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This is when the protesters should be carrying

Redefining the Terms

Certain terms have taken on meanings in the discussion of our economy that are no longer the reality. And certain symbols and traditional wisdom are upheld that are no longer relevant. In order to understand the economy and the discussion of today, these things must be understood in a new context. So without further ado, here is the initial Glossary of the New Economy

Homeowner. Redefined as Home Borrower 

Nothing defines the last few years of this economic climate in almost all advanced societies at the elevation of the term ‘homeowner’ and all that it taken to mean. What is commonly referred to as a ‘homeowner’ is actually an individual or couple who have entered into an agreement with a lending institution (a bank) to transfer ownership of a property by temporarily placing the property in a joint deed whereby both the lending institution and the ‘homeowner’ jointly own the property in a relationship whereby ownership is gradually transferred from the bank to the borrower. So redefining common expressions:

• Keeping homeowners in their homes = allowing the home borrower to remain in the property primarily owned by the bank though he is not keeping up his obligations under the joint ownership agreement. 
• Expanding homeownership = Beholding more home borrowers to bank debtors and increasing ownership of property by banks. 
• Propping up the housing market = Attempting to control home prices so that existing home borrowers may continue to occupy their homes and pay interest to their banks rather than allowing market forces to set prices. 
• Homeownership is desireable = Increased bank debt and indebtedness is desireable 

If the situation were such that normal people could purchase their homes without paying 3 times what they were worth in combined principal and interest, then ‘home ownership’ might be good and could actually be defined as what it should mean. As it stands, very few people are homeowners, while many more are home borrowers.

Investor. Redefined as Trader 

What most people consider to be ‘investing’ is in fact ‘trading’. This is because the financial sector primarily exists to make money off of price movements in the values of assets. Therefore, most of what is considered investing is actually trading on the values of assets in the hope of a financial gain. And, for most people, the actors in this drama in fact are forced to operate as little more than traders in order to merely retain the value of people’s ‘investments’. So, redefining common expressions:

• Investment Advisor = Person consulted by someone who wants to figure out the most advantageous way to trade their money to make the most gain. Investment advisors are often financial engineers, meaning they use pseudo-science to try and predict how to trade their client’s money. 
• Portfolio Diversification = Trading in a variety of ways so as to limit the downside of exposure to trading losses. In the worst case, trading mechanisms that have absolutely no reason to exist outside of the financial world, such as naked short selling, betting on failure (derivatives), hedging, etc, are used to try and confuse the issue and make trading gains in any possible manner. 
• Sound Investment Advice = Advising clients to put their money in trading mechanisms that offer the best short-term probability of going up, irregardless of the benefit to society of such trading. 

Trading is not inherently bad, and in fact most advisors are bound by their fiduciary duty to do their best to make their clients money. However, in most cases, the only way to do this is to hitch their wagon to larger and larger trading organizations (ie, Wall Street Banks, hedge funds, etc) in order to get whatever gains are to be gotten out of the financial system. So, to understand that investing = trading is to understand that when you hand over money to an investment advisor, financial engineer, or other financial professional you are in fact feeding the casino of so called investments that is destroying the economy.

Ensuring access to credit. Redefined as Allowing Society to Live Beyond its Means 

Policymakers and politicians justified the great bailouts of the economic crisis because they feared a collapse in the availability of credit. From individuals to businesses to governments, we live in the age of credits. In a modern society, availability of credit means almost everything:

• Individuals and families believe they cannot obtain autos, homes, or an education without resorting to credit. 
• Businesses rely on credit to operate, to grow, to develop new products, and to capitalize everything, from equipment to real estate. 
• Governments rely on credit to finance their operations. 

Credit is linked to investment, because many investments underlying assets consist of principal and interest on credit that is due to be repaid. While credit may serve a good purpose as the only means to fuel growth, the growth of credit and, later, derivatives (means of hedging against credit losses ) over time has replaced ‘real’ industry as the substance of a larger and larger part of the economy. Credit has therefore become a large part of the economy, which is obviously unsustainable, Therefore, the term ‘ensuring access to credit’ merely refers to keeping this economic illusion going a little longer. 

Globalization. Redefined as Reducing Labor Value
Like credit, globalization is also a tenet of modern economic thinking and policy. Globalization refers to the ability of businesses to locate parts of their enterprise anywhere in the world they can. Globalization is made possible by information flow, transportation, and better automation, and is motivated by corporate profit motives, by emerging economies desire to expand quickly, and by a desire to bring many parts of the world to a higher standard of living. The net effect of globalization, however, is to reduce the value of labor of most kinds, therefore it is inherently equalization (or deflationary) depending on the society.

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When Owing Money Means Nothing and Speculating is Everything

How Quantitative Easing Is Destroying the Economy, and We Are the Enablers

Radio ads can be a good barometer of the true state of mind of a populace.  This is especially true today.  “The big banks got their bailout”, says one.  “You can get yours”.  “You have the right to have your debts settled for pennies on the dollar”, says another.  Others proclaim “Rebuild your 401K”.  “These days, you must be a smart investor”.  “Buy and hold is dead”.   These ads now occupy perhaps 25% of the radio and television airtime in certain markets.  They are a very visible sign of a trend – that owing money means nothing in our society today, and speculation is everything.

