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.

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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Like all years, there will be good news and bad in 2011. Because of the bad planning, bad judgment, and bad behavior of previous years and decades, some of the potential bad news is very scary indeed, as I’ll get to in a moment. The odds are that 2011 will be a not bad year, but the risks are higher than normal for economies emerging from a recession. I’m going to deal with the scarier parts first, and then move on to happier things, so bear with me.

GEOPOLITICS

North Korea has worn out everyone’s patience, including China’s, but nobody knows what to do about it. As well Kim Jong Il and his anointed successor have grown up being told that they are always right, and everything they want to do is perfect, which makes them unlikely to listen to even allies (or ally) like China when they don’t like what China has to say. As a result, while the odds are against it, and some kind of negotiated stand-down is still the most likely outcome, North Korea’s narcissist leader could go too far and finally provoke a disaster, up to and including a shooting war. This is specially true now that South Koreans have turned hostile to North Korea because of it’s recent killing of South Koreans.

Iran will continue to work towards nuclear weapons, plus the missiles to deliver them, no matter what anyone says to them. Nobody in the Middle East or the West wants that. The critical question is: do China and Russia put their narrow self-interests before peace, or do they work to stop what could lead to a potential (nuclear) war in the region?

What seems like a revolution in a country that rarely makes news in the West, Tunisia, could become a massive problem for America, and complicate the entire geopolitical equation. What started as food riots in Tunisia rapidly became political protests, and led to the ouster of the former president, Zine El Abidine Ben Ali. As this gained attention elsewhere, the long-suppressed opposition to Hosni Mubarack’s American-backed dictatorship in Egypt flared up. America is now in a position of supporting a despot against what could become a popular uprising. This not only makes it look hypocritical for cheering on democratic uprisings in places like the Ukraine and Iran, but is a big risk for them going forward. If Mubarack falls, he’s likely to be replaced by a government far less amenable to Washington, and much more hostile to Israel. This could seriously complicate the Middle Eastern political situation, especially in the wake of the PLO’s embarrassment by Israel, as revealed by leaks about concessions that PLO leaders were prepared to make to get a Palestinian state. Moreover, there are now protests in the streets of Yemen. This could be the beginning of the end for the satrapies of the Middle East, redrawing the map of one of the key flashpoints of global geopolitics. And if Saudi Arabia’s monarch were to go, you could add real uncertainty to the price of oil, and the strength of the global recovery.

ECONOMY & FINANCE

Canada spent 2010 crowing about what a great country it is, how well it fared in the Great Recession, and how sound it’s public finances and banks are. We may well eat those words in 2011 as our economy slows down, the price of oil goes up, increasing tension between oil-producing and manufacturing provinces, and consumers find that they are struggling with too much debt. If we’re truly unlucky, we could have the crash that everyone else had in 2008.

As well, the unfunded liabilities of retirement benefits promised to civil servants are starting to come home to roost. Already in developed countries around the world, stories are starting to appear about the unpopularity of high salaries and retirement benefits accruing to civil servants. This will continue to grow as a story – and as a fiscal reality at federal, state/provincial, and municipal levels of government. Ultimately, these stresses will lead to pitched political battles, with civil servants rightly pointing to the fact that they have firm contracts for these benefits which can’t be rolled back after-the-fact, and critics rightly pointing out that governments can’t afford to fulfill the promises they’ve made. As this problem continues to gain prominence, as it has in the financial crises in Europe, it will raise the noise level of the debate everywhere else. We’ve already seen the final resolution in a parallel case: the unions of the American car companies gave back the store when the alternative was to bankrupt those paying for pensions and benefits. But it’s going to be a long, painful, noisy road before we get there.

America’s financial position could get even worse than it was in 2008, only this time it will be the state governments in trouble rather than banks and car companies. The list is led by Illinois, California, and New York, but more than half of all state governments are in some financial difficulty, and not all of this is related to the anemic recovery. The over-promises made by governments to their civil services, as just noted, is now threatening to overwhelm state finances. There’s a very real chance of multiple state insolvencies in 2011, leading to a run on state and municipal credits, and potentially triggering a run on the dollar and US Treasuries. What happens after that is anyone’s guess.

