this group, of the committee’s statements about what they is seeking in a candidate, and something of the backgrounds of each of the interviewers. The interviewers hear and see nothing of the information Mr. Sulu is feeding Marc, and Marc gives nothing away by his demeanor. However, the interviewers know exactly what Mr. Sulu is doing for Marc, because each of them is getting the same kind of information from their own genies.

At a critical point in the interview, Mr. Sulu tells Marc that the company interviewing him has just issued a press release announcing the signing of a contract in Venezuela. The services they are to provide to the Venezuelan government are dependent on exactly the kinds of skills Marc has. Mr. Sulu estimates that the company will need either him, or someone very much like him, and quickly. Based on this information, Marc makes a calculated gamble, and toughens his negotiating posture, asking for a lower base fee plus a share of the profits, rather than a flat fee for the entire project. Realizing that his genie has tipped Marc off, the interviewers quickly agree before Marc has a chance to make any further evaluation and up his demands.

There are handshakes most of the way around. However, the personal health profiles each person’s genie transmits to every other genie indicate that there are slight but measurable health risks between Marc and one of the interviewers if they come into direct physical contact. Accordingly, on the instructions of both genies, they merely nod in a friendly way. No offense is taken by either party; this is a common social occurrence that carries no stigma.

Marc leaves, satisfied that he has an entry into a major new contract, and has started to build a useful new relationship. Feeling cocky and preoccupied with his good fortune, he has to be reminded by Mr. Sulu to call for a “shields up” alert again for his walk back to the car.

 The First Era of the relationship between humans and technology was technology as a passive tool, starting with the stone tools used by hominids over 2 ½ million years ago, and includes the vast majority of today’s computers and communications systems. I believe that Siri and similar developments represent a revolution, and the beginning of the Second Era: technology as companions and assistants working alongside us.

The Third Era will arrive much faster, within the next 10-20 years, or even less: technology that can think and act independently of humans.

Libraries are cutting edge. Schools are not. Librarians move with the changes in technology. Teachers do not. And we need to ask ourselves why that is, because we spend a lot more on our schools than on our libraries.

Now let me make the obvious amendments: Not every library and librarian rides the cutting edge of technology, and not every school is stuck in the 19^th century. But if you had to make a generalization about each of these two pillars of our culture, that would be the one to make, because it’s largely true. And this is ironic, because these two institutions should, theoretically, complement and support each other as sources of knowledge, understanding, even wisdom in our society.

Why is this so? Why have they moved in such divergent fashions when they have so much in common? Well, first of all, libraries are affected by something very like market forces. In a world where a computer may cost a few hundred dollars, and where I or almost anyone else can perform the research that we need online, without ever venturing into a reference library, and where kids and younger adults live and play in cyberspace as easily as they breathe, then what is the role of a library? When people can buy and download books into an iPad or smartphone, and carry an entire library’s worth of books in a laptop in a backpack or briefcase, what is the role of a library? When cyberspace provides places for people with like interest to congregate, discuss, and network, no matter where they live, what is the role of a library? When you can consult experts, either live or through their video, audio, and published works, from wherever you are, what is the role of a library? When traditional print media are under siege by cybermedia, and you can read any newspaper or magazine from anywhere you want, what is the role of a library?

Nobody forces you to go to a library; you go because you want something and they have it, whether for pleasure or for serious intent. As a result, libraries have to operate at the cutting edge of technology, because otherwise they will loose their relevance, and patrons will stop coming through their doors. And librarians have long since not only realized this, but embraced it, seeing in technology new, and more powerful tools that can help them to help library users.

There is no such force acting on schools. Students are required by law to go to public school (or find an acceptable and sometimes expensive or labour-intensive equivalent), so schools have an effective monopoly – which they abuse by forcing students to endure years of agonizing boredom. It is well-intentioned boredom, and possibly useful-at-times boredom, but boredom notwithstanding.

Next, for the most part, except in major cities, libraries are lightly administrated and not terribly politicized. Most community libraries have a volunteer board that steers and assists them. There is usually a head librarian who acts as an executive, but there are not layers of administration heaped on top of the basic operations. There is no “ministry of libraries”, and about the most political aspect of libraries is their funding, and whether it’s too much or not enough.

Public schools, on the other hand, are top-heavy in administrators. They have principals and vice-principals, each of whom must adhere to ever-thickening books of rules about what they can and cannot do, plus the many things they absolutely must do. Teachers have forms to fill out to convince the education bureaucrats that they are complying with the prescribed teaching plans and teaching the prescribed material. Each district has a board that administers the buildings, the staffs, the budgets, and the pedagogy. And every state or province has a secretariat or ministry, usually a very big one, to make sure that everyone else is doing just the right things at just the right moments. (And an obvious comment: clearly the sheer size of our education system, and the importance of its task require that there be administration; but private schools seem to function perfectly well with a much, much lighter load.) All of this mass of people making sure that other people are doing just the right things, and only just the right things means that change is very difficult. It is a dead weight on the progressiveness of schools.

Next, libraries don’t usually attract a lot of political attention. Those who don’t like them typically just don’t go there. They don’t argue that what’s being done in libraries is undermining our rights or our government, or spreading unhealthy lifestyles or propaganda. Schools, unfortunately, have become highly politicized, and everybody disagrees about what should be done, and how, which tends to exacerbate the paralysis.

And whereas people who don’t like libraries probably never liked them, and probably never went to them, everyone had to go to school. And everyone who went to school as a kid thinks they know what’s going on in our schools, and that it’s really pretty simple stuff that anyone could do, if they weren’t occupied doing more important things. Couple this with the widely held misperception that teachers have a cushy number, knocking off work at 3, taking extended holidays at Christmas and in the Spring, and enjoying Summers off, and it’s clear to anyone that teachers don’t work very much or very hard. Nobody complains about “librarian’s hours,” because people mostly don’t care, even when libraries are publicly funded. Of course, that this perception of teachers and teaching is mostly wrong doesn’t get much attention.

Then there’s the union issue. Librarians in big cities tend to be unionized, but with smaller community centers, this isn’t usually the case. And while there is clearly a valid and legitimate reason for teachers’ unions, they have, in the main, tended to block and fight changes in the way schools operate. They must feel threatened by such changes, although I’m not sure why. But the result is that they act like lead boots, further adding to the difficulties that prevent schools from changing.

The end result of all this is that we have one of the critically important foundations of our society and economy – our school systems – mostly stuck in the 19^th century, whereas our libraries are racing forward into the second decade of the 21^st century, and stretching towards the third.

It’s not good enough, and it needs to change. But who has the courage, the will, and the authority to change it? That may turn out to be the critical question for the 21^st century.

© Copyright, IF Research, September 2011.

There are innovations in the field of innovation itself, as well as older principles of innovation that have been around so long that many people either aren’t aware of them, or ignore them despite their value. I thought it was about time to explore both trends.

The particularly interesting thing about innovation is that its entire purpose is to carve out a future in the shape you want. It is a true tool for inventing the future. In this blog, I’m going to talk about what you should be trying to achieve with your innovation, the manner in which you should be focusing your innovation, rather than how to go about it. I’ve talked about how elsewhere (like here), so with that in mind, let me outline the 9 trends in innovation that I see emerging – or re-emerging – today.

1) Exclusivity is overrated; fanaticism is more valuable

There’s a natural tendency in sales to discount prices in order to boost volume. Unfortunately, this is a bad trade-off. Suppose you have a 25% pre-tax profit margin on your widgets, and offer a 10% discount to boost sales. That 10% comes right out of your profits, cutting your pre-tax profits by 40%, from 25¢ on the dollar to 15¢. Moreover, in today’s environment, offering people a 10% discount is virtually an insult, and may actually reduce sales rather than increase them.

One strategic way that companies attempt to counter the discounting impulse is to create a premium brand, and one of the ways of creating a premium brand is to foster a sense of exclusivity about your products or services. Their reasoning is that people are less likely to expect discounts on something that only certain people are eligible to own. Of course, if you look at the ads for luxury goods, most notably luxury cars, you can see that this doesn’t always work – and may not even work any better than for a mass-market brand.

A better way to avoid discounting is to seek to create a fanatical customer base that is devoted to belonging to, or being a member of the experience you create. A classic example of this is the Disney Company, and the clearest example I know of is found with the Disney Cruise Line (“DCL”). People rarely think of Disney offerings as being “exclusive,” yet, on one of the Disney ships, the cost of a one-bedroom suite with concierge service can be 50-100% higher than a comparable suite on a competitor’s boat. If you read some of the online forums for DCL, you will see repeated queries from confused consumers wondering why DCL suites are so overpriced. The simple answer is that whereas other cruise lines have fans who buy suites, Disney has fanatics that would rather pay more for the Disney experience than less for anything else. As a result, the suites sell-out almost as quickly as they go on sale, with the result that Disney can charge big premiums for them.

