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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Future of Work

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

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

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

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

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

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

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

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

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

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

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

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

What Happens When Too Many People Are Unemployed?

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

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

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

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

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

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

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

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

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

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

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

What Should We Do About This?

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

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

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

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

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

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

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

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

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

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

Risk management

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

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

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

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

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

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

Possible Positives

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

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

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

Potential Negatives

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

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

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

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

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

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

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

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

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

The Costs of Being Wrong

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

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

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

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

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

Inflation

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

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

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

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

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

Deflation

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

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

Recession

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

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

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

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

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

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

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

So what do we do now?

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

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

© Copyright, IF Research, June 2011.

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

If we’re lucky, 2010 could be a lousy year. If we’re unlucky, 2010 could be a disastrous year, worse than 2008, because there are potential nasty surprises lurking out there. Such surprises could precipitate another, even worse financial crisis, and dump us into a global depression, instead of the recession from which we are now emerging. I’m going to deal with the issue of the nasty surprises in a later blog, so just for the moment, I’m going to assume that none of them will happen, and the economic future will unfold about as it looks now. And, although I’m looking out to the year 2020, I’m going to start by looking at 2010 on its own before moving beyond there.

The Prospects for 2010

America is out of its recession, but I would hesitate to call what we have now a recovery. It’s true, U.S. GDP grew by a reported 3.5% in the third quarter of 2009, but that was, in many ways, misleading. In the first place, it was heavily influenced by government stimulus, especially the “cash for clunkers” program. Since government stimulus will be tapering off in 2010, and the car incentives are finished, this source of economic strength will be missing. But even more revealing, barely was the ink dry on the reports of 3.5% GDP growth when they were revised downwards to 2.8% – an unusually large and rapid downward revision.

To see what’s ahead for the U.S. economy, let’s start with public sentiment. One of my favorite indicators of economic strength is the frequency with which the word “recession” appears in the mainstream media (“MSM”). This indicator has been known and used for decades, but before the Internet, you had to be in the MSM to have the ability to perform this count. In 1995, I realized that I could do it myself using Googles’ news website, and since September of 1995, I’ve done just that every week, and then graphed the results. Here’s how this graph looks today (the X-axis has been inverted since “recession” is inherently a negative idea):

© Copyright, Richard Worzel, December 2009.

One of the interesting things about this indicator is the date when it said we felt the best about the world, which was July 30th, 2007. This was just five months before the indicator dropped suddenly at the beginning of 2008, indicating that concerns were rising. This subsided in the Spring of 2008, but then collapsed in earnest in October of last year – a trough from which we haven’t yet recovered. Clearly, we were all feeling fat, dumb, and happy in mid-2007, without realizing how bad the underlying fundamentals were. And the most important lesson to draw from this is that sentiment indicators are not good predictors of problems, only feelings.

Yet sentiment is important. It embodies what economists call the “animal spirits” of an economy, being the courage to go out and do things, like take risks to make and spend money, and the willingness to trust that the other side of a transaction can and will fulfill their part of an agreement. Without these feelings of courage and trust, people hunker down in a hole, don’t spend money, and the economy’s heartbeat stops, which pretty much describes what happened last year.

Now, looking at the chart again, we can see that although our “animal spirits” have recovered from the depths, we are nowhere near where we were at the beginning of 2008. We’ve climbed back, but seem stuck halfway – and that’s a pretty fair estimate of what I expect for 2010. The economy will grow – but slowly. Unemployment will stop exploding, but employment will be painfully slow in coming back. Indeed, employment typically is slow to return at the beginning of a recovery because business owners are still wary of potential problems, and because they can increase working hours, through additional shifts and overtime, without hiring additional staff. This increases productivity and profits without increasing risks – a good bet in perilous times, but tough on those out of work. So, the prospects for America’s economy in 2010 are weak, at best.