Before we examine the ramifications of this, we must check our politics at the door.  Both left and right will find reasons to be offended and reasons to cheer what is discussed here. The destruction of the economy is not a typical left vs right issue, though politics certainly plays its part.  Rather, by following misguided ideals and belief systems, policymakers and populations of all stripes are causing a feedback loop (or unstable system) that is destroying the economy. This feedback loop is simple to diagram.  It looks like this:

The economy is being sucked into a black hole

Three groups are shown:  (1) The government and central banks (who are considered one for this discussion and who are largely unable to separate themselves from one another in the minds of the populace anyway), (2) individuals and businesses (the real economy of goods and services, or ‘Main Street’), and (3) credit giving institutions (primarily large investment banks, or ‘Wall Street’).  The straight arrows between groups represent the principal behaviour or obligation of the group to other groups.  Red arrows and bubbles represent decrease, green represents increase.  The curved green arrows represent self-reinforcing trends, or ‘inner loops’.
  

Setting the Stage. Maturing economies such as the US, Western Europe, and Japan, have transitioned from manufacturing and production to services. Emphasis has shifted towards consumer goods, real estate, and financial products and away from manufacturing.    Labor earnings have become flattened. Globalization, information flow, and population demographics have increased this trend, as emerging economies have embraced manufacturing for both their own needs and those of the developed economies.  As capital has flowed away from real economic activity toward services, the financial economy and emerging economies, a situation of over-indebtedness at all levels of mature economies has developed.  This is the giant debt bubble that policy makers are trying to keep inflated.  These trends have been evident for perhaps 20 years, and they set the stage for the current unstable feedback loop we are experiencing.  The cause and effect relationships causing the feedback loop are characterized by the following, all of which can be easily derived from the diagram:

1)      Easing Reduces Authority.  Governments and central banks have universally used low interest rates, money printing, bond sales, etc. to respond to over indebtedness, following a set of economic theories that they hold dear.  They use this money to give low interest loans on favourable terms to banks in the hopes banks will lend. But, as easy terms are extended to banks, government’s authority and legitimacy goes down.  This is because the populace (especially debtors) observe the government giving breaks to the banks and demand the same breaks for themselves.  They want their home loans modified.  They default, sometimes intentionally, on their credit cards. They choose bankruptcy.  They consider credit repayment unimportant. Owing money means nothing.  Governments and banks attempt to counter this, through stigmatizing non-repayment and placing too much emphasis on concepts such as ones ‘credit score’.  But the trend remains, and grows worse. Since the economy and businesses are made up of individuals making individual choices, this erosion of authority matters very much in the performance of the economy. Economists call this ‘moral hazard’, and may decry it, but few observe its very real negative effect on the economy.

2)      Speculating Replaces Credit. As economic conditions worsen and authority goes down and credit repayment goes down banks balance sheets worsen.  Banks respond by turning to ways to generate money that do not involve businesses or individuals (speculating in markets).  They also make less credit available. After all, who will loan money when owing money means nothing? Instead, they speculate.   Increased speculating is marked by the repeated blowing and deflating of asset bubbles, such as house prices, energy, and equities, as speculative money flows back and forth between asset classes.  It gives the illusion of economic activity, but it is not.

3)      Main Street Joins the Party. Some parts of the real economy may start speculating in order to try and join the party.  They do this through their ‘investments’, most of which are merely speculation on the movement of asset prices.  Even governments join the speculation through such mechanisms as retiree pension plans.  Speculation becomes the only game in town.  The financial component of the economy becomes bloated. Systems used to enable dearly held societal institutions, such as ‘home ownership’ and ‘retirement plans’ are set up to benefit speculation.  Speculation becomes an accepted norm in society as a part of a ‘financial plan’.  Individuals and businesses willingly give more and more of their money to the speculators, not wanting to miss out.  This also makes it very difficult to unwind speculation because doing so would impact parts of the real economy that are now entangled with speculators.

4)      Banks Turn to Influence Peddling. As repayment goes down and banks derive less and less of their money from credit extended to individuals and businesses, they turn to influence peddling to enable themselves to gain more ability to speculate and stay afloat and to game regulation to work in their favor.  This causes government authority to erode even further, as the populace comes to believe their government is ‘run by bankers’. 

5)      Taxes Drop.  As credit availability goes down and economic conditions worsen and government authority worsens, tax revenues to the government go down.  This is both due to declining business conditions and to tax avoidance.  After all, if the government has no legitimacy, why should one be obligated to pay taxes to it? Again, moral hazard affects the real economy.  Taxes on gains from speculation are unable to make up the difference, due to influence peddling by banks to gain tax-preferential treatment. 