Of course, creating fanatics is not easy. It takes years of work, meticulous attention to detail, and outstanding customer service. In an environment where management wants instant results, where the bottom line seems to scream for cutting corners, and where customer service is known simply as “overhead”, none of these are popular choices. But look at those companies that have fanatics instead of fans, look at their profit margins, and then ask yourself whether it’s worth it or not. Nobody said innovation was easy, but if you’re serious about it, ask yourself what you would have to do to convert customers into fanatics. (I’ll come back to Disney because they do so many things so well, as you would expect from a company where innovation has always been part of the corporate culture.)

2) Create ecosystems, not products

If you look at the best technology names in the world today, they don’t create individual products, they create systems that interact and support each other. The Macintosh computer was a marginal success with less than 5% of market share when Apple introduced the iPod in October of 2001. But under the revitalizing and visionary influence of Steve Jobs, who had returned to the company he co-founded, the iPod was not just another “me too” MP-3 music player (and remember that Apple wasn’t the first to introduce such players). It was merely the front end of a music-and-information system that included iTunes in cyberspace, arrangements with most of the major music companies that made it easy, legal, and relatively inexpensive to download music, plus provided a means for entrepreneurs to plug in and use the iPod for their own ends. Podcasting became a way for people to become their own broadcasters, and create an audience for themselves without having to work through a media company. And along the way, the revamped iMac became the world’s first computer that sold essentially as an accessory to an MP-3 player, the iPod.

When Apple introduced the iPad, they also introduced an App Store, which resulted in thousands of entrepreneurs creating applications and selling them to iPad owners. This storm of creativity was supported by Apple, and Apple was able to sell and profit from things they hadn’t created. But they benefited even more than mere profits because competing touchpads had to cahse after not only the Apple interface, but also all of the apps available for the iPad.

facebook is perhaps the best example of creating an ecosystem, only here they’ve created the ground, and allowed others to plug into it and grow their own businesses, from games, to advertising, to organizing groups for disparate reasons, and much more. It has become the de facto means for communicating for many people, especially the young and the technologically adept, to the point where many people no longer use email or IM outside of the facebook ecosystem. And facebook gets paid through advertising for providing this fertile ecosystem, and benefits from the entrepreneurial instincts and efforts of those who create more networks, games, recipe groups, political groups, and more. They have become an engine that entrepreneurs can plug into.

Likewise, Google has created an ecosystem that includes free tools, free email, free news, free tracking systems, free data storage, and more. And it all integrates, and funnels down into their revenue generation. People like free things, they like useful, powerful free things even more, and they’re willing to put up with the attendant ads that make it possible.

3) “It’s not the customer’s job to know what they want”

This comment, apparently, is something that Steve Jobs has said repeatedly within Apple. If you are innovating, then you are, by definition, doing something new. And if you’re doing something new, then your customers won’t know if they like it until they’ve actually tried it. Hence, it’s your job to figure out what your customers are likely to want before they know themselves. Let me give you an example of why this is so.

When the very first cellular licenses were being offered, I was working with a group that bid (unsuccessfully) for one of the licenses. My job was to write the science fiction section of the application; you know, the part that said people would be able to send fax messages from their cars, and walk down the street talking on the phone. Since, at that time, most portable phones had their guts in the trunk of a car and were highly unreliable, this was all very wild and wooly, and people wondered what kind of funny-smelling cigarettes I had been smoking.

Meanwhile, our financial backers were nervous about whether there was actually a market for this very expensive technology, so we commissioned a consumer survey to find out how many people were likely to want a cellular telephone. The survey results came back, and everyone was pleased and relieved that there was, indeed, a big enough base on which to build a business: the survey indicated that fully 7-8% of working adults would consider acquiring a cellular telephone. Of course, now this seems foolish as our survey results were short by more than a factor of 10. But it was difficult for people to know if they wanted a pocket telephone, something they had never experienced.

To truly innovate, you have to imagine not only what might be, but also how your clients or customers might like something they’ve never experienced before. Fortunately, there are some guidelines to help, one of which is next.

4) Seek beauty and perfection in what you offer

I did some work for Lexus US, and the CEO, Mark Templin, told me a story to make a point about their cars. He said that one of his neighbors came over and knocked on his door to tell him that she was going to buy an SUV, but not from Lexus. He blinked, and said, “OK, I appreciate you telling me. May I ask why?” It was because, she said, that too many people owned Lexus RX’s, and she wanted something that stood out. He thanked her, they finished the conversation, and she went home.

A couple of weeks later, he saw her again, and she was driving a Lexus RX, just as she had said she wouldn’t, so he went over to her house and knocked on her door, asking her what happened. “You know,” she said, embarrassed, “I tried all of the others, then tried the RX, and yours was just so much better that I couldn’t imagine owning anything else.”

Seeking perfection sounds like a hippy-dippy, naïve, lamb-choppy thing to say, so let me approach it in another way. If you asked your mother to use your product, would she find it easy to do so? Would she enjoy it? Do people connect with what you offer in an emotional way that makes them feel good about themselves as well as with what you’ve sold them? Are they proud of owning or using what you offer?

It’s easy to make something “good enough”, and good enough often sells. But if you are truly trying to innovate, good enough is never enough. Magnificent is what you’re after. Or, again quoting Steve Jobs, you want to create something “insanely great.”

Indeed, the insanely great 1984 Macintosh created such a powerful impression that it is still benefiting Apple today. Apple’s head of design is an Englishman named Jonathon Ive. In a September 5^th, 2011 article in the Los Angeles Times, reporter Jessica Guynn related the story of Ive’s first encounter with the Macintosh computer:

“He says the company’s revolutionary nature was clear to him from the moment he first touched a Macintosh computer. At the time he was nearing the end of his four-year industrial design studies in England. Not one to read an instruction manual, he was frustrated with personal computers and feared he was ‘technically inept.’ Then he turned on a Mac and said he felt an instant connection to the computer and to the people who designed it.

‘I could just use the product straightaway. It was a really profound moment. I don’t think I ever had actually quite the same sense of ‘wow’ with a product before,’ Ive said.”

If Ive had not felt such a strong and immediate connection with the original Macintosh, he would almost certainly not have joined the company. And if he had not, himself, sought to create perfect, intuitive products while he was working within Apple, he would not have come to Jobs’ attention when Jobs was seeking a new head of design. But because both things happened, Ive wound up as Apple’s Head of Design, and become an internationally renowned designer. His goal is always to “make something that looks like it wasn’t really designed at all because it’s inevitable.”

Seeking perfection supports the goal of creating fanatics, as described in #1 above, but while related, it’s separate. Indeed, if you don’t have beautiful, magnificent, insanely great products, you’re not going to be able to develop fanatics. The two complement each other.

5) Create experiences, not products or services

Companies often become so focused on what they’re doing that they lose the customer’s perspective, thinking only of what they’re trying to do, how they need to market, distribute, sell and deliver their offering. But if you think about it, the customer doesn’t care about any of that. The customer only thinks about what they experience, and what they would like to experience (if, indeed, they know).

There’s an old marketing cliché that “Nobody wants a quarter-inch drill; what they want are quarter-inch holes.” That’s still true, but what has also happened is that consumers are looking past or through the product or service, and considering their experience with the results. Or at least, that’s what they want to do. This is particularly evident among car companies.

For 31 years, BMW used the marketing slogan “The Ultimate Driving Machine.” Then, in 2006, they changed it to “The Ultimate Driving Experience.” This would be consistent with the quarter-inch hole dictum: do people want a driving machine, or a driving experience? Clearly, BMW decided that, at least for now, they want a driving experience.

Lexus is perhaps an even more powerful illustration of the importance of experience instead of product. In a 2009 interview with David Brimson, the head of Lexus UK, publication The Executive Issue commented on Lexus’ rise among luxury cars in Europe that:

Customers had to fall in love with the complete experience, the product and the customer handling, this made the Lexus brand famous, then customers were more loyal and told their friends about Lexus.

“A car is new and exciting for a while, but after the ‘honeymoon’ people get used to it,” Mr. Brimson explained. “After one or two service cycles the car is just a tool. But if customers have a real relationship with the retailer, that helps to bond them to the brand.”

Brimson went on to describe why focusing on the experience is actually quite difficult:

…automotive retail has remained largely [unchanged]. By looking through [the customers’] eyes we learned more. We saw that we were forcing them to perform the way WE wanted.