Meanwhile, the situation of the PIIGS of Europe isn’t getting any better. Bond investors aren’t buying the Euro bail-outs of Ireland and Greece, and it becomes a question of whether the skepticism stops there, or whether it spreads to Italy, Portugal (already under scrutiny), and, most importantly, Spain, the fourth largest economy in the Euro-zone. The real risk is that someone that the market isn’t already worried about, like Belgium, goes belly-up. If that happened, it would throw everyone’s credit into question, and could trigger a run on almost all Euro-credits (possibly exception Germany). And if there’s a run on Euro-credits, it could trigger a run on the Euro – but if that happens at the same time as a run on the dollar, where do currency traders flee? There are no other currencies capable of taking the gaffe. Gold, of course, would skyrocket, but there just isn’t enough gold to absorb the demand – but that would leave an awful lot of unhappy investors looking for alternatives, and crowding into niche currencies like Swiss francs and Canadian dollars, spreading the pain by forcing their currencies to shoot up.

If none of these disasters occur – and it’s hard to see how we can dodge all of these bullets – then the global economy will continue to improve. (Admittedly, this is a little like saying “If we don’t die, we’ll be fine.”) America’s economy will grow, but not terribly quickly. Projections range from 1.5% to 3.5%, which really indicates how uncertain the outlook is. I would estimate that, absent major shocks from the issues above, the U.S. economy will grow closer to the high end at something close to 3-3 ½ %. This will lower unemployment, but very slowly, leaving a lot of dissatisfied Americans, and threatening Obama’s re-election in 2012.

And the U.S. Congress is likely to be more than slightly fractious, with the Tea Party ideologues trying to run Congress on right-wing ideals and running smack into the real world of congressional politics. This is going to lead to widespread frustration on many fronts, and from all parties involved. It’s going to be particularly interesting to watch the Republican party try to digest the Tea Party-ites, while the Tea Party tries to take over the GOP. I suspect the GOP will win through sheer size and inertia, but will use the Tea Partiers as shock troops in the war against evil (the Democrats) and the devil (Obama).

A related question will be: Can anyone in the Republican party stop Sarah Palin? They’re scared to death she’ll win the nomination – and blow the election. What Americans should be more afraid of is if she wins the nomination, and then wins the election. Everyone I talk to about this says that it’s not possible (except for die-hard right wing-nuts who say “Please God!”), but stranger things have happened in electoral politics.

TRADE & EMPLOYMENT

Tensions between trading partners over competitive devaluations, notably between China, America, and the Euro block, will rise. If cool heads do not prevail, we could see a full-out currency war, and, if protectionists, who are in the ascendant everywhere (“American jobs for Americans!”), get their way, it could degenerate into a 1930s-style trade war with disastrous results.

There’s another aspect of the employment picture that is also worrying. What we are seeing is a massive change in the world of work. As the Rapidly Developing Countries (“RDCs”) like China, India, Brazil, Mexico, and so on, expand their economies, and take on increasingly sophisticated jobs at wage rates that are significantly below those of the developed countries, jobs have migrated, and will continue to migrate, from developed countries to RDCs. In effect, a global economy implies a global labor force. What we are now witnessing is wages in the RDCs rising, and wages in the developed world falling – an equalization of the disparities in wage rates. Since workers in developed countries won’t like this, it is going to further exacerbate the acrimony between trading partners.

TECHNOLOGY

There are a number of technological developments that will start to emerge in 2011, and continue through the decade. The first is that television broadcasters and their delivery people – being satellite and cable providers – are fighting a running (and ultimately losing) battle against online video. Smartphones already offer TV without a television, and in the home users are increasingly going to turn to devices like Apple TV and Google TV, combined with services like iTunes, YouTube, and Netflix, for their video entertainment. Given that this also opens up their living rooms to Internet shopping, it’s going to be difficult time for traditional TV suppliers. It’s also going to be an even greater reason why video production companies are going to gradually move away from TV distributors: they can start having relationships with individual video consumers instead of broadcasting through middlemen.

