21st Century Economics

The 21^st Century Business Model  

Here in Vermont, we spend a lot of time and effort holding on to “the good old days”.  Its nice to walk into a local store where you know all the sales people and the owner by their first names and they all know you.  Mostly because of that, we don’t mind that the store’s inventory is not as large and prices are not quite as low as the mega-mart over in the big city mostly because of that good old fashion Vermont service.  This is a 20^th Century business model that is coming under increasing pressure to change.

Part of that change is that the growing use of computers and the internet is making it more and more possible for people to shop almost anywhere in the world for almost anything they need or want and at prices to which most store-front sellers can’t compete.  Even without the competition of a nearby mega-mart big-box store, the global economy will eventually affect most merchants and many service industries.

One way to address some of that competition is to go online.  Nowadays, even local stores are often expected to be listed in online directories with store hours, maps and phone numbers.  It is becoming increasing important to have an online presence just to remain competitive but with a little extra effort, you can also create added income streams and cash flow with a surprisingly modest investment

The most elaborate web sites cost about $250 per page but it is possible to begin with building a simple static web site using free template-based applications and online web hosting services with monthly hosting fees as low as $10.  Alternatively, you can use some easy online services or hire a programmer to create a dynamic web site in which you frequently change web-page content in as little as one hour per month.  Annual costs can be as low as $360.  Any business can break into this market with one of three basic options without the need for expensive computers or training.

The Menu Option:             You can setup a simple static web site that offers a menu or inventory listing of your sales offerings.  Similar to a restaurant menu, you list what you sell or just list types or groupings of merchandise or services, but without prices.  You also list store hours, maps and contact information.  The advantage is like having a large, detailed, online business card or permanent advertisement for about $120 per year.

The Take-Out Option:            If you already have a small or computer-based inventory, you can easily setup an online version of a take-out order by allowing web users to see all or some of your inventory listing and place orders online for later store pickup.  By adding a simple order save function, you can allow people to build their shopping list over some period of time (weeks or months) and then schedule the in-store pickup for a specific date or they can place special orders or orders that require preparation.  The order could show up on an in-store printer and be prepared for customer pickup and payment.  This avoids online money transactions but can still enhance sales and provide a value-added service for your customers.

The E-Commerce Store:  The most elaborate online sales option is to put up a full function store web site.  There are turnkey, off-the-shelf, e-commerce software packages and online services that can provide this capability starting around $50/month.  Such a web site does everything for you except delivery.  It takes the order, adds in shipping, handling and tax and then collects the payment.  All you have to do is collate and mail the order or prepare it for pickup.  Such sales can be for a very select portion of your inventory that might appeal to online buyers outside of your immediate store location. 

Don’t dismiss these options too quickly because experience shows they can enhance customer service and might lead to large volumes of sales at less labor and lower overhead expense than in-store sales.  These options are ideal for home-based or Vermont specialty stores and many small businesses.

This is the 21^st Century and your sales competition as well as your potential buying market is growing every day.  You need a 21^st Century business model if you are to survive.   It is possible that your regular customers of the future could be a rancher in Wyoming or a schoolteacher in Japan.  They, too, might get to know you by name and you know them and they are repeat buyers from you because of your good old fashion Vermont service.

What has happened in the financial markets

Banks are just money stores.  They sell DEBT!   Banks sell money by making loans and mortgages to people at an interest rate so that the people pay back more than they borrowed.   They sell debt!  Remeber that.  It is in their best interests to put you in debt to them by any means possible.  In that light, much of what they do makes much more sense.

Actually, you don’t exactly buy money but they do lease it.  By offering various services, safeguards and payments, the bank gets people to put money into the bank’s inventory.  The bank then makes payments to the depositors by giving them payments in the form of savings interest rates, free services and other benefits.  They can afford to make these lease payments because the interest rate they get from their loans is much higher than they pay out for the use of the money they are loaning. 

The pool of money that is deposited ends up being very large when compared to the amount that has been put out in loans.  In fact there are laws that mandate that the bank must hold in reserve a very small pool of money to cover the normal fluctuations of deposits and withdrawals.  It amounts to only 10% of the total amount of money they have lent out.  This is called fractional banking.