E-mail is a great example. Many of our premium customers live on their Blackberries, an increasing percentage want to use e-mail or use mobile internet, just as they would normally in their jobs. But very few retailers have processes to respond to e-mail in anything like an acceptable time, so customers really have to use the phone.

So forget the quarter-inch drill; go for the experience. And the experience starts and ends when the customer thinks it does, not when you think it does. Sticking with cars for the moment, the customer experience begins when she first thinks, “I wonder what it would be like if I bought a new car? What’s out there?”, not when they walk through the door of a dealership. This means that the experience includes how easy it is for them to get information about the cars you sell, if they can find the information that they actually want (even if they don’t know what they want), if that information is satisfying to them and encourages them to continue moving forward, and so on.

And the ideal is that the experience persists even beyond the customer’s life span, that they have talked glowingly about you and what you do so that their kids or their friends want the experience as well. You are aiming not just womb-to-tomb, but beyond as well. Their experience becomes a permanent relationship (which is fanaticism) – and that leads me to the next trend.

6) Eat your own lunch – and everyone else’s

The world changes. This is such an obvious statement that people never really think about what it means. It implies that your market changes as well. And that means your offerings have to change. Yet, many companies resist the idea of introducing significant changes to what they do for fear it will eat into their existing sales and hurt their revenues. The reply is obvious, and again, it’s so obvious that people never actually think about it: whether you introduce changes that eat into your existing sales or not, someone else will. So the question then becomes: do you want to cannibalize your sales, or let one of your competitors do it? This is an old, established principle in innovation, but one that is so well known that people take it for granted – and don’t, as a result, make use of it. And with the speed with which things are changing now, this old principle takes on a new urgency.

Worse, you also need to take risks when you introduce new things, precisely because the world is changing so fast. If you make timid changes, you risk being left behind.

I have to come back to Apple again, because Apple does this better than anyone else. Apple popularized the use of the mouse-and-desktop metaphor. (They didn’t invent it – that was done by Xerox at their PARC research group, but they were too timid to exploit it.) And Apple were the ones to first push customers to move beyond it. People still use mice with their computers – but Apple found them too limiting for their iPods and iPads, so did away with them, substituting touch and tap technology instead. They were the first to do away with floppy disks, and, more recently, with any kind of external drive, including CD and DVD drives in their MacBook Air.

Yet, what Apple and Jobs did was far more profound than just leapfrogging their own creations. They went outside of the computer industry and ate other industries’ lunches as well. In the words of a New York Times article (David Carr, “Steve Jobs Reigned in a Kingdom of Altered Landscapes”, August 27^th, 2011, NYT website), “[Jobs] didn’t set out to destroy existing business models, he just noticed their lack of relevance and came up with new ones that kept consumers happy and Apple fat. Along the way, he changed the vocabulary of media: Songs became files, subscriptions became apps, and media became just one more way to make that thing in your hands appear all the more magical.”

So, when you set out to innovate, make no small plans, and don’t even think about protecting your own business and your existing sales. Think beyond the boundaries of what you sell your clients, and think instead what you could do for them with what you have.

7) Speed kills – your competitors

Carrying on the discussion of how Apple has grown seemingly effortlessly over the past 10 years, they have forced the pace of change to the point where competitors are struggling to catch up to their last innovation while they’re already working on its successor.

I remember when Apple introduced the iPhone in January of 2007. There was a lot of criticism of what it couldn’t do, and of its shortcomings. I thought such criticisms, while perhaps warranted, were short-sighted because I knew that Apple’s pattern was to introduce a product, and then immediately and rapidly work to improve it. Sure enough, most of the shortcomings of the original iPhone were corrected (or at least improved) in subsequent releases, first of the software operating system, and then of the device itself.

There’s even a management cliché about this process: “Ready! Fire! Aim!” Introduce your revolutionary device, even if it’s not quite ready for primetime. Meanwhile, work like fury to smooth out the shortcomings, and listen carefully to the bitching and complaining about it so you can make the improvements that will make a difference to people who are using it. Use the market as the beta tester, because waiting too long saps your speed and allows competitors to catch up.

Of course, speed can kill you, too, if you don’t listen, or don’t want to listen, to criticism of your offering, or are unwilling to change it. If you bet the farm on a new offering, and then refuse to tinker with it, you will create enormous momentum – towards the scrap heap. So, you need to keep ahead of your competitors, and force them to make bad choices and introduce poor imitations of what you’ve done – but you also need to treat your own offering as a poor imitation of what it is going to become when you improve it.

8) Make lots of small mistakes

This seems to contradict trend #6, but it doesn’t. In a handbook I created for my consulting clients, titled “Innovation and Leadership: Techniques to Lead Creativity”, I talk about why companies proclaim their dedication to innovation when they secretly loathe and despise it because of the risks it forces them to take, and the fear of failure that comes with such risks. I then suggest that the way to overcome that fear is to institute a process of continuous improvement (from the Japanese process of kaizen), introducing a steady flow of minor changes that, collectively, add up to massive improvements over time. There are two aspects of this that complement, rather than contradict, my “speed kills” trend.

First, when you create a culture of continuous, all day, everyday improvement, and everyone is always looking to do things better today than they did the day before, the cumulative changes add up very quickly, supporting the Need for Speed. Creating that culture is not easy, but in today’s market, I believe it is essential.

And second, when you use creativity-enhancing techniques in the quest for a steady flow of small improvements, you will occasionally stumble across a really big idea as well. Of course, most people either back away from a big idea because it’s so scary, or fail to recognize it at all because it seems so different, so out of context, so “outside the box.”

What’s more, pursuing incremental improvements on an on-going basis does not preclude making a concerted effort to find the Next Big Thing, either, although that is harder.

I worked with one client, taking them and their people through an “Inventing the Future” process. At the end of that process, two things happened. First, the workshop participants came up with what I thought was a brilliant new approach to their market that was a relatively simple (although not easy) extension of their existing customer service process. It would have created substantial market differentiation, setting them apart from everyone else in their very busy market. Yet, their reaction was definitely ho-hum. They didn’t see it as being that important. This is, in my mind, a classic example of failing to recognize. They were looking for something dramatic and flashy. This was – but they didn’t see it that way, and so chose not to pursue it.

Meanwhile, as a result of preparing and running the visioning sessions for them, I had an idea that went ’way outside the box, bringing technology into their business in a dramatically new and different way. However, they hadn’t hired me for my ideas, but for my ability to stimulate their thinking and facilitate their brainstorming process. Indeed, this was explicitly spelled out in the terms of engagement. Accordingly, I approached the management privately, told them I had an idea that might be of value to them, but warned them it was a radical departure from their current way of doing business. They didn’t want to hear about it. They didn’t ask any questions. They basically just brushed it off without knowing anything about it.

9) Use technology to make magic

When people marvel to me about all the changes technology has introduced over the past 10 years, my reply is always, “You ain’t see nothin’ yet!” Technology is advancing so quickly that it’s almost inconceivable what we will experience over the next 10 years.

Yet, technology is doing things that even 20 years ago people would have dismissed as improbable, impossible, or thought was just plain magic. So exploit that magic. You may be in an established, mature industry that uses very little technology. But look for ways of improving your customer experience of your offerings by using technology to make it magical. Again, Disney is great at this.

I was on one of their new cruise ships in January of 2011, and while there were lots of interesting, well-executed things on this ship, one thing caught my imagination and stuck in my mind as really neat: they had magic pictures on the walls (or bulkheads, if you insist). When you were walking through some of the public areas, there were all kinds of pictures, illustrations, photographs, and decorations from their movies and creations. A few of them, though, were magic: while they looked like pictures, for example of a pirate ship, when you walked up to them, a motion sensor turned it from a static picture to a cannon battle between the pirate ship, and a port city fort, complete with sounds.

There was no compulsion to do this. Disney’s earlier ships had static decorative pictures and such on the walls. But this was an opportunity to use technology to make something ordinary into something magical. And since Disney sells the experience of magic (even though they don’t actually have magic), it was a natural progression for them.

You don’t have to be Disney to do this. You could run a lunch counter, and offer your regulars the opportunity to order their lunches by email. Once you had that established, you could email photos of what they normally ordered, along with suggestions for sides that might complement such dishes, and an offer for a (first time) discount if they were ordered together. Once you got your regulars used to that, you could match similar taste combinations from the things that other customers who liked what this customer liked, and make suggestions of things they haven’t tried, along with a (first time) discount to encourage them to experiment. In short, you could use technology to look for ways to make their experience (Trend #5) easier, better, and more memorable. In fact, I’m sure there are lunch counters that are doing just this, even though I don’t know about them.