6)      Main Street Turns to Subsistence. Businesses and individuals turn to subsistence behaviours such as saving, cutting expenses, etc.  These behaviours may be beneficial, but often the populace is forced into situations where subsistence becomes very difficult, marked by high unemployment, downward pressure on wages, and rising costs for essentials like food, shelter, medical care, and energy. This, in turn, lowers credit demand even further, forcing banks to speculate and more and more of the economy to become speculators. Businesses and individuals curtail risk and innovation, preferring a protective, muddle-through stance, which drops their tax revenues, and reduces their hiring.  ‘Zombie’ organizations become the norm.

7)      Government Increases Fiscal Risk and the Cycle Repeats. As tax revenues worsen, governments turn increasingly to fiscally risky behaviour, like foreign deficits, bank credit guarantees, and money printing. In other words, they do more easing. Under the current ideals and belief systems, money generated this way is largely turned over to the banks for use in speculation.  Some makes its way into the real economy as stimulus and relief, but by a large margin, it goes to the speculators, because policy makers are following belief systems that ignore the negative feedback loop.  This in turn drives the government authority down further, because the populace has enough information sources at its disposal to derive what is going on.  Economists are fond of making arguments as to why government money printing is OK, however, their arguments cannot account for the real economic effect of the erosion of authority and negative feedback loop that this causes.

The destabilizing feedback loop that is destroying the economy is evident.  The more governments respond to economic distress by easing monetary terms to banks, the worse the economic situation gets, and the more they cause the real economy to either turn to subsistence behaviours or to increased speculation.  Owing money means nothing. Speculation becomes everything. More and more money will accumulate in the speculative inner loop, and more and more parts of the economy will become entrapped in this loop. Speculators will survive for a while but the real economy worsens and becomes entrapped in the subsistence inner loop, where they may remain, even for a generation or more, as opportunity evaporates.

These trends seem destined to increase until (1) the populace tires of being forced into the Faustian choice of either subsistence or speculating, and revolts or (2) the speculation becomes unsustainable causing a massive, uncontrolled unwind.  Both conditions seem to be rapidly approaching, portending some truly frightening consequences.  This may happen soon, or it may take years.  But we are definitely moving toward some very unhappy outcomes. Unfortunately, due to the amount of erosion of authority that the government has brought upon itself, the government’s efforts to intervene will be less and less meaningful to the populace.  More of the populace will slide into subsistence or turn to speculation, not realizing that by joining the speculators they are enabling the very banks they blame for the problem and reinforcing the feedback loop that is destroying their economy. The only mechanism that could possibly reverse the feedback loop are:

1)      Government would have to re-establish authority and the notion that owing money does indeed mean something.  This could only be done by establishing this first for the banks – ie – reversing the bailouts, credit guarantees, favourable credit terms, etc. that have been granted in the name of the ‘emergency’ credit crisis.  Bank’s assets would need to be reckoned truthfully, instead of allowing them to make overly rosy assumptions that serve only to allow them to keep speculating. Since this would probably cause some part of the financial system to fail, so this could only be done by having alternative mechanisms of credit made available to the real economy while the cancer of the big banks is cut out and its entanglement with the real economy unwound.

2)      Individuals and businesses would have to realize that by willingly joining the speculation, they are in fact reinforcing the cycle that is destroying the economy.  They would have to rediscover the meaning of the term ‘investment’ and start investing their money in things that benefit the real economy rather than just joining speculators.  Innovation, not speculation. Notions like ‘timing the market’, ‘inverse positions’, diversification’, ‘managed risk’, etc,  would have to be reckoned for what they really are – non-value added speculation.  A new class of ‘economically responsible’ investment behaviour would have to emerge.  Thus starved of their fuel, the speculative large banks would die or shrink into institutions that benefitted society.

3)      Main Street would have to embrace new forms of economic activity. Deteriorating economic situations are marked by poverty in the midst of plenty.  This is where we are headed.  But the populace still has economic resources, in the form of labor, innovation, and capital.  These resources must be harnessed towards building new systems, new ideas, new economies.  Once we take it back from the speculators, we can put it to work.  We can connect with one another to rebuild what misguided behaviour has destroyed.

So there we have it.  Owing money means nothing and speculation is everything, which is a predictable outcome of the behaviour of governments, banks, and the real economy.  As long these trends continue, the feedback loop will ensure we remain in a worsening economic situation, which easing behaviours by governments will only make worse.  And, as long as the real economy sees fit to join the speculators, they will continue to willingly participate in their own economic destruction.  Every individual has choices to make.  They can choose to force their government to re-establish authority, which is clearly the right course.  They can choose to put their politics aside, roll up their sleeves, and do what is right to rebuild their economy. These are the easy choices, but the moral choices are more difficult. Each must choose whether to join the speculators or not. And each must choose whether their debt obligations are meaningful or not.  These are choices that are not easy to make, for they cross moral and financial welfare boundaries, and fundamentally affect livelihood. 

Economy Mindmap

This mindmap attempts to show a view of the 3 levels of the economy, and how the planet and financial institutions at various level interact with it. It will be periodically updated.

Economy Mindmap

Labor Shock - RealEconomy,org

Labor Shock and Its Role in the Economic Crisis

Commuters on their way to work in Bangalore's Electronic City

Bangalore, India, April 2009: Everyday Hosur Road feeds thousands