While this small pool of deposited money is held by the bank, they try to make it earn more money by making investments.  Some of this is in Treasury Bonds but mostly it is in things that people want to buy by borrowing money from the bank. 

In this regard, this money bank operates like any other store.  It has sales people (loan officers) that try to sell their inventory (debt) and inventory managers (asset managers) that try to attract more deposits from more people.  The profit of the bank is made from making that small pool of deposited money earn additional income while it is in the banks control. 

Now suppose that our economy is booming and lots of people are earning lots of money.  They will want to put it into a bank for safekeeping and that makes the small pool of deposited money grow much larger.  When the bank has millions of dollars just sitting in its vaults, not earning money on interest loans, then the bank is effectively losing money. 

The response is to tell the sales staff to make more loans - this is, get more people into debt to the bank.  The problem is that in a given community serviced by several banks and in a booming economy, there may actually be a shortage of people that want to borrow large sums of money.  To entice borrowers, the bank will lower their interest rates and loan application standards.  They don’t want to lose money, just get that initial sale, so, for mortgages, they offer a low rate for the first few years and then will raise the interest rate back up. 

But again, the community is serviced by several banks and there are just so many mortgage loans that can be given out so the bank looks for other kinds of investments that can earn money.  Most banks have a portfolio manager that handles the various Wall Street investments.  But this is not the kind of investments that normal people make.  A bank might have $300 billion in its pool of deposited money and it is not legal for them to put very large sums into one stock investment and it is not cost effective to make thousands of small (under $10 million) investments in stocks.  

So the banks have come up with their own kind of investments.  These are the kind of investments that you need billions of dollars before you are allowed to participate.  One kind is to bundle all of your mortgages and sell them to another bank or investor.  This had the effect of giving the bank an immediate return on its mortgage loans and the buyer gets its reward by gaining the long term high payoff that every mortgage pays.  There are also tons of other weird and very complex “instruments” that banks use – like derivatives. 

These high cost instruments cost billions of dollars and are valued based on their risk level.  As with most investments, if the bank is willing to take on a little more risk, then the reward is potentially larger. 

Ah but here is the problem.  As the pool of deposited money gets larger, the bank is under pressure to get more of that money out into investments and earning profits for the bank.  When they have tapped out the market for loans and investments at a safe and secure risk level, they are under pressure to change that acceptance level of risk and loan out at greater and greater risks.  In this case, the risks may be that the collateral of the loan is not worth the value of the loan or it might mean that the derivative has a high risk if the economy fluctuates any.

In the great Savings and Loan Crisis of the late 1980’s and early 1990’s, that was just such a situation.  A booming economy and the offer of high interest rate on deposits brought in billions of dollars.  When the real estate boom of the 1980’s hit, the S&L’s wanted to make all that deposited money work for them.  Deregulation had removed most of the normal safeguards allowing the S&L’s to invest in more than $160 billion of bad loans – mostly for real estate that was not worth the amount of the loan.  The US government paid $128 billion to bail out the S&Ls. 

Over the past 30 years, the baby boomers have put more than $7 trillion into various stock market, real estate and banking investments.  Companies like Bear Stern took those deposits and made a lot of investments – mostly in the high risk derivatives.   They were overextended and under-collateralized into high risk ventures that collapsed when the national economy took a dive. 

One of the impacts of the baby boomers retiring is that they will be selling off their homes.  Many have second homes or very large homes that they will not want to keep in retirement.  The sale of these homes will oversupply the market and drive prices down – which is exactly what is happening right now. 

That combined with the devaluation of the dollar on world markets and you can see why Bear Stern defaulted.  But stand by, this is just the beginning.   The sub-prime mortgage problem, the massive rise in bankruptcies and the devaluation of the dollar will combine with the real estate crash to make for one awful economy and any financial institution that took on a little more risk than was prudent will find themselves in big problems. 

Unfortunately, that includes the federal government.  The FED has a finite ability to manage these crisis situations.  One is to lower their prime interest rate but it is now below 1.25 – the lowest since WWII – and if it goes much lower, the primary tool that the FED can use is gone.  In addition, the FED has just paid out $160 billion to guarantee loans for the Bear Stern bailout.  Since this is a federal guarantee, the buyer has very little risk and if they begin to falter, you can bet they will call in that guarantee. 