“Any sufficiently advanced technology is indistinguishable from magic,” said author Arthur C. Clarke. Technology is making magic on a daily basis – so find a way to bottle this lightning, and turn it to your advantage.

There are many other developments in innovation beyond what I’ve said here. I started work on this blog by listing ideas, and then wound up discarding a bunch of them in order to focus on the ones I thought were most relevant right now. If you are truly interested in innovating, then it must become a way of life, not just something you think about when reading an online article.

And if I can help, contact me.

The stock markets have fallen out of bed since President Obama signed the ludicrous debt ceiling deal. I don’t wonder about that; what I wonder is why they took so long. I was expecting stocks to fall two weeks earlier than they did. But now the question becomes: What happens next? This is actually a much deeper question than it seems, because it goes far beyond just the behavior of stock prices and markets. But let’s start with stocks.

When I started work on this blog, the S&P 500 index was at 1,119 which put it almost exactly half way between the October 4th, 2008 high of 1,565 and the March 6th, 2009 low of 667. Specifically, it was 452 points below the high, and 446 above the low, so almost exactly half way. (And if you want to look at that in percentage change terms, it’s 40.4% down from the high and 39.9% up from the low.) That would seem to imply that while there may be more risks yet in holding stocks, we may be getting through the worst, and should start compiling lists of stocks we want to buy. Indeed, since I went to virtually all cash in my personal and corporate investment accounts more than two weeks ago, I am waiting for buying opportunities, and creating just such lists.

But there’s an old stock market cliché for times like this: Never try to catch a falling knife. Don’t buy when markets are in free fall, because you’ll only wish you waited longer. Barton Biggs, a well-respected market analyst and money manager, was interviewed on Bloomberg TV, and said he had a list of great stocks that were now bargains, but that he wished he’d waited longer to buy them – and that was 150 points higher. So, that being said, what are the risks, and how will we know when the worst is over?

Well, first of all, you need to consult a properly licensed investment advisor for specific information, someone who knows your financial position, tax status, age, risk tolerance, cash flow, and all the other pieces of information that go into making a proper assessment of your investment needs. I am not that person, and this is not intended as investment advice. Here endeth the small print.

Risk management

Let’s take a step back and see if we can find some benchmarks. To do so, I want to go back to a concept that I’ve written about repeatedly in this blog, and use regularly with my consulting clients: the ratio of risk managment. What are the possible risks? And what are the potential returns? Once you’re assessed those, you’re in a better position to make decisions, rather than just guessing whether the markets will go up or down.

By my definition, risk is the cost of being wrong. So, if we invest in stocks now, or don’t invest in stocks now, what are the risks either way? Let’s start with the potential positive risks, because, unfortunately, this is a much shorter list.

Could the markets surprise us on the upside? There are three factors that drive stock prices: interest rates, corporate earnings, and investor psychology. I don’t foresee any upward pressure on interest rates unless there’s a true financial panic. Even if there were a panic, there are so many trillions of dollars invested in U.S. Treasury securities that there is nowhere else for them to go. Accordingly, absent an end-of-the-world type scenario, I believe interest rates are a neutral influence at worst, and probably slightly positive.

Next are corporate earnings, which have been surprisingly good of late. Yet, I believe the outlook for the U.S. economy – and all others that are at least partly reliant on it, which is everyone – is worse now than it was before the manufactured debt ceiling crisis. That political stunt by Tea Party fanatics shook people’s faith in the American political system, and raised doubts about the American economy that weren’t there before. As a result, more people are talking about a double-dip recession now than before, and such talk tends to become self-fulfilling. Moreover, falling stock markets tend to make people feel poorer, which makes them spend less, which slows demand, which slows the economy. All told, then, I would have to assess corporate earnings as being neutral at best from here, and possibly negative.

Finally we come to investor sentiment, which is always the hardest to get a handle on. Moreover, if the markets have a couple of high-flying up days, then psychology can change from being deeply fearful to being deeply greedy overnight. But one solid indicator of market sentiment which has been consistently good is market volatility. High volatility times, even when markets are rising, are times when there’s lots of uncertainty, which is why values seem to change overnight. The best environment for bulls is one where markets make a slow, steady advance, not ones where markets zip up, then down, then up again. And a handy index for this is the Chicago Board Options Exchange SPX Volatility Index, or VIX index (VIX:IND). This index recently reached levels unseen since April of 2009. All told, then, I would suggest that market sentiment is unsettled and nervous, which is definitely bad.

So could markets surprise us on by running away from us on the upside? There’s always that possibility, but I think the odds are pretty small that we will lose a lot by staying on the sidelines. If the market recovered to where it was in May, the S&P 500 could go back to 1360, which would mean we might miss a gain of about 22%. And that’s if the market took off so fast we couldn’t respond. So the risk of being left behind by the market is, in my view, relatively limited.

Possible Positives

Another positive development is that falling stock prices have also brought down commodity prices, notably oil. Since high oil prices act like a tax on the economy, lower oil prices clearly benefit economic growth.

And banks are generally in much better financial condition now than they were in 2007 – except those that have loaned too much to weak European sovereign credits.

Beyond these points, what might is likely to happen to the economy? Well before the phony debt crisis, the outlook for the U.S. economy was disappointing at best, with feeble growth, weak employment, and nothing on the horizon promising to change that. Now the outlook is worse, as I said, so at best we could see the economy return to that slightly depressing, feeble outlook. So, again, the potential to be surprised on the upside, or the return half of the equation, seems limited. Now let’s turn to the potential risks. Alas, here the list is much longer and more compelling.

Potential Negatives

I’m going to list the risks, and merely touch on most of them rather than go into exhaustive detail. The prospects are dreary enough without dwelling on them. I’m going to save the worst ones for last. Here are the major risks that I see now:

• Stocks go down because they go down. Markets develop a mind and momentum of their own, and while I don’t believe you should ever rely on momentum investing, it’s also clear that when investors become fearful, and especially when they panic, it’s dangerous to get in their way. In particular, investors, particularly boomers hoping to retire, were deeply shaken by what happened to their investment portfolios in 2008, and are likely to be faster to bail out on markets rather than try to ride them out. This increases volatility, which, as I’ve said, is a bad thing.

• A possible double-dip recession. There is no real reason why the U.S. economy should go back into recession. I had been expecting it to dribble along in a slow growth, jobless recovery that was disappointing. Now, though, the talk about a double-dip is, as I said, likely to become self-fulfilling. There’s no fundamental reason for it, but the phony debt ceiling crisis shook confidence, and ultimately the economy. And the markets run on confidence.

• America’s downgrade from AAA. This doesn’t help, but it is currently a split rating, with only Standard & Poor’s lowering America’s credit rating, and only on long-term debt. If the two other major agencies, being Moody’s and Fitch’s, were to follow suit, that would be an enormous negative, but that doesn’t seem to be in immediate prospect. Neither, though, is America likely to get its AAA rating back anytime soon. Canada was downgraded from AAA in 1992, and then got it back ten years later. But that was during a period of strong economic and productivity growth, and the Government of Canada, under Prime Minister Jean Chrétien and Finance Minister Paul Martin ran 10 years of budget surpluses, paying off big chunks of government indebtedness. The odds of America doing that are vanishingly small. The only reason American debt has performed as well as it has so far is because, in the words of one commentator, “It’s the best looking horse in the glue factory.”

• Weak economic growth compounding American government indebtedness. The Tea Partiers have overlooked the primary fundamental of government finance: that government revenues and expenditures are inexorably tied to economic performance. A weak economy will sap government revenues and force up expenditures, compounding deficits, and piling up debts. Slashing spending in such an environment cuts jobs, lowers economic growth, and increases deficits. This is precisely what happened in the 1930s under President Herbert Hoover. He and his counterparts in Congress kept slashing spending to try to bring the deficit under control, only to find that economic growth fell further, increasing the deficit. In response, they slashed spending even more. It became a vicious cycle, and this is still the textbook example on how a government can turn a recession into a depression. Unfortunately, right-wing politicians in America seems to be embarking on precisely the same policies now.

• Another negative that has ramifications that go far beyond stock prices is the high rates of unemployment for men and young people. We can see the results in the riots in Greece and Portugal, but now in London as well. In America, the official unemployment rate is 9.1%, but the percentage of working age (16 to 64) American men who are employed has fallen from about 85 percent in the early 1950s to under 65 percent now. Some put the actual unemployment rate of men in America at 25%, and that for young people at 45%. These numbers are hard to confirm, because unemployment surveys don’t include people who are so discouraged that they’ve given up even looking for work. Whatever the true numbers are, this is bad news economically, bad news socially, and bad for America’s future.