Another extension of something we’ve already seen is augmented reality, which is adding information to the real world. Hence you might look at a picture of an intersection on your smartphone while you’re getting driving directions, and have arrows and labels appear on the photo (or live) image of your location, identifying the stores (or addresses), and possibly listing items that are on sale you might be interested in. Location advertising is catching on, and will become bigger over time, in part because merchants (and cellphone suppliers) want it. How eager consumers are for this is going to be the real determining factor.

The real advance in augmented reality, though, as well as many other potential applications, will come if consumers adopt near-eye video monitors. Near-eye video means putting an eye-sized video screen right up in front of your eye, which means that a small image can look very big. If such monitors are clear except when there are images for display, they could look like a pair of ordinary glasses, but act as computer (or video) monitors. If that were to happen, augmented reality could become an everyday tool. The real key is whether consumers want near-eye video; the technology has been kicking around for years as the lineal descendent of jet fighter pilots’ heads-up displays. So far, though, consumers have shown little interest. On the other hand, 3D images have been around since the 1800s, but only recently have consumers found a form they were willing to accept. The same is true of ebooks (about which more in a moment), which have been kicking around for well over a decade, but didn’t make the grade until Amazon and Apple made them desirable. What technology will be capable of in the future is relatively simple to foresee. What consumers will want, especially with technologies they’ve never experienced, is much harder to project.

Perhaps the biggest technological change coming in this decade is going to be the arrival of everyday robots and computer intelligences. This marks the full emergence of the Third Industrial revolution. The first, which blossomed in the 19th century, was when humans used machines to augment their muscles. The second emerged in the 1960s when machines (computers) helped humans manipulate information and make decisions. The third will happen when seemingly intelligent computers make the decisions and act on them autonomously, while humans set objectives, but leave implementation to the computer. Functioning robots, as opposed to prototypes and toys, already exist, but they are expensive, and used only in specialized situations. As computing power continues its faster-than-exponential increase, and decision-making and self-learning software becomes more sophisticated, robots, computer intelligences, and automation will begin to appear in industrial, commercial, and health care facilities. This will lead to two major effects: First, it will lead to a significant increase in the standard of living by increasing worker productivity. And second, it will throw more and more people out of work as automation becomes financially preferable to human workers, and in a steadily widening range of jobs. This is going to cause the divide between those who are gainfully employed (the well-off, and the so-called “gold collar” workers) and everyone else to expand dramatically. This is a recipe for political and social instability.

Meanwhile, social media will continue to expand, and their influence will become more pervasive. The pressure for another means of communicating beyond keyboarding, text, and screens is building, but so far, no one has come up with a better interface between users and computers. Near-eye monitors, verbal commands, virtual keyboards, and gesture commands have been tried, but have not gained much traction. It may be that Microsoft’s Kinect™ may be the beginning of something big, if it can translate into an interface that is used in serious computing as well as gaming. Perhaps Apple will, once again, revolutionize computing with a new interface. If someone does come up with a more intuitive computer interface that is faster, slicker, and more natural than typing, then social media will explode like a gasoline fire on a hot, windy night.

And ebooks have finally arrived, after many years of false promise and false starts. As happened in music, Apple didn’t invent the ebook, and wasn’t the first mover, but has produced the most popular device for it in the iPad that will only get better in successive versions. What hasn’t happened quite yet is for ebooks to become something more than text on a screen and printed words on a page. There is a hybrid out there, waiting to be invented, that is significantly more powerful than either medium alone. We may see it emerge in 2011.

The revolution in health care is only getting started. Computer intelligences are going to start being used to identify new epidemics as they emerging, and to analyze the microbes involved to find cures in record time. A new technology, called Genetic Programming (“GP”) is about to emerge on the health care scene, and will first produce diagnostics and prognostics in the treatment of cancer, and eventually revolutionize cancer treatments and drugs themselves before moving on to other areas, such as diabetes and other diseases.

Meanwhile, the continuing struggle to find enough money to finance all the health care that consumers (and voters) want in the aging developed economies is going to heat up. Ironically, there are lots of ways of improving both the effectiveness and the efficiency in health care, but our social structures have become so calcified, and health care has become so politicized, that it’s impeding real improvements. It’s ironic that this is happening simultaneously with a technological revolution in health care that promises so much.