There is no honest appraisal of the US economy that does not lead to the conclusion that we are headed for a major financial crisis in the next decade and it will be unlike anything we have ever seen before.  

In keeping with the theme of looking to the future, it might be a useful exercise to look at what are reasonable expectations for what parts of the US economy will be like a decade from now.  I say “parts” of the economy because it is nearly impossible to predict the complex combination of trends, forces and events that make up the whole. 

We can, however speculate just as we can say with some confidence that, in general, it will get cold again next winter, there are a few things that we can say with reasonable certainty about the economy of 2020.

Let’s begin by defining what the world will be like in 2020.  China, India and the US will collectively account for 55% of the global gross domestic product (GDP) representing one third of the total world population.  Asia’s share of the GDP will be more than twice as large and the US.  China will surpass the US as the world’s biggest consumer market.  Much could be written about the known and probable impact of the rising markets in China and India but to keep this article reasonably short, let’s limit our look to how it will affect the US and Vermont economy. 

The cost of oil – more specifically, gasoline – will probably be the largest single change between now and then.  There have been no new oil fields discovered in the past 30 years and some believe that the total known world supply is now down 50% - the so-called “Peak Oil” point.  The Government Accounting Office reported that of 21 serious studies trying to date reaching Peak Oil, 19 of them conclude that we will reach it by 2040, but 16 of them place it before 2030 and 8 place it before 2020.  The variable is the unknown quantity of oil that remains in the ground.  What this means is that sometime in the coming century, we are likely to see the effective end to petrochemical fuel use for transportation. 

However, by 2020, the demand created by China and India and others will have doubled the current 80 million barrels per day production requirements.   Conservative estimates from the Congressional Research Service projects that China alone will “generate increases in demand by 500,000 barrels per day or more”.  This exceeds the current production capability of both existing oil fields and existing refineries.  The result will be that oil will be rationed, bid on or fought for – all of which will raise the prices. 

There are possible sources for more oil – deep ocean wells, Canadian tar sands, shale and old well recovery schemes, but these become cost effective only because the price of oil has risen high enough to make them worth developing.  We may well discover other fields but the industrialization of China, India and many other third world countries will most likely more than absorb any new sources found or developed.

Increased oil prices will impact the entire economy with higher prices.  What is not made with petro-chemical products is transported by petroleum fuels or powered by utilities that use petroleum fuels.  Typically, this will extend to a consumer spending slowdown, which will impact the rest of the market – worldwide.

Unfortunately, unlike previous oil price increases that came at a time of robust economic growth and high inflation, this rise will happen when the world economies are dealing with marginal economic growth, an aging population of baby boomers, unstable political conditions and low inflation.  That means that sellers of goods that are impacted by rising oil prices will have little room to pass those added costs on to the consumer.  Governments will have little sway with inflation controls (like the FED interest rate cuts) because they can’t cut the rates any lower when it is down to near zero.  The end result is that there will be first, stagflation – slow or zero economic growth and rising unemployment.  Inflation may very well increase simply because governments will need to inject more money into the system as tax revenues decline but public costs rise.  There will be tax increases but in the US they will be subtle and hidden – such as letting previous tax cuts expire or lowering the levels at which higher tax rates apply and raising the levels at which tax decreases apply.  This is common practice for US politicians so that they cannot be held accountable for lowering spending.

Unfortunately, these short sighted and short-term offsets are effective only for a limited time and then they become part of the problem.  Higher taxes paid results in less money to be spent in the economy.  Higher costs for the same goods while salaries and jobs remain level or decline will kick off a recession – a decline in GDP –, which will evolve into an economic depression – a larger decline in the real GDP.  Because of the world economies dealing with marginal economic growth, an aging population of baby boomers, unstable political conditions and low inflation, this depression has the potential to be more severe and longer lasting than any since 1929. 

See my other articles about the problems that the baby boomers will inject into this mess.