Despite this, the outlook for inflation is dismayingly bad. I consider the price of oil to be the bellwether of rising prices, because of its pivotal position in the global economy. The price of a barrel of oil dropped from $147 to $30, and has bounced back to over $70. Now, it’s true that $30 a barrel was clearly an overreaction by a market that was wondering if the world was coming to an end, but you still have to ask why it would bounce back so far and so fast. The answer, as it often is in this day and age is simple: China, India, Brazil, and the other Rapidly Developing Countries (RDC’s). They barely went into recession, or merely experienced growth slowdowns, which were over relatively quickly. As their economies bounced back, their thirst for oil began growing again. And when the developed country economies begin growing again, all of the bottlenecks that caused the price of oil to spurt upwards in 2006 & 2007 will come into play again, and the price of oil will, once again, spurt upwards, stoking the next inflation cycle. And because of the growing relative importance of the RDC’s in the global economy, we will all experience more inflation much earlier than we would normally expect in this economic cycle.

This same combination of RDC growth and developed world recovery will play out again and again beyond oil. Food will be one of the next places it will happen, followed by other commodities and resources. The net result is that we will start hearing about an indicator that went out of fashion in the 1980s: the “Misery Index.” The Misery Index is the unemployment rate plus the inflation rate, and reached an annual high of 20.76% in 1980[1]. For comparison, it reached a modern low in 1998 at 6.05%, and its post-World War II low was in 1953, when it was 3.74% If America’s unemployment rate sticks somewhere around 10%, which I expect it will, and inflation reaches 5%, which it might despite the weak U.S. economy, then the Misery Index will reach 15% – a level not seen since 1982 when Ronald Reagan was president. All of which is why I say that if we’re lucky, 2010 will be a lousy year.

Canada’s 2010 – Canada will have an uneven year, which is to say that some parts of Canada will do quite well, while others will continue to suffer. Most of the suffering will be done in Central Canada – Ontario & Quebec – because of their reliance on manufacturing, especially in cars, their overwhelming ties to the United States, and the strength of the Canadian dollar. All of these mean that the two former powerhouses of the Canadian confederation will now lag most of the rest of the country in recovery. Indeed, if the loonie continues to strengthen against the greenback, Central Canada could have an even worse year than the United States.

Meanwhile, those provinces that supply natural resources, particularly Alberta and Saskatchewan, and to a lesser extent B.C. and Newfoundland, will do much better. With oil strengthening, and food following, the two Prairie provinces will build on their previous strengths and outperform the rest of Canada, as well as the United States, and their strength could continue to boost the price of the loonie. The resource provinces will also increase their trade with the developing countries of the world, notably China. Indeed, I would suspect that we will see a return of corporate takeovers of Canadian resource companies that could cause the Toronto Stock Exchange to outperform most developed world counterparts in 2010.

All of this will add political friction between the new “have” and “have-not” provinces that will make life testy and interesting in Parliament in Ottawa.

RDCs – Meanwhile, the RDCs, again lead by China and India, but also including Brazil and to a lesser extent Mexico, Malaysia, and Indonesia, are bouncing back from a fairly traditional inventory-led recession or growth slowdown.

There is more to RDC growth than China. Everyone has heard of India, and India will continue to try to accelerate its growth. However, watch Brazil as well, which is becoming the next powerhouse after having settled its long-standing problems of political and economic stability. We will be hearing more and more about the giant emerging in South America.

China’s ambitions – One particularly important issue for the future is China’s pegging of its currency to the U.S. dollar, which means that it has effectively executed a competitive devaluation against the Euro, Yen, and other currencies while maintaining its undervalued status against the greenback. This will cause the U.S. trade deficit to continue to run unsustainably high, and will inflict even more damage on other developed country economies. This is not the behavior of a player concerned about its image in the world, or even in its own long-term enlightened self-interest, but it does accord with my beliefs about what motivates China.

I believe that China has two primary objectives that trump all other concerns; one immediate, and the other long-term. The immediate one is the Chin’s leaders are desperate need to keep economic growth high in order to keep employment growing. If they aren’t able to achieve at least 8% growth in real GDP per year, then by their own reckoning, unemployment will rise, and with it, social and political unrest. And, from what I’ve seen, China’s leaders are more concerned about hanging on to their political power – which means political stability – than anything else. The welfare of its trading partners pales into insignificance in comparison to this critical domestic need, especially when you consider that in 2007 – the last year of strong global growth – China experienced a reported (but unverified) 10,000 spontaneous demonstrations about economic and living conditions around the country. The Red Army may be large, and it may be strong, but it can’t be everywhere, so political instability scares China’s leaders like nothing else. Accordingly, if China’s economy needs exports for strong growth, then it will contrive to have exports at any cost, especially if someone else pays that cost. China is not the first country, or the only country to play the trade game entirely selfishly. Indeed, you could say they’ve stolen Japan’s playbook from the post-war era. But China is playing it very well, if cheating for narrow self-interest is your yardstick.