• The political deadlock in the American Congress. America has become steadily more polarized over the past 20 years. There have been many analyses of why this is, but I think there are two primary reasons. First, the media have discovered that it is more profitable to be biased and outraged than it is to be balanced and thoughtful. Fox News in America, and News of the World in England are or were the exemplars of this trend. And with the splintering of media caused by the Internet, people can now choose to consume only those viewpoints with which they agree. This creates the echo chamber effect, where like-minded people reinforce their own prejudices. The result is rather like being surrounded by yes-men: you become convinced that your point of view is the only valid one. This pushes people with different viewpoints farther apart, and causes them to summarily dismiss any views that don’t coincide with theirs as being obviously, even maliciously wrong.

The other reason is jerrymandering. As I’ve discussed this at length in another blog (found here), I won’t go through the arguments again. But the result is that the extremes in American politics are being over-represented, and the center is being ignored. According to The Economist newsmagazine (14 April 2011), the results are pretty stark: “On average, House Republicans have voted with their party’s majority 91% of the time and Democrats 90% of the time. The picture is very similar in the Senate.” This is making American ungovernable, as was clearly on display during the unnecessary debt crisis, and an America that cannot govern itself becomes a danger to itself and others, geopolitically as well as economically.

• Finally, the greatest immediate risks out there right now relate to the financial crisis in Europe. Greece is functionally bankrupt, and all that is left is to decide how to cope with the financial mess. The other weak members of the EU are being shunned by the credit markets with more or less justification, but the net result is a potential run on European sovereign credits. The results of this could be very much like the run on Bear Sterns or Lehman Brothers in 2008, with the same kind of knock-on consequences. Worse, this financial crisis could lead to the possible collapse of the Euro as a currency, which would endanger the survival of the EU. And that would be a very big economic (and financial) shock indeed, especially as the world’s central banks don’t have as many resources left to battle a global financial crisis.

The Costs of Being Wrong

So the cost of being too pessimistic is the potential to lose a market gain of perhaps 20-25%. The market cost of being too optimistic would be a repeat of the kind of bear market we saw following the 2008 market panic, which could be a further 40% drop. But the greatest risk is that the problems in Europe and America are compounded by policy mistakes, such as those followed by Herbert Hoover in the 1930s, or a market collapse brought about by forces that overwhelm the world’s central banks, such as the collapse of the European Union with the subsequent economic catastrophe. Either of these could produce a market drop similar to that of the 1929 to 1932 period, which was a fall of 89% would take the S&P 500 down to the vicinity of 170 points – an 85% drop from where it was when I started writing this blog. That, and the very dangerous economic fallout that would come with it, are the real risks.

So if you’re only mildly pessimistic, weigh the potential for a 25% gain against a 40% drop. If you’re really scared, weight that 25% upside against an 85% downside. Add in your assessment of the probabilities of each, and place your bets accordingly. As for me, at the moment, I’m staying on the sidelines and watching the carnage, biting my fingernails all the while.

My last blog dealt with the debt ceiling debate within the U.S. Congress – if “debate” is the word for what looks like a combination of Mexican stand-off and Russian roulette. I’d like to update my comments with some things to watch:

1) August 2nd is probably not the deadline. I believe the actual deadline is unknown, and uncertain. If the rating agencies drop the credit rating on US debt, or the markets start to panic, that will start a chain of events that will probably be irreversible, and trigger a US default. Yet there is a real danger that all three parties involved in this mess (Republicans, Democrats, and the President) actually believe that they have until August 2nd to back away from the abyss. In fact, the ground may collapse under their feet while they’re still posturing on the edge.

2) Suppose that the Speaker of the House of Representatives (John Boehner) and President Obama do arrive at a deal in time. What they may not be counting on is hold-ups by others, such as a defeat of their deal by ideologues within the Republican party in the House, or a filibuster by a disgruntled ideologue of either party in the Senate. This could prevent a deal from passing in time, and could trigger the events described in point 1 above.

3) Even if a deal is struck before panic happens, this event has already caused significant damage, and we won’t know the extent of that damage for months or years. As one of the commentators I follow, a retired money manager who keeps tabs on things for his own interest, put it in an email to me: “a great deal of damage has already been done. Anyone who would have said a year, or even six months ago, that there would be major talk of the US defaulting would have been laughed out of the room. Foreign investors, incl. the central banks, are already ‘voting with their feet’, as witnessed by the price of gold that this morning leapt through the 1,600 level and the fact that last week was the 16th month in succession that assets under management dedicated to emerging market bonds funds were up.” In effect, the United States government has called its own credibility into question, and announced loudly to the world that it is dysfunctional and untrustworthy on financial matters. US debt is no longer “risk free”, and investors will hereafter try to find other, less schizoid places for their money, which will cause U.S. interest rates to rise, further exacerbating the U.S. deficit by increasing interest costs. This is an incredibly dumb action by the U.S. Congress, notably the brain-dead ideologues in the Republican Party.

4) There are members of the Republican party that are saying they won’t vote raise the debt ceiling under any circumstance, which is an ideological statement, not a rational one. There are Republicans who are saying a default would not be as bad as Obama is saying, that he’s fear-mongering. That’s a clear illustration of their ignorance. There are even Republicans who are saying that default would be a good thing because it would force liberals to cut spending – completely overlooking the fact that it would dramatically raise the interest rates the US government would pay, which would raise the total interest costs, which would increase the deficit. It is truly frightening that our collective future is at the mercy of such idiots. Moreover, if a default happens, these same idiots will blame Obama because they always blame Obama.

5) There are only two small pieces of good news of the last week or so. First is that while the American public is condemning all sides on this issue, its greatest condemnation is for the Republicans fanatics. Hopefully this will scare them enough that they will rethink their positions. The other is the bizarre, Rube Goldberg-ian mechanism proposed by Senate Minority Leader Mitch McConnell. In effect, it would allow Republicans to vote to give Obama the power to overrule them and raise the debt ceiling. They think that this is somehow different from voting to raise the debt ceiling. The only thing to recommend this wacko idea is that it might lead to the debt ceiling being raised, and rescue the Republicans from themselves.

6) So far, most Democrats have been remarkably silent (or at least unnoticed), but I suspect that some left-wing ideologues will say they won’t vote to raise the debt ceiling if Social Security, Medicare, or Medicaid are affected by cuts. These people are as dangerous as the Republican fanatics. The US has no choice but to cut its deficit, as I’ve written elsewhere. Any such Democrats are idiots, too, if they hold to this position.

7) Some have suggested that President Obama has the power to raise the debt ceiling without Congress by virtue of Section 4 of the 14th Amendment, which says “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” First, I don’t find this unequivocal, but more importantly, how many investors would be willing to take a chance on buying debt that may not be legal, and might subsequently be declared invalid by the U.S. Supreme Court? I think this is a non-starter.

8) The financial markets aren’t reacting more because they don’t think that the Republicans are serious about refusing to raise the debt ceiling, while the Republican fanatics assume that the markets don’t care. Meanwhile, the bond market is torn because investors are so concerned about what’s happening in the EU that many are fleeing to US Treasury issues. Where else is there to go? Both of these effects leave the impression that things are better than they actually are – and may given the parties involved in negotiation more time before a panic occurs.

9) Most of the reactions I’ve had to my blog have been wishful thinking, along the lines of “This can’t happen. This is all posturing. They’ll come to an agreement.” I certainly hope so, but I’m not seeing signs of it. I can only hope that there is real progress being made in the back rooms on this, because everything I see in public pronouncements indicates two sides that are too far apart to reach a deal. And, by the way, through this and other of my blogs, I’ve been ripped as being both a tool of the Republicans (by liberals), and a tax-and-spend liberal (by conservatives). I guess I must be doing something right.

Possible calendar of events to default – or avoidance thereof

Let me offer a possible timetable of events for avoiding a default. Anything worse than this must, I think, lead to default. Anything better may avert it, although that’s not certain:

Thursday, July 21st, 2011 – Markets begin selling off in earnest as time runs out to craft, draft, pass and sign legislation permitting the debt ceiling to rise. (Foreign exchange markets are already starting to move.)

Monday, July 25th, 2011 – One or both of the rating agencies offer one last warning, saying that a ratings downgrade is imminent unless a deal emerges to raise the debt ceiling. As well, both agencies emphasize that raising the debt ceiling alone is not enough; the deficit must be tackled in a realistic manner as well.

Wednesday, July 27th, 2011 – Congressional leaders and President Obama announce the outlines of a deal, forced on them by falling markets, plus a fast-tracking process to get it through both houses of Congress in time. Markets have dropped by about 8% from a week earlier, or more than 1,000 points on the Dow Jones Industrial Average.