© Copyright, IF Research, January 2011

The polarization of American politics is evident from the way that Republicans and Democrats seem to loathe each other. They scream at their counterparts; they rant for the cameras; their surrogates in the press besmirch each other as worse than foreign enemies. Indeed, the fact that John McCain, the unsuccessful Republican nominee for president, in his concession speech urged his followers to support Barrack Obama as president, was seen as a betrayal by Republicans. And the fact that President Obama has tried to reach out to moderate Republicans at times is seen as a betrayal by the Left, and an attempt to colonize and domesticate the center of American politics by the Right. (Let’s ignore, for the moment, that broadening your base is smart politics, and frankly what any smart president or national leader should do. The fact that George W. Bush made no attempt to reach out beyond his narrow, partisan base, save in the dying days of his administration, is merely one of many pieces of evidence that confirms my belief that he wasn’t a smart president. It has also left his party in dire straits.)

Now, American politics has always been a blood sport, right back to the conflicts between Jefferson and Adams, Hamilton and Aaron Burr, or Lincoln and Stephen Douglas. I can remember the first presidential election I was old enough to be aware of, Eisenhower versus Stevenson in 1956, where the popular jingle that made the rounds was crudely partisan: “Whistle while you work; Stevenson’s a jerk; Eisenhower’s got my power, so whistle while you work.” (My folks were Republicans.) But what’s happening today is much worse, dangerous to Americans and the rest of the world as well, and it all comes back to something we learned about in high-school social studies: gerrymandering.

The art of gerrymandering

Gerrymandering is the art of re-drawing electoral districts for the express purpose of benefiting a specific group, whether political, racial, economic, or otherwise, and it’s not a pretty concept. It basically seeks to screw those that do not fit into the group being favored by isolating them in a district whose boundaries make it difficult or impossible to defeat the representative of the favored group. Hence, a district that elects a member of the U.S. House of Representatives which has boundaries that effectively make it a safe seat for the Democratic Party disenfranchises all Republicans (and others) in that district, because only Democrats will be elected. And gerrymandering is being actively practiced in drawing the boundaries of members of the House of Representatives, with the connivance of both Republicans and Democrats, and with the limited approval of the U.S. Supreme Court. The Court ruled in 2006, hypocritically in my opinion, that it is OK to bias elections in the favor of Democrats or Republicans, but you cannot bias them on the basis of race. I’m sure this makes sense to someone (like the Supremes), but it makes no sense to me. However, my opinion counts for nothing, so gerrymandering is the law of the land in American national politics (and many states as well). What’s more, computer analysis and detailed demographic data has allowed the political parties to draw exquisitely precise district boundaries to create as many safe seats as possible (and to look as grotesque as you can imagine). Hence, in the 2006 mid-term Congressional elections, something like 96% of all incumbents who chose to run were re-elected – a record that The Economist newsmagazine said would have done credit to North Korea.

So what?

Now let’s look at the implications of this. First, it artificially polarizes American politics, and disenfranchises those Americans who are moderate – which, depending on how you look at it, is close to a majority. In a Republican safe district, the Republican incumbent cannot be defeated by a Democrat; he (or she) can only be defeated by another Republican in the primaries. This means that the entire political spectrum for anyone wishing to be the Republican nominee is from the center to the extreme right-wing. Likewise, in a Democratic safe district, the Democratic incumbent can’t be defeated by a Republican, only by another Democrat, which means that their political spectrum is from the center to the extreme left-wing. As a result, Republicans naturally move away from the center to the right, and Democrats naturally move from the center to the left, leaving those in the moderate middle of both parites unrepresented, and polarizing the House of Representatives.

As an aside, the Senate is not directly polarized in the same way because there are two senators for each state, and since state boundaries were fixed long ago, no gerrymandering is possible. However, state party machines are polarized, which tends, indirectly, to move senators away from the center.

This polarization leads to confrontational, “gotcha” politics, more intent on scoring points against the other party than formulating intelligent policy, or serving America’s broader interests. If you can make the other guys look bad, even if it harms America, you’ll probably do so because you need to be elected, and that’s the name of that game. And that means that the American Congress often creates dangerous, harmful policies, even when American legislators, as a whole, know it’s the wrong thing to do. That makes it dangerous for the rest of the world, because economically as well as militarily, America is still the only superpower, and what it does affects everyone.