The second motivation is long-term: China wants to dominate the world, replacing America as the only superpower. This again is supposition on my part, but is, I think, pretty obvious. And if they want to supplant the U.S. as the only global superpower, than inflicting economic damage on your principal geopolitical competitors is not a bad long-term strategy, even if it costs you something in lost trade along the way. It reduces the amount of money your competitor has for military and diplomatic strength. It focuses their attention on domestic issues. And it creates friction between domestic political parties. All of these are helpful to a China that is eyeing the top spot, and would prefer to get there without military conflict.

Beyond 2010

If we assume, once again, that none of the terrible “what-if” scenarios happen, then what happens after 2010?

America’s economy will continue to recover, but more slowly than desirable, and more slowly than in earlier recessions. This was not a typical recession, but was precipitated by too much debt accumulated by consumers, state governments, and, ultimately, the U.S. federal government. It takes time to pay off debts and recover spending power after the excesses of the last 25 years, which is why this recovery will be so anemic. Moreover, with so much of the U.S. housing market still under water, with mortgages bigger than current property values, it will take a long time for home owners and mortgage lenders alike to recover from the scars. This means that 2011 and 2012 are likely to continue to be less than robust.

Beyond 2012, I expect that the U.S. economy, pulled along by the global economy, the Rapidly Developing Economies, and American ingenuity and grit, will begin to pick up speed. And unless some additional shocks or surprises occur, I would expect the economy to continue to grow, and prosperity to return, through the balance of the 2010′s. It will also be accompanied by persistent high inflation – perhaps not high by 1970s standards, but higher than we’ve been used to in the past 20 years or more. This may make it tempting, beyond 2012, for central banks, lead by the U.S. Federal Reserve Bank, to put on the brakes, raising interest rates significantly in order to slow inflation. However, higher interest rates will actually have relatively little effect, because this bout of inflation will be driven primarily by bottlenecks and shortages, particularly in oil production and food, as mentioned earlier. This is going to pose a real quandary for central banks: How can they temper inflation when it’s mostly caused by too little supply rather than by too much money? The only way to lower inflation in that kind of environment is to lower economic growth – and that won’t be very appealing to any central government after years of soft growth.

All told, then, this is going to be a fragile decade for America and her mature trading partners, and the potential for bad things to happen will remain high for quite some time.

RDC’s – The RDCs will continue to grow rapidly, boosting each other’s growth, and gradually pulling the rest of the global economy with them. They will be the principal drivers of the global economy this time around, not the U.S. The bigger question, and one worth watching carefully, is whether their consumers begin to increase their consumption, taking the place of consumption-happy Americans. And how the RDCs deal with the challenges of rising, and persistent, inflation will also tell a great deal about how mature their governments and central banks are.

Canada – Canada’s economy will continue to be uneven, with Ontario and Quebec lagging behind, and the resource economies moving forward with the prices of their resources. However, both Ontario and Quebec are committing significant resources to capture some of the new industrial strength of the green economy. This, along with the slowly improving automotive market, will gradually allow Central Canada to begin strengthening with the advent of the ‘teens of this decade. Meanwhile, low interest rates, kept in place to stimulate economic growth, may produce a bubble in real estate prices in Canada, especially in the major cities, that may threaten Canada’s stability. It would be ironic, indeed, if Canada dodged the bullet that knocked off the American economy in the financial crisis of 2008, only to get hit by it in the next economic cycle. And yet, that is, implicitly, what Mark Carney, the Governor of the Bank of Canada, has been warning for some time. As well, the leading edge of Canada’s baby boom will be entering their 70s by 2020, and that will lead to lower economic growth, and shortages of skilled labor in many areas of the economy. The next 10 years will be a decade of real potential combined with real challenges for Canada.