Economics has been called the Dismal Science because of the frequency that economic analysis indicates negative or bad financial conditions are in the future. Just like paranoid people thinking everyone is out to get them, sometimes, its true. It is unfortunate that the 21st Century will see a significant period of time in which the US, as well as the world economy, will be lower than in the previous century. To understand why, we have to look at history.Brief Background: I have been a consultant in a variety of subjects for the past 40 years. Among other consulting subjects, I tried investment consulting for about 3 years. My niche, at that time, was

“Event Investing- “If you know an event is going to happen, you can profit by it”.

During theY2K scare my services were very popular but it died off soon after and I moved on, however, not before I researched other pending and inevitable “events” that might impact an investment portfolio. I discovered the confluence of three major trends supported by three separate economic theories. These trends and their consequences are specifically:

Trend #1 - Insurance companies and investors have known for years that people do certain things at certain ages. The 77 million baby boomers bought houses in the late 80’s and early 90’s as they moved into their peak earning years. A trend that is inevitable is that about 76% of those same boomers will sell their homes as the owners age, moving out of their primary homes for a smaller home - usually a ranch style (one floor) or a condo (no yard maintenance). As with the buying boom of the late 80’s and early 90’s, this sell-off will occur over a relatively short period of less than 10 years.

Trend #2 - The baby boomer population is ill prepared for retirement. We now have the lowest (NIPA) savings rate since the early 1950’s. Most boomers have less than one year’s earnings in the bank. Of those that do have private investments, it is in the stock market – more than $7 trillion is in mutual funds alone. In contrast, many boomers have non-cash reserves but they still have the highest average net worth value in history. A very large percentage of that net worth is in real estate.

Trend #3 - Many boomers have invested in their homes with the idea that it will gain in equity and, when sold, will provide a substantial boost to retirement savings. This is an overlying reason that adds to the motivation to sell, as noted in Trend #1 above. Thinking that they may take advantage of the kind of real estate appreciation that has taken place in the past, a home bought in the mid to late 80’s would, by that logic, be reasonably priced in the seven figure range by the time they retired in the early 2010’s. For those boomers that are not saving the way they know they should, it is a comforting thought to know that they will have a large influx of cash, from home equity, just when they need it.

My premise is that these three trends converge and clash with standard economic realities of supply and demand to create a very different and potentially dangerous financial situation for a significant portion of the boomer population. Here is what will happen:

The boomers make up 48% of all US households or about 21.9 million homes. In a period of less than 10 years, following Trend #1, as many as 16 million homes (or more) may be put on the market. The expected buyer population will be less than 10% of the volume needed to maintain a modest market demand. As a result, the housing market will plunge to it’s lowest depth since before WWII. This is the economic reverse of the buying boom of the late 80’s and early 90’s. Home values will fall. A home that could sell for $600,000 in 2004 will sell for about $250,000 in 2015. The home equity that so many are planning on, intended to support retirement, will disappear.

The housing slump we are experiencing in 2006 to 2008 may or may not be the early stages of this rush to sell but it is very clear that as early as July of 2005, supply was beginning to exceed demand and by the end of 2007, home prices have dropped by 20-40% in some markets and the time on the market has gone from less than 60 days in 2004 to more than a year in 2007.

The stock market will also suffer greatly because all related aspects of the housing market will also fall. No new homes will be built while there is a flood of existing cheap homes on the market. Wood, construction, new furniture, carpeting, and many other aspects of the housing market will fall. Real estate values, REITS, GNMA, and other land-based investments will fall. This and Trend #2 and #3 will cause boomers to pull a lot of money out of the stock market. Our economy thrived when the boomers put more than $12 trillion into the stock market in the 80;s and 90’s.

In the ten years that the housing market is suffering excess supply and reduced demand, that same investment money plus the interest it has earned (estimated to be over $18 trillion) will now be pulled from the market with very little being added back in. This, at a time when rising Medicare costs, declining Social Security benefits massive welfare costs will be squeezing federal funding entitlement programs to their highest levels in history. This will bring down a significant portion of the rest of the stock market as well as much of the US economy into a ten year recession or even into a depression.