A more dangerous side effect

But there’s another, subtler and potentially even more dangerous side effect. While most of the districts from which the members of the House of Representatives are elected are gerrymandered to be safe, there are some that are not or cannot be. This often gives the representatives in those “unsafe” seats the deciding votes in a close issue where votes matter. By the nature of House politics (whose members are up for election every two years, and hence are effectively always running for re-election), this means that they can ask for almost anything, and get it. Hence, if one such district has a lot of, say, widget manufacturers who are being hurt by cheap widgets from China, or religious fundamentalists who despise the distribution of condoms to teenagers, the representative from that district can make a trade: she gives her vote on, say, a budget appropriate bill in exchange for protectionist legislation against Chinese widget manufacturers, or a prohibition against funding contraception counseling in Third World countries. Meanwhile, this may well provoke retaliation, or poison a sensitive foreign-policy relationship. As a result, American policy on a broad range of issues is, at times, being made by widget manufacturers, or fundamentalists, or some other group that is only interested in its own narrow, parochial interests, and couldn’t give a damn about broader issues, or America’s broader interests.

So, what can be done about this? Well, some states establish independent tribunals to set Congressional district boundaries, and there is some faint hope that this idea will spread, and return (some) sanity to American politics. But truthfully, the backroom pols of both parties much prefer the present system, especially because it’s so difficult to explain, and doesn’t fit a 30-second sound bite. They like exercising power behind the scenes, and will fight – dirty, if possible – to make sure that no one takes it away from them by making it understandable. Therefore, an enlightened and active electorate is the only solution.

Please feel free to forward this to anyone you think might find it of interest.

© Copyright, IF Research, August 2009.

A wild card is a low probability event, which, if it occurs, has dramatic consequences. I believe we now face such a wild card. The idea occurred to me just last week, as I was riding a plane from A to B. Sometimes ideas coalesce for no apparent reason, and as I was reading about the pretty useless cap-and-trade emission system that the U.S. government seems about to pass, a number of different pieces came together to create a sudden insight: that the U.S. government is going to fail, possibly even go bankrupt. This is heresy for someone who studied the financial markets all his adult life: U.S. T-bills have been the world’s primary “risk-free investment.” For this not to be the case implies a financial earthquake of massive proportions.

This is a wild card, instead of a dead certainty, for the same reason that a flu pandemic is a wild card: that there will be a pandemic is an absolute certainty, but nobody knows whether it will start this afternoon, three years from now, or three decades from now. Likewise, the U.S. federal government, unless it makes a Herculean effort to change direction, will fail. What isn’t known is whether it will be this month, or five years hence. It cannot be a long way off, but the precise timing of this biggest-of-all-bankruptcies will come to pass if present trends are unchanged. I really don’t want this to happen, but am very much afraid it will, which is the reason for this warning.

During the financial crisis of 2008, the U.S. government deemed that some banks were “too big to fail,” meaning that if they went bankrupt, they would bring the entire financial system down with them. Therefore, the government concluded, there was no alternative but to pour hundreds of billions of taxpayers’ dollars to rescuing these banks and their incredibly selfish executives, no matter how ideologically or ethically repugnant it might be to do so. And, in my opinion, they were correct, both in their presumption that some banks are too big to fail, and that they had no alternative but to rescue them.

Now, eight months later, we must ask an even tougher question: Is America too big to fail? And who is capable of saving it if necessary?

First, let me explain the reasons why it might fail. Because of the brain-dead management of the U.S. federal government under George W. Bush, the American government went from the biggest surplus in history to the biggest deficit in history, and at precisely the worst time. (Frankly, how Bush could ever consider himself a conservative is beyond me, but that’s another discussion.) The reasons why it was the absolute worst time fall into two categories: those we knew about, and those we didn’t know about ahead of time. Those we knew about were the impending insolvency of Medicare around 2019 – 10 years from now – and the somewhat more distant insolvency of the U.S. Social Security System in 2041. And meanwhile, these two programs cost the federal government more than $1 trillion last year, or about one-third of the entire budget.