Europe – In theory, Europe should be the strongest region of economic growth in the developed world. Yet, it is going to struggle at least as much as America, if for different reasons. Britain’s housing market and mortgage market went through pretty much the same wringer as America, and it’s government ran persistent deficits through the fat years that leave it without much ammunition to face the challenges ahead. China has instituted what amounts to a competitive devaluation by pegging its currency to the U.S. dollar, which has been persistently weak compared to the Euro, and will make it harder for Europe to compete with China in world markets. But the clincher really is that Europe is old, and the labor forces of its member countries offer either no-growth or are shrinking. Since, simplistically, GDP growth is composed of labor force growth plus productivity growth, this means the either Europe must massively improve its productivity, or it is going to see its economic growth stagnate, and its share of global output shrink throughout the next 10 years.

Well, first of all, the developing countries had a really rough first half – but mostly that was due to what has classically been described as inventory overhang, about which more in a moment. They had been doing so much business with the developed countries, especially America, that they had a whole raft of product in the pipeline when the U.S. economy hit the skids. Now they’ve liquidated that inventory by cutting production, which slashed growth rates in the first half, and are now back to filling current demand. As a result, they’ve taken a hit, but are bouncing back.

Next, the developing countries, especially in Asia, have stimulated their economies, and are seeing the response. Their investment in infrastructure, both at the governmental level, and plant and equipment for corporations, is strong, and consumers have responded to stimulus with demand, just as it says in the textbooks. But in addition to that, the developing countries are trading more and more with each other, and, consequently, are not as reliant on demand from America, Europe, and the other OECD nations as they were before. Hence, as the fast growing countries start picking up steam, they help each other grow even faster, even without their biggest customers. For example, Brazil now buys more from China than it does from America, it’s traditional major supplier, with the result that as Brazil rebounds, it helps China, and vice-versa.

Meanwhile, things don’t look as bad as they did back home. The governor of Canada’s central bank, The Bank of Canada, has declared the recession in Canada is over. The U.S. Federal Reserve has said that the bad news isn’t as bad any more and we are probably at or near the bottom of the recession. France and Germany are starting to look better as time goes on, and will see positive growth this quarter. But it’s not going to be a quick rebound, because this is not a typical recession.

Not your traditional recession

A traditional, inventory-liquidation recession happens when the economy has been booming along, and everyone’s making easy money. As a result, organizations try to sell as much as they can, filling their pipeline with products to be sold, and operating at or near capacity. In the process, they take on short-term debt, typically bank debt, to finance their operations and inventory. As a result, when something happens to slightly jiggle the apple cart, or when the interest paid to the bank to finance inventory start to hurt more than the potential profit warrants, corporations decide to try to lighten up a bit by cutting back on new purchases and production. When everyone tries to do this at the same time, demand nosedives, and the economy goes into the tank. When the inventory has been cleared, the bank debt has been paid off, and the smoke clears, a few companies go broke, but the economy as a whole resets, and starts growing again in a new cycle, typically with strong growth for the first couple of years following the recession. This kind of traditional recession & clearing process took anywhere from 6 months to 2 years.

This is not that recession, not in America. This recession was triggered principally by consumers having too much debt through 25 years of using their home mortgages as an ATM. That kind of long-term debt takes time to pay off, and consumers have to consume less than they make in order to do it. This puts a long-term damper on the economy that takes a long time to wear off.

If we are lucky, America’s economy will be almost flat for the balance of this year, but start growing – slowly – next year. By 2011, it will start to pick up, but growth will still be anemic, and people will be complaining that the recession hasn’t ended. In fact, we are likely to see an unusual combination of rising economic output AND rising unemployment for an uncomfortably long time, perhaps even into 2012.

Possible shocks to be wary of

If we’re not lucky, then the American consumer, having been shocked into a penitent, saving mode, will stay in his or her shell and refuse to buy anything, or will only buy what they have to, for a long time. Add to this the potential for further financial market shocks, which I’ll describe in a moment, and you have a very gloomy scenario indeed. Moreover, if growth stays weak, and unemployment stays high, President Obama may wind up losing the White House in 2012, despite the structural weaknesses of the Republican party, because the economy is the single most consistent indicator of electoral success.

Now, what might be the possible further shocks? Well, if economic growth stays weak, the U.S. government will want to continue to stimulate demand, which means running deeper budget deficits for longer than currently planned. And as I’ve said before (“Wild Card Warning”) the U.S. government is already at risk of running out of money because of the enormous amount of debt it must raise on the open market. If lenders grow weary or leary of U.S. debt, then the U.S. government faces a credit crunch of its own that could precipitate a new financial crisis, and tip the global economy into a renewed depression. Or, if that can be avoided, the banking system is not yet out of the woods, because loans they made for commercial properties are turning bad, and may put further holes in bank balance sheets, again precipitating a new crisis. Neither of these are inevitable, but are real dangers that should be watched carefully, and for which contingency plans should be formulated now.