All this is happening while the 77 million boomers are moving into their old age and placing greater demands on the health care infrastructure (20-22% of GDP). For a critical period of time, the normal (median) prime taxable work force (ages 35-44) will actually decrease to about 10% the size of the boomer population. This decrease is because following the baby boomers, came a very rapid drop in birth rates to the lowest levels since 1900. This was as a result of the introduction of “the pill” and the rebound effect from the boomer’s rapid growth. This and the fact that the boomers will continue to constitute the largest single voting block of special interests in US history, will greatly limit the government’s ability to manage and respond to the economy while they try to meet the massive demands placed on SS, Medicare and Medicaid.

I realize this sounds like one of those doom and gloom disaster books but there is very firm evidence and historical precedence that all of the above will happen. One counter that is often offered is that immigration will soften the impact of these major trends.

It is true that there will probably be an increase in immigrant labor but almost certainly not on the scale of the size of the baby boomer population. Congress set a limit on immigration in 1990 at 700,000 but it is estimated that we have reached as high as 1million per year since then.

Since boomers will be retiring at a rate of 5 million per year for 15 years, the immigrant influx will be less than 20% of those leaving the workforce. Perhaps a more difficult aspect of the immigrant migration is that historically, they take the lowest paying jobs, paying the least amount of taxes of any social group in the US. With as many as 40% not paying any taxes (illegal immigrants and those below the minimum poverty line for being taxable). This will ADD to the problem by putting an added burden on social services, welfare, medical care and job loss. Immigration will change the numbers a little but will not significantly alter these events.

Another argument is that people are living longer, staying in their homes and working later in life. These are all true statements, based on the best evidence and models available now, however, the reasons for this happening is an effect not a cause.

People will be living longer but that will only exacerbate the need for additional resources to support the elderly. Aug 2, 2005 the Commerce Department announced that the savings rate fell to 0.02%. The US Household Debt is now at an all time high of 86% of the GDP - in 2004 the US economy Household Debt increased by $1.05 trillion – in one year. Since the US savings level has been the lowest in US history over the past decade and continues to be negative or in the low single digits of percentage, there is not enough personal wealth (on a national scale) to fund even a typical or normal retirement, and certainly not one that lasts years longer.

People will stay in their homes because the value of their homes will drop significantly as other boomers sell their homes. Those that stay will do so only for so long – until they cannot afford the upkeep and taxes or until they need the equity to live. This may have the effect of extending or delaying the impact of real estate sell-off by the boomers but it will not significantly alter it.

People will work later in life but most often at jobs that pay considerable less than during their peak earning years. Service industry jobs will be by far the most common with incomes and work hours that will provide subsistence income but little more. Again this may have the effect of extending or delaying the impact of under funded retirement of the boomers but it will not significantly alter it.

The only reasonable fiscal response to the seriously under funded social security fund is to apply a “means test” to those that have income from other sources. If you earn a certain amount or have a certain amount of value in assets, then your social security benefits will be reduced and your Medicare co-pay will increase. This is already being done to military retirees but it will eventually be applied to everyone. When instituted, it will reduce, not encourage, people working later in life and for longer hours.

The analysis of these events and similar past performance has been the subject of economists for some years now. I have collated studies from several sources in deriving these predictions. There are three critically different economic theories that I have used:

The Social Influence Model – This model is based on the predictable actions of individuals averaged across an entire society. In this case, it supports the descriptions of what has and is expected of the baby boomers as they age. This model predicted and was confirmed by the real estate boom in the late 80’s and early 90’s as being the result of the Boomers moving into their home –buying years. It predicts a corresponding sell-off in the 2010-2020 period.

The Confluence of Technology – This model is based on the idea that the market is affected by the interaction of technology to a constant background demand by society. When technology allows and supports change, it happens. This theory says that the Tech Boom happened – not because the boomers were in their prime earning years, but rather because communications and marketing technology combined to provide a means for the boomers to spend the money they had. In this model, it was the application of technology that caused the loss of more than 500,000 jobs in highly skilled middle management and high technology jobs while at the same time increasing industrial productivity, GDP and real economic growth. It also predicts that healthcare costs will continue to rise faster than the economy for the next two to four decades.