America has, for decades, been piling up debts to be paid by later generations, ably aided and egged on by the U.S. Congress, which loved the fact that it could make promises of immediate benefits to voters, especially vote-happy seniors, and leave the tab for someone else to pick up. Moreover, lobbyists and voter interest groups make it very hard for any elected official to resist the temptation to raid our children’s piggy bank, because our children and grandchildren don’t have enough votes to stop us. The result, before last year’s financial crisis, was an unfunded liability that was estimated in a report published by the U.S. Federal Reserve Bank of Kansas City to amount to $65 trillion by 2050. And according to the Government Accounting Office, the non-partisan watchdog of the American government, the only solution would be for the federal government to start getting its financial house in order immediately if not sooner, by making tough choices, cutting spending, trimming benefits, and postponing the age at which voters qualified for benefits.

Clearly, that’s not what Bush did. (Although to his credit, he did try to do something about Social Security. His proposals were wrong-headed, and insufficient, yet the U.S. Congress spiked even that weak-kneed attempt.) Accordingly, even before the crisis, the U.S. government was driving towards a brick wall at 60 miles an hour.

Next was the U.S. trade deficit. America, as a nation, consumes more than it produces, with its trade deficit reaching a record $847 billion a year in 2007. This means that its trading partners, notably but not exclusively China, are selling Americans that much more in goods and services than America is selling to them in return, with foreigners accepting IOUs for the difference. China alone has something approaching $2 trillion in foreign currency, and while there are Euros, Yen, and other currencies in there, most of their reserves are in the form of U.S. treasury bonds and T-bills.

Since Americans consumed more than they produced, this meant, in effect, that they were systematically transferring their past or future wealth to their trading partners in exchange for a more luxurious lifestyle today.

Clearly, neither the build-up of an unsustainable U.S. federal debt because of government deficits, nor the export of America’s wealth to its trading partners can continue forever. Yet, America has the largest economy in history, so it can run up a tab for a long time before this becomes a problem.

Now let’s turn to the issues we didn’t know about before the crisis: the costs of bailing out the banking system from the worst financial crisis since the Great Crash of 1929, and the hopes of forestalling what might become the worst recession/depression since the Great Depression of the 1930s. The Bush government, via the Treasury and the Federal Reserve Bank, decided they had no alternative but to weigh in, throwing money around without regard to long-term consequences. If they hadn’t, they believed the global banking system would likely have come crashing down around all of our ears, and the global economy would have collapsed with a devastating crash that would have thrown tens of millions of people out of work, and done enormous harm to the global economy. And the U.S. government was not alone; virtually all of the world’s major central banks (eventually) went along with the policies for the same reasons, and many of the world’s governments also plunged ahead, trying to spend their way out of recession.

I have real concerns about the apparent ease with which President Obama has taken to spending money. It is true that he inherited this mess, and probably had no choice but to spend, and it’s also true that he’s only been in power for five months, but he seems to be trying to do everything at once, and ignoring the cost. And while I understand the political imperative to make your major moves early in your mandate, the scope and size of his moves are breath-taking. For the current fiscal year, the total of U.S. federal government spending is projected to be $3.6 trillion, so that the government will have to borrow almost $1.8 trillion to finance its deficit, compared to $1.2 trillion in fiscal 2009, and $0.455 trillion in fiscal 2008. In short, the deficit has almost quadrupled in two years.

That’s the situation as it is today. And the net effect of all of this emergency spending is to bring the brick wall America was racing towards much closer, and to push the pedal to the metal, so now America is racing towards it at 180 miles an hour instead of 60 miles an hour. The only question is: How many years will it take before we go splat?