Canada’s dilemma

In contrast, Canada will experience an interesting dilemma: the demand for oil and food is already growing again, in large part because of the developing countries, and Canada is a major producer of both. (Most people are not aware that Canada has the second largest petroleum reserves in the world, after Saudi Arabia, and is America’s biggest supplier of oil. It’s very expensive tar sands oil, but it is flowing, and makes Canada a petro-power.) As a result, on average the Canadian economy will do pretty well among OECD nations – but this average is deceptive. Demand for Canadian commodities will and is already pushing up the Canadian dollar. This will further damage the country’s industrial heartland in Ontario and Quebec, which are already being hollowed out by the woes of the auto industry, and the transfer of manufacturing to lower cost producers like China. Meanwhile, the parts of Canada that produce commodities, notably Alberta and Saskatchewan, will be feeling no pain. This will exacerbate the real political stresses within the country, where almost two-thirds of the voters come from Ontario and Quebec, but virtually all of the strength in tax revenues, and the large majority of the economic growth, is coming from the western part of the country. It creates an almost impossible situation for the national government, quite aside from the current government’s short-comings and evident weaknesses.

Looking farther out into the future, unless the nasty contingencies described earlier occur, growth and prosperity will return to the “rich” countries, although slowly, and this time people will be more cautious. Some of the thrifty virtues our parents preached will once again be rediscovered, and time will heal the wounds, investment will once again accelerate growth, and (more measured) good times will roll again. This pain, too, shall pass.

Destruction carries the seeds of recovery

In its wake, it will leave the developing countries stronger, the developed countries growing again, but more cautious, and a more interconnected and interdependent world. If we have learned nothing else, we have learned that in today’s world, no one crashes on their own. This cautionary tale may well pave the way to a more stable world economy, and one where fair trade for all is seen as the only alternative to disaster.

Every boom carries the seeds of its own demise. Likewise, every crash sows the seeds of new growth, and new innovation, just as many forests require forest fires to renew themselves. This time will be no different. Carrying the metaphor forward, we’re not out of the woods yet, but that glow on the horizon is more likely to be the dawn than a renewed conflagration. Hold on to that.

by futurist Richard Worzel, C.F.A.

I’ve been a free trader all my adult life. I studied international trade in university, watched it develop with the collapse of the Bretton Woods Agreement in the early 1970s, and have seen the amazing consequences of globalization, which has lifted hundreds of millions of people out of desolate poverty. Moreover, it makes sense: free trade is merely an extension of occupational specialization, so that just as it makes sense for the cobbler to make shoes and sell them to the farmer in exchange for food, it makes sense for countries to do what they do best, and trade with each other.

Of course, freer trade (because we don’t really have free trade) has a downside. It creates winners and losers. Some folks do very well out of free trade, including consumers who get cheaper goods, plus those who are capable of competing and finding new markets. Some folks lose their jobs, as those jobs migrate to other places where the wages are lower, or there’s a natural advantage. I remember hearing one labor leader, who represented workers at GM when those workers were on strike, saying in a radio interview that “We’re not going to let workers in other countries take our jobs just because they’re willing to work for lower wages.” I thought to myself: here’s somebody who’s really out of touch with reality: why should you be able to keep a job if there’s someone else who can do it as well, but for less money? Of course, if you have the job and are losing it, you will naturally object that it’s unfair. But I can’t see as you can make a reasonable case to anyone not related to you that you are entitled to that job.

But my purpose here is not to defend free trade, but, perversely, to warn about one of its unintended consequences. The fundamental (and correct) premise of free trade is that it destroys older jobs, and creates new jobs that offer better pay and working conditions. But it does that only if workers have the ability to fill more demanding jobs that require more thought and higher levels of education. Otherwise, workers wind up competing by cutting their wages or taking poorer, less rewarding service jobs.Generally speaking, this means that free trade benefits developed countries because they usually have better levels of education than developing countries. It also benefits developing countries because less remunerative jobs migrate to countries where those jobs are not only welcome, but a distinct improvement on what those people had available before. Hence, both sides are better off.