The Economic Cycle Theory – This is actually a group of theories that describe (“Long”) waves of economic activity based on the repeating character of generations, innovation and money flow. Usually based on some variation of the Kondratieff Wave theory, economic cycles derive their credibility by noting well defined cycles in past performance going back to the 1700’s. This perspective predicts an impending decline (recession) in the near future based on the confluence of a 40 and 80 year cycle of innovation, income, spending and productivity.

These three theories have completely different perspectives, variables and algorithms and yet they all predict virtually the same future over the next 50 years. In fact, because of the emotional knee-jerk response of most private investors and the behavior shown by the boomer consumer and voter in the past, these events, in all likelihood, will actually be much worse.  

It has begun!

It has begun!

The January Effect is a well known and fairly consistent trend in stock market swings. In the 4th quarter, each year, large institutional investors dump losing stocks to take losses that will offset their wins over the previous year. This puts a lot of supply of poor stocks on the market and puts a lot of cash into the hands of the investors. The fact that these are stocks that normally are not swept up by others and the holiday spending spree of the consumers, usually absorbs most of this sell-off so we normally do not see a large drop in the market nor a rush to sell off winners. However, after the New Year starts, these same investors, now flush with cash, want to invest and most do so in January.

With all this pressure to increase the market, in fact, quite the opposite is happening. It is taking a dive. This means that the market drop is actually much worse than it appears. It is diving despite all this upward pressure - or more precisely, investors have lots of reasons to buy but instead they are selling in large numbers.This is not a new trend. The NASDAQ and Dow hit highs in October and have mostly been going down since. This has a lot to do with the Bush administration’s policies of trade, tax and politics but it also has to do with the normal cycles of regression to the mean of normal and typical stock performance. We have been due for a recession for some time.

I may have been wrong about that date. It might have already started. This is not that unusual since it is common for investors to buy on rumor and sell on history (news) – making them always over reactive to even the hint of good or bad news. In this case, they are perhaps acting sooner than I had expected or maybe just reacting to a shorter term crisis that will coincidentally run into the large crisis looming just ahead.As one of the more informed generations of investors, they may well be aware of the coming problems created by the boomers and may well be also reacting to that crisis a few years in advance. This can happen if the institutional fund managers are of the mind to be cautious about what they know will happen eventually.

Bottom line is that a major financial downturn has started and will continue for the next two decades or it will take a short spurt upward for a year or two before taking the plunge for two more decades. Either way, prepare now or suffer later. 

The “Old” Business Model

It Still Has Value!
The Old Model
The current business model that is and has been the mainstay of the business world since Edward Taylor’s time is best represented by a large “U” shaped graph in an X-Y coordinate system. The “X” axis is market share - meaning how many people are buying the product or service. The “Y” axis is profit.

In some localized markets, the top three may change but the forth one in the list will always be far down in the market share and profits from the top three. It has been a fact of business for the past 75 years…..  

High Risk Speculation

Hidden High Risk Speculation
Losses

The bottom line is that getting rich slower is a much safer bet. 

Future Technology: News and Information

Future Technology
News and Information
Newspapers:

One developing example of this is that African Americans and Hispanics have, on average, about 40% less exposure to computers in schools than Caucasian students do. That is happening now. What will their job prospects be like in 10 or 20 years? When they finally recognize this fact to the point of doing something about it, therein lies opportunity. Watch for it.  

Rich-Poor Gap = Trouble

Rich - Poor Gap
Trouble Ahead

We are becoming a nation of nations, a global economy and a more closely interrelated world society. What happens in one place, often affects other societies, economies and politics. If we are to take lessons from history, then consider the following:

Don’t take my word for it. Read and watch over the next 4-5 years and see if the pointers and indicators are saying that we are headed for trouble. If they are, then ask yourself, when are you going to react to what you see? When you hear the thunder and see the dust cloud, will you wait until you can see the angry red eyes of the charging heard of elephants before you run for cover?  

Wealth , Power, Influence

Wealth , Power, Influence
They Got it, You Don’t
Consider this:

If you are smart, you will watch to see if this is true and if it is, do something to both protect yourself and to take advantage of it.