But while these issues would naturally come home to roost in a matter of years or decades, there’s a more immediate problem: the financial markets look towards future events, and use their best efforts to avoid holding securities that they think will depreciate. Now add to this general observation the immediate reality that the U.S. government must sell an unprecedented amount of bonds and T-bills to finance 46% of U.S. federal spending. But who is going to buy them? With the U.S. already the biggest debtor nation in the world, with its biggest creditor, China, already musing publicly about whether the U.S. government is capable of supporting the debt loads projected, and with market players musing about whether the U.S. government will lose its AAA credit rating, who is going to want to step up and buy more U.S. securities than have ever been sold before? Why would any sane investor want to take that kind of risk? I can’t find any good answers to these questions. Even if they make it through the next year, and find buyers for $1.8 trillion in new debt (in addition to rolling over the existing debts), the Obama administration is projecting deficits, and hence borrowing needs, amounting to some $7 trillion over the next five years or so ­– and those projections are thought to be optimistic. The net result is that whether it happens today, or three years from now, sooner or later America won’t be able to borrow as much as it needs.

And that brings us to the crux of the matter: What happens when that time arrives? I hope to hell I’m wrong, but just for the moment let’s suppose my reasoning is correct. If the American government tries to sell all of this new debt, and doesn’t find enough takers, than the U.S. government won’t have enough money to pay the bills it is so freely running up. Its checks (or cheques) will start to bounce; it will be functionally bankrupt.

If that were to happen, the next logical step would be for the U.S. Federal Reserve Bank to step up and buy the bonds and T-bills itself. It, technically, has the ability to do that, but practically it would mean printing money to cover government IOUs, and an absolutely unprecedented amount of money at that.

But the U.S. dollar doesn’t trade in a vacuum. Printing this amount of money would do two things, both of them bad. First, America’s trading partners would sell U.S. dollars in favor of almost any other currency. (This may be one of the factors driving the Canadian dollar up so quickly in the last few weeks, for example.) And secondly, it would trigger domestic inflation, as greenbacks became worth progressively less and less. Both would move towards the same end: it would trigger a run on the U.S. dollar, pushing it into a downward spiral as currency traders sought to sell, but could find no buyers. The dollar would go into free-fall.

In turn, these events would have three knock-on effects, none of them good. First, it would mean the U.S. government would have to cut its spending drastically, or risk having its checks bounce. This happened to the government of New Zealand in 1984 , and it caused a national crisis there. But America is not New Zealand, and if it cuts its spending, both the American economy and the global economy will get hit hard at a time when both are beginning a fragile recovery. Second, it precipitates another financial panic, worse than the one last year, only this time the biggest rescuer is the one that needs rescuing, which could crash the entire global financial system. And third, the global trading system, which uses U.S. dollars as its principal medium of exchange, slows to a crawl because there is no other currency big enough to replace the greenback. This might mean that global trade would plummet.

What happens after that is anyone’s guess, but it’s hard to paint an encouraging scenario, or even one that’s not wildly pessimistic. So let’s circle back to my opening question: Is America too big to fail? Perhaps, but who is big enough that they could possibly save it? There are only two players even close to having the size for this task: China, and the European Union. Neither of them are big enough. Probably the two of them together aren’t big enough. And it may be that all of the central banks of the world, combined, and backed by their national governments, may not be big enough. Moreover, it would take a degree of cooperation and willingness to accept losses by the rest of the world that, going by past performance, is unlikely in the extreme. So, based on what I can see now, America will probably go bankrupt, and create a panic and even deeper global recession in the process.

Of course, people are endlessly inventive, and it may be that someone will come up with clever solutions that will save the day. For instance, the Federal Reserve could raise interest rates significantly to help make America’s debts more attractive. But that won’t happen unless there is a crisis that trumps domestic politics, because raising interest rates by much would likely throw America back into recession, dragging global growth down with it. So, absent some miracle solution, America is going to crash – I just don’t know when.

Believe me, I hate writing about this, especially since I know that many people will inevitably blame the messenger. So instead, let me turn this into a question: Am I wrong? Is my reasoning incorrect, or are my facts wrong, or my interpretation too pessimistic? Perhaps I have the timing wrong, or am overestimating the scope of the problem. Let me ask, then, does anyone else have a different view? I’m not asking for political views, pro-Democrat, pro-Republican, anti-Democrat or anti-Republican; that is frankly a boring and unimportant sideshow. What I’m interested in is: Is American likely to fail? And if so, what can be done about it?

I’d like to hear your thoughts. Thanks.

© Copyright, IF Research, June 2009.