But what happens when the students in developing countries are better educated than those in developed countries? In the past, this would have sounded nonsensical; education is expensive, and so is more likely to be available in rich countries. Yet, this pattern is changing, partly because of our own laziness, and partly because of our conviction that we are naturally superior, and hence naturally deserve higher paying jobs.

A recent column in The Economist newsmagazine, published on June 11th, 2009, and entitled “The Underworked American,” described the development of just this kind of situation. American children, the Lexington columnist said, do substantially less work – and presumably learn less – than their counterparts in Europe and Asia. Our children go to school fewer days a year – about 180 days compared to up to 220 days. Over a 12-year primary and secondary school career, this means that American children “lose out on 180 days of school, equivalent to an entire year” compared to their future competitors abroad. They also have school days that are two or more hours shorter, and far less homework. And the same is true in Canada as well, which tends to mirror the patterns of its largest trading partner.

It has been known for many years that post-secondary education in North America is the finest in the world, but that secondary and primary school education lag behind other countries, including most of the emerging Asian countries. And there are other indications that things are going wrong as well.

Indicators of trouble

The first indicator is that graduate schools largely could not function without foreign students filling their classes. In many graduate schools, including most of the best, foreign students fill the majority of spaces. Interestingly, when I recount that to American audiences, their almost knee-jerk reaction is that we should get those foreigners out of there, and make room for American students. I gently point out to them that the reason there are so many foreign grad students is that there often aren’t enough Americans to fill the classes – there aren’t enough Americans who go to the trouble to work through grad school, and those that do apply, may not be as well prepared as their foreign counterparts.

The other, and in some ways more worrying, indicator is the steady rise of cheating at the undergraduate level. I was at a party the other night, and met a very bright young women. She has a graduate degree, and has started her own business, but is finding it tough to make ends meet. This isn’t unusual: the early days of any new enterprise can be tough. What caught my attention is that she said that she could make a very good living off the Internet by writing essays for undergraduate students who are too lazy or too ignorant to write their own. And this is only one example. Anyone who wants to look can find lots of descriptions of how colleges and universities are struggling to cope with widespread cheating. In other words, while education is clearly the currency of the future, we are systematically cheating ourselves, first with inferior primary and secondary education, and then by looking for ways of ducking the hard work of post-secondary education.

“Yellow Peril”?

I was recently a panelist in a discussion about the problems of North American education on a public-affairs program called “The Agenda.” One of the panelists had written a book about the short-comings of the American education system, and his thesis was that while we are the best at the world in holding football rallies, our education is going to relegate us to second-class status (this is my summation of his work, not his). We also had panelists who had grown up in other countries, one in India, and one in China, and they both agreed that school children worked much harder there than they do here. And there was a representative from a teachers’ union, who was brought in from another city by a remote hook-up. I was there as a futurist who writes about education (I’m a columnist for Teach magazine).

After the moderator introduced the topic, and spent some time talking with the author, the gentleman from China, the woman from India, and me, asking us all what we thought, he turned to the woman from the teachers’ union. That was when things became decidedly sticky. She was most insistent that there was nothing wrong with our education system, it was the finest in the world, and that we were all preaching a racist doctrine that amounted to scaring people about the coming “Yellow Peril,” meaning a metaphoric invasion of Asians. The author and I just looked at each other in disbelief, then he commented that we weren’t talking about a yellow peril, but an intellectual peril, where we were rendering ourselves uncompetitive in a world where education standards were rising. She wasn’t having any part of it; it was all lies, foul lies, and we should be ashamed of ourselves.

At that point we ran out of time, which ended the discussion, but off-camera, the host apologized to us for the unreasonable attitude of the union representative. I took it as yet another sign confirming my concerns about education and our future.

So the bottom line is this: Free trade is good for a country and a people if they are prepared to step up to more challenging, and more rewarding, work that requires better education and deeper thought and insight. Instead, we are trying to see how little work we can do. We idolize Homer Simpson instead of the author of the Iliad, and look for short-cuts instead of digging in to see much we can learn. In the short run we can get away with this. Eventually, it will mean a long slide into (relative) poverty, with our children and grandchildren having more and more difficulty finding meaningful work.

Free trade doesn’t work for the ignorant.

–

© Copyright, IF Research, June 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.