Friday, July 29th, 2011 – Grandstanding Republican fanatics try to stall or fatally amend the legislation, but are slapped down by Republican leadership. The bill clears the House.

Monday, August 1st, 2011 – Members of both parties attempt to filibuster, delay, or fatally amend an identical bill in the Senate, but are voted down by combined Republican and Democratic Senators. The bill clears the Senate.

The bill goes to Obama to sign. He signs it with the media watching, and thanks leaders of both parties and in both houses of Congress. He also announces a task force with members from both parties to come up with $1.5 trillion in budget cuts and revenue increases over the next 10 years, such cuts to be enacted by the end of 2011, plus a secondary goal of recommending budget cuts and tax code revisions amounting to $4 trillion over the next 12 years, to be enacted after the elections of 2012.

The Federal Reserve announces a special debt issue to provide the government with immediate cash, which it purchases from the Treasury, pending a successful new public bond issue. Critics call this “QE3”, but it’s really about the only way the Treasury can get enough money fast enough to meet obligations – by having the Fed print it.

The markets rally slightly, then begin sinking again more slowly on the continuing crisis in Europe and the weak economy in America. Moody’s and Standard & Poor’s maintain their negative watch on the US credit rating.

—————–

Is this the way it will happen? Certainly not. First of all, I don’t know enough about the process of passing legislation through the US Congress, but I do know that the Treasury Secretary has said they must have a deal by July 22nd in order to get the legislation done. Moreover, there are too many aspects of this very complex future for me to successfully get them right. What I’ve tried to do is come up with an at-the-last-moment scenario to use as a benchmark to see how the process is going. As I said, if the process lags behind this, then a default seems likely.

Just so you know, I am backing my words with actions. I have, at this point, sold or am in the process of selling all of my investment holdings except for (a) precious metals, and (b) a small investment in developing economies. I may sell both of these positions before the dust settles. I am also trying to minimize my holdings of US dollars.

© Copyright, IF Research, July 19th, 2011.

The world as we know it may very well end on August 2^nd. This won’t be the end of the world in a metaphysical or spiritual sense, but rather in a financial and economic one because of the incredible, almost unbelievable stupidity of the extreme members of the Republican Party. These wing-nuts are using the financial equivalent of the threat of nuclear winter to negotiate their agenda of spending cuts, coupled with no tax increases or even tax cuts, to eliminate the U.S. federal deficit, or else. In this case, the “or else” is a refusal to raise the debt ceiling for the U.S. government. If that happened, then the U.S. government would run out of money by about August 2^nd, and begin to default on its obligations. There are two major aspects of this: financial, and political. Let me deal with the financial aspects first.

The debt ceiling is the maximum amount of debt that the U.S. government is allowed to borrow to finance it’s operations, and is legislation originating in the House, approved by the Senate, and passed by the President, like any other financial legislation. The U.S. government cannot borrow any money beyond this authorization. Given the current massive deficit being run up by the American government, this would force the U.S. government to default on its debt. Such a default would produce a vast disruption in the financial markets, and cause America’s credit rating to be downgraded from AAA to AA or less. This, in turn, would require many pension funds and other investment groups required to hold nothing but AAA securities to sell all of their holdings in U.S. government bonds and T-bills. This forced sale would trigger a panic on Wall Street, and in financial centers around the world. U.S. treasury bonds and T-bills are considered the most secure investments in the world – but then, suddenly, they wouldn’t be. Investors would have no idea what was safe, or where they should put their money. And the amount of U.S. securities held by investors, including countries like China, runs into the trillions. If there were a run on U.S. securities, it wouldn’t just be dramatic, it would be cataclysmic because there would be nobody to buy them.

And it wouldn’t just be the U.S. federal government. All of its agencies and the agencies it supports would be downgraded (and their securities dumped). And it’s quite possible that a number of state governments would also be downgraded as well. Indeed, as anyone who has studied financial panics of the past (as I have) knows, once a panic starts, the mob sells anything with any hint or rumor of possible financial difficulties. As a result, the panic would instantly spread to all of the shaky sovereign credits of Europe (Greece, Ireland, Portugal, Belgium, and more), and move into American state governments (Illinois, California, and more), and into corporations thought to be less than rock solid. Eventually, everything would become suspect, and gold and precious metals would shoot through the roof.

This would cause a huge spike in interest rates, causing stock prices to collapse, and, worst of all, would critically damage investor confidence. Since all investment markets rely on confidence, this could produce a panic as severe, or worse, than the panic that seized Wall Street in October of 2008. Worse than that, there would be no U.S. Federal Reserve to save the markets from themselves. They wouldn’t have any money with which to operate, and whereas the U.S. government was seen as the only possible savior in the Panic of 2008, it would be the cause of the problem this time. With no one left to act as “lender of last resort,” it’s entirely possible that financial markets around the world would collapse, possibly triggering a depression on the scale of the 1930s or worse. We really do not know how bad it would be – only that it would be unprecedented, and very, very scary.

But if the consequences are potentially so extreme, why are the markets not reflecting this? Let’s run over the potential counter-arguments.

“This is all just negotiating tactics. They won’t allow a default to happen.”

Perhaps so, but playing chicken while driving a truck full of nitroglycerine over rocky terrain doesn’t leave you much room for mistakes. Moreover, I’m not sure that the players involved are smart enough to understand the magnitude of the problem, and they could easily misjudge the situation. Even if they are planning to come to a last minute compromise, it’s not clear that the markets will wait that long. The rating agencies have already warned that if they don’t see a settlement by mid-July, they could downgrade U.S. securities, even without a default. Since a negotiating posture is only effective if you make the other side believe that you’re serious, the Republicans will have to act as if they are prepared to allow a default if they don’t get what they want. In so doing, they may also convince the rating agencies of the same thing, triggering the kind of run on Treasuries that I described above.

Moreover, the markets might get spooked before the rating agencies can act. The thing that scares investors most is uncertainty. If the biggest, most important financial entity in the world suddenly looks shaky, investors might suddenly decide that they need to run for the hills. Once a panic starts, it would be very difficult to stop.

“The U.S. government can’t possibly be this stupid. This is all show. It’ll blow over.”

Not true, and there’s precedent to prove it. On June 17^th, 1930, President Herbert Hoover signed the Smoot-Hawley Tariff Act of 1930 into law, raising tariffs on 20,000 imported items, and triggering a massive trade war that caused global trade to drop by two-thirds in a period of four years. Yet, Hoover had been warned by over 1,000 of America’s most eminent economists. He had been intensively lobbied by Henry Ford, who called the bill “economic stupidity.” The CEO of banking giant J.P. Morgan begged Hoover not to sign the bill – but he did, for political reasons.

Make no mistake, this is a very, very dangerous situation – a big, honkin’ Black Swan if there ever was one – that is comparable to the massive error of passing Smoot-Hawley. So don’t count on the government coming to its senses. History argues that governments sometimes do stupid things for ideological and political reasons.

“You’re exaggerating. The effects of a temporary halt in payments couldn’t possibly be this extreme.”

Who knows? This has never happened before. Once the U.S. government has failed to live up to its responsibilities for any reason, and for any period of time no matter how short, it will be impossible to regain the “full faith and credit” of a borrower that is beyond suspicion. Indeed, the rating agencies have a policy of automatically downgrading the ratings of a borrower that fails to live up to all of its obligations, if any investors lose money through delayed or halted payments of interest or principal. At time of writing, for instance, Standard & Poor’s has just warned that if Greece extends the payment schedule on its debts, as is being discussed within the EU as a possible solution to Greece’s debt problems, that would constitute a default and trigger a downgrade. And the rating agencies are still smarting from being accused (correctly) of not being tough enough on issuers in the asset-backed securities markets prior to 2008. They won’t want to be seen to be committing the same mistake again so soon, regardless of the consequences.

Perhaps I’m wrong, but as a former credit analyst, and one who used to assess sovereign credits for a living, I don’t believe I am. Moreover, those who pooh-pooh the consequences have no basis or evidence for their assertions. It is wishful thinking, pure and simple.

“This is nonsense. It can’t happen. They won’t let it. This just isn’t possible.”

Who’s “they”? This is just more wishful thinking, and is comparable to pulling the covers over your head to ward off danger while the house is on fire.

“You’re being irresponsible by talking about this. You’re going to create a panic by doing so.”

No, the irresponsible, brain-dead idiots at the extremes of the Republican party are running that risk. I’m just talking about the potential consequences of their actions. Besides, I’m not the first, nor am I the most important person to discuss it. The rating agencies have issued very forceful (for them) statements on this. The Chairman of the U.S. Federal Reserve, Ben Bernanke, has said this is dangerous folly (although not in those words). The International Monetary Fund has warned that this is an irresponsible and exceedingly dangerous path that could cause a “severe shock” to the American and global economies. The current Secretary of the Treasury, Tim Geithner, has said that it would be “catastrophic”, and even one of George W. Bush’s economic advisors, Keith Hennessey, has publicly said that he’s “terrified” at the prospect. I doubt if my comments will make much difference – except to my readers. For them, I hope it helps them prepare contingency plans in case the unthinkable happens.

“A default would actually be helpful, as it would force America’s government to face the reality of its financial position.”

Nope. As I’ve already said, it would trigger an absolute panic and bankrupt the government, which would then be forced to make long-term policy on the basis of emergency conditions. It would have to make bad choices, possibly even very bad choices, because better choices would no longer be available. Tackling the deficit is going to be tough. Trying to do it while simultaneously trying to keep the global financial markets and global economy from complete collapse would be impossible. This is just a bad idea.

“This is Obama’s fault. He’s the one that’s being unreasonable. We have to bring down the deficit, and this is the only way to force liberals to cut spending.”

Presidents and Congresses have disagreed about critical issues before, but no one has ever used the debt ceiling as a threat, and it is the Republican extremists that are doing so. This is on all fours with strapping a bomb to your chest, and threatening to blow everyone up if you don’t get exactly what you want. It’s no less threatening, and no less extreme than that, and it is Republican extremists that are doing it, which brings me to the political dimension of things.

I grew up in the Republican party. My father was a die-hard Republican, and I was raised that way. I voted that way when I first started voting. Since then, I’ve voted more discerningly and hopefully more thoughtfully for candidates that I thought were the best (or least-worst) choices, both Republican and Democrat. But this is not my father’s (or my) Republican party. The current Republican party seems to have been captured by fanatics who believe that ideological purity is more important than reality. They are spoiled children, throwing a tantrum to get what they want, and endangering us all in the process.

And those who have regularly read my blog know that I believe the U.S. budget deficit must be tackled, hard choices must be made, and sooner rather than later. But what the Republican extremists are demanding is that a process that should be thoughtfully devised, then carefully negotiated, and implemented over a period of years in order to minimize the necessary harm inflicted must, instead, be accomplished overnight, and that all the costs must be borne by someone else’s constituents, not theirs. Some of these extremists have even demanded tax cuts be part of the deal, even though such cuts would increase the deficit, not decrease it. They are clinging to an ideology as defunct as Soviet Communism, and pointing to the Reagan tax cuts as being self-financing, even though Reagan’s own budget director, David Stockman, has said that tax cuts in today’s environment would be a bad mistake. Indeed, in talking about extending the Bush tax cuts during the 2010 debate, Mr. Stockman said that the Republican position was “Utterly disingenuous. I find it unconscionable that the Republican leadership faced with a 1.5 trillion deficit could possibly believe that good public policy is to maintain tax cuts for the top 2 percent of the population”.

But extremists don’t want to hear that, and so they don’t listen. They have substituted ideology for thought or reason. They are ideologues as blind as any group of religious fanatics, except they could cause much greater harm to a much larger group of people, both at home and abroad.

“Forcing the government into default is the best way to make sure we’ll beat Obama in 2012.”

I haven’t actually read any reports where someone has said this, but some Republicans seem to be thinking it awfully loudly. If I’m right in thinking this, then it is a morally bankrupt attitude, verging on treason. It amounts to saying that you are willing to crash the American economy, trigger a collapse of the world banking system, and bankrupt many American citizens for selfish political gain. It would be like deliberately losing a war in order to win the presidency.

“So, what should we do about it? If the situation is as bad as you say, what’s the answer?”

Now we come to the reason for this blog: to offer some thoughts about what individuals should do to prepare for this possible black swan event.

The first thing to do is to hope that the participants are more intelligent than I give them credit for, and resolve this issue quickly, before they spook the markets or the rating agencies. If they wait too long, it may be too late, so August 2^nd (or sometime that week) may be the outside deadline; the markets might panic before than. And writing to your Congresscritter wouldn’t hurt. Tell them that Congress & the president need to come up with a credible plan for reducing the deficit through painful spending cuts, tax increases, and especially through reductions to Social Security & Medicare entitlements, but that not raising the debt ceiling is not a legitimate negotiating tactic.

Next, watch the news for developments. Assuming that we can’t influence the participants (and they seem impervious to argument no matter who offers it), then you need to prepare yourself for the worst. You needn’t do it all at once, but make sure you stay ahead of the market’s perception of a crisis. And this is where systematic risk management comes into play.

In this situation, we are running two opposing kinds of risk: the risk that there will be a panic, market collapse, and massive recession or depression; and the risk that the U.S. won’t default, that a crisis will be avoided, and the markets will continue to advance. Let me deal with the second risk first.

If a crisis is averted, and the world carries on with business as usual (which is what I devoutly hope will happen), then the market will carry on as if nothing important happened. As the stock market has been rising of late, it’s possible that if you sold holdings in advance of a possible crisis, you could forego potential capital gains by liquidating your holdings. This is a potential opportunity cost, but not a large risk. Suppose the S&P 500 were to regain its previous 2008 high before you could manage to buy back into the market. This means it would have to run up by about 16% in a very short period of time. So, on the extreme high end of things, the second risk is that you might forego about a 16% gain from where we are today – and that’s assuming that the market keeps going up, and actually goes up much faster than it has of late. I think this is highly unlikely, but let’s leave it at that: the risk of missing an upside move by the markets is foregoing a 16% increase in your portfolio.

The Default Risk

Now let’s consider the first risk: that, intentionally or not, by August 2^nd or somewhat before or after, the U.S. government defaults on its obligations, and that triggers a panic. What would be the financial risk if you don’t prepare for that possibility?

Well, first, how far might the market fall? In the market panic of 2008, the S&P 500 fell more about 54% from its October 4^th high. The stock market crash of 1929 was slightly worse, with the Dow Jones Industrial Index (“DJII”) falling on the order of 58%.

But the initial market crash of 1929 is not the biggest risk; the potential for a prolonged severe recession or depression is. Indeed, the stock market decline from 1930 to 1932 was actually worse than the crash of 1929, with the DJII falling 79% from the market low of 1929 to the market bottom in 1932. All told, from the 1929 high to the 1932 low, the DJII lost an incredible 89% in value. And that is, in my opinion, the comparable risk investors run from a potential default, aside from any economic damage they might incur, such as losing their income or their home.

So, now we come to the issue of risk assessment: Which is the greater risk? Missing out on a potential 16% investment gain from here, or losing 89% of the value of your current portfolio from here, plus experiencing significant economic suffering? Remember that the markets are largely ignoring the closed-door discussions on raising the debt ceiling, so that if a deal is announced, it is unlikely that the stock market will blast off to that 16% gain in a short period of time, whereas if a default occurs, everyone will thunder for the exits at the same time. In my mind, there is no comparison: it is far riskier to ignore the potential for a default than it is to forego the potential for gain.

So What Actions Should You Take to Prepare?

If you concur with my assessment, what do you sell, what do you buy, and how do you prepare? I’d start by selling investments that have done well for you, but may have limited upside from here. You can always reinvest later if the crisis passes. If the days tick by, and there is still no word of settlement, I’d start selling more earnestly, including things that perhaps you don’t feel have done as well as they should. Remember that the rating agencies have warned that they are expecting to see a settlement by the middle of July. If no such signals emerge, they may start being more vocal, and the markets may become more unsettled.

If, by the third week of July, there is no sign of a settlement, and the two sides continue to say they are deadlocked, it’s time to take serious defensive action. Sell any investment that is not a disaster scenario holding. Perhaps even sell money market funds to hold cash. And check the terms and conditions on your financial accounts. Following the banking crisis of the Great Depression, financial institutions added clauses that give them the option to require 3-5 day’s notice of a withdrawal. Just because they have waived that requirement for almost 80 years doesn’t mean that it’s not there, so check with your banker or broker.

In the extreme, if it seems likely that a disaster is going to happen, think about what you think will hold its value. This starts with gold & precious metals, but also think about how you want to hold it. If you have investments in a mutual fund that invests in precious metals, and the company that runs that fund goes bankrupt, what will the value of your holding be? Cash is likely to be worth having, or being able to get hold of quickly – but who’s cash? Do you want US dollars? And always keep in mind safety. Do you really want to have bunches of cash under your mattress? What about the risk of fire or theft? How do you want to deal with that? These are issues that deserve some serious consideration.

And if a deal is struck “at the last minute” (whenever that might be), and there is no default, and no run on the markets, then what? Then you take a long look at the risks as they are at that time, and, if you’re convinced that the risks are now on the upside (i.e., that you might lose more by missing a major market advance than remaining on defense), then unwind your defensive positions, and go back to your investments.

If I’m overreacting to the potential risks, and life goes on as usual instead, it will have cost you some money in transaction costs, and you might possibly forego some upside on your investments. If I’m correct in my assessment of the risks, then taking a defensive position may make the difference between financial survival or not.

And, for the record, I sincerely hope a deal is struck. I may wind up looking foolish, rather like Chicken Little screaming that the sky is falling, but I would prefer that result to the horrors of being proven right. If it’s a choice between pride and survival, I’ll pick survival. But I’d be prepared for either one.

© Copyright, IF Research, July 5th, 2011.

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There’s an unusual amount of dissension among economists and other commentators about whether we’re heading towards higher inflation or devastating deflation, and whether the economy will continue to grow, or slip into a double-dip recession. This is happening because we are in uncharted waters, with few, if any, precedents to guide us.

My own view is that the American economy will continue its anemic growth in a mostly jobless recovery; that the prices of necessities, particularly food and energy, will continue to tick upwards, gnawing away at workers’ real take-home pay; and that the economy’s precarious growth could be tipped over into a renewed recession by one of several different crises. I believe, in short, that all of the scenarios described above are possible. So, how do you plan for the future, whether it’s your investment portfolio or your company’s marketing plans?

Let’s start by looking at the various different forces at work on the economy today.

Inflation

Those concerned about inflation are connecting dots and concluding that inflation or even hyperinflation are ahead of us. They see the U.S. Federal Reserve Bank (the “Fed”) pour newly-printed money into the economy via so-called quantitative easing, and they watch oil and food prices rise, and decide that one is causing the other. And since monetary inflation, caused by printing too much money, affects all prices, oil and food prices are merely harbingers of a much broader, more rampant inflation. This is not the case because these two dots aren’t, in fact, connected.

The Fed is, indeed, printing money, but it’s a kind of money with a relatively low inflation potential. Normally, the Fed, or any central bank, creates money by encouraging the banking system to create it. They do this by lowering reserve requirements, or by lower interest rates. Reserve requirements are the amount of cash that banks must hold for every dollar of money they loan out. Since this requirement is a small fraction of the loans on their books, every dollar in increased cash reserves creates many dollars loaned out and placed into the economy. Likewise, lowering interest rates makes it more attractive for corporations and individuals to borrow money, increasing the loans outstanding, which again multiplies the amount of money in the economy. This is high-impact money.

What the Fed is doing is almost literally printing money, then using it to pay the government’s bills. (There’s a bookkeeping entry where the U.S. Treasury issues bonds, then the Fed buys the bonds for cash, which the Treasury then uses to pay bills. Hence, the U.S. government borrows from itself, and prints money as a result.) But while this money winds up in the economy, the effect is only of the amount of money printed, not some multiple of that amount. This is a technical issue, but the effect is that while, yes, there is some inflationary effect from the Fed’s quantitative easing, it is nowhere near as important as the inflation hawks fear, especially in an economy where demand is weak, and there is virtually no leverage for workers to increase their wage demands.

Meanwhile, the prices of food and oil are going up because of the supply and demand for food and oil, without reference to the amount of money being created in the United States. Hence, the prices of food and oil are going up even in Japan, which is experiencing persistent deflation, not inflation. Both are global commodities, and the demand for both is being driven by the rapid expansion of the Rapidly Developing Countries (“RDCs”), like China, India, Brazil, and Indonesia. Hence, in an example I’ve used before (because it’s so compelling), China’s middle class expanded dramatically during the 40 years from 1960 to 2000, with the result that China’s food consumption tripled in forty years. As the developed world economies emerged from recession (albeit slowly), and added their demand to that of the RDCs, the demand for both rose faster than the supply, pushing prices up.

Unless the developed world slips back into recession, or the growth of the RDCs slow significantly, the prices of both food and oil will continue to move up.

Deflation

Deflation is a widespread, persistent decline in prices, and is actually more dangerous than inflation (although neither are desirable). To see this, consider what happens if you’re considering buying a new car, but believe that the price will go down if you wait a month. Chances are you and others like you will postpone your purchase. A month later, if you are proven correct, but believe that the price of the car  you want will fall further in the next month, you’re likely, again, to wait to buy the car. Hence, deflation creates a vicious, downward spiral: people postpone purchases, which lowers demand, which causes prices to fall, which cause people to postpone purchases. When entrenched, deflation can wreak havoc on an economy – as has happened with Japan. Japan has experienced almost 20 years of recession-like non-growth in part because of deflation. (The Japanese government has also made persistent policy mistakes that have prevented the economy from breaking out of this cycle.)

So, are we likely to experience the same kind of persistent, widespread declines in prices? Based on what I’ve said above, not in oil and food, but what about beyond that?  In many ways that depends on what happens to the economy. If the U.S. economy continues to grow, even weakly, then the prospect of serious deflation is remote. I could see the possibility of weakness in discretionary consumer purchases, such as TVs and consumer electronics, if employment growth remains weak. When people are hurtin’ financially, they’re less likely to splurge on a large luxury item. So let’s turn to the prospects of a renewed recession, which is the scenario where I can see widespread deflation.

Recession

There are several reasons why this recovery is weak. First, it was provoked by a severe financial debacle, and such recessions typically take longer to recover from as people feel poorer. It will take time – years – for people to rebuild their balance sheets, and meanwhile, demand will remain weak.

Next, there is no group within the economy to really stimulate demand. Most recoveries are lead by the consumer, but as I’ve just said, that’s not happening this time. Governments, notably the U.S. federal government, have largely shot their bolts, and are now more worried about repairing their balance sheets. And businesses, which are actually in pretty good financial shape as a group, see no reason to overextend themselves. In particular, businesses are not eager to take on more staff. Instead, they are either asking their current employees to work longer hours or take on additional shifts as demand slowly rises, or they are investing in increasingly sophisticated automation. The knock-on effect of this is that employment is likely to stay weak. In total, then, this is a recovery without leadership.

A longer-term problem is that all countries are going to experience a squeeze in employment growth, but it will be particularly noticeable in the developed countries. First, a global economy implies a global labor force, which means that workers in Canada or America, for instance, are competing with workers everywhere. It used to be most noticeable in low-skilled industries, but as RDCs increase the number of highly educated people they have, and as they build up more sophisticated commercial bases, they are competing in broader swaths of the global workplace, including very highly skilled areas that used to be the exclusive preserve of rich countries. Meanwhile, in an attempt to minimize the differential in labor costs, companies in developed countries are automating as quickly as they can. This is helping in that companies that might otherwise go out of business are surviving, but even when they do, it means that they do so with fewer employees. Hence the economy will grow faster than the number of jobs.

Automation is also affecting RDC economies and workers as well, but their faster rate of GDP growth is masking the effects. Still, the Chinese government worries about not creating enough jobs to maintain social stability.

But beyond economic growth and employment growth, there’s another factor that’s in play: the fragility of governments, notably because of their heavy debt loads, means that the recovery is not as robust. It also means that the recovery would be easier to derail, much as an overloaded boat is easier to sink.

This brings me to my major point: we are vulnerable to nasty surprises or shocks. If, for example, Greece defaults on it’s debts (or perhaps I should say “when” as it seems pretty inevitable to me), this could trigger a re-evaluation of all sovereign and sub-sovereign (i.e., state and local) debts. This might throw a jurisdiction like California or Illinois into the spotlight, or trigger a run on Portuguese bonds. It could, in short, trigger a panic that could produce another financial catastrophe. Only this time, governments have fewer bullets available to stop a financial stampede, and we could well see the financial collapse that we so very, very narrowly avoided in 2009.

Is this likely? Probably not, but the odds of it happening are higher than I would like. And if a scenario like that does happen, then deflation is a real threat, and you can forget about inflation because even the RDC economies will slow or go into reverse.

So what do we do now?

The highest probability is still for continued economic growth in the developed world, albeit slower than we would like, and that’s how I’m placing my bets right now. I believe that the cost of necessities will continue to rise, but that it won’t degenerate into high, widespread inflation. This is consistent with a slow growth scenario coupled with rising demand from RDCs.

But I’m also watching developments very carefully, and have an exit strategy in mind in case I don’t like the way things develop in Europe, with the foolish, almost-suicidal discussions over the U.S. federal debt ceiling, and with credit watches on shaky governments (both national and American states). I’ve been saying this for some time, and it may be that readers are getting bored with the message, but this is a time to plan for the worst, and hope for the best. I’m not sure, in the current situation, what else you can do.

© Copyright, IF Research, June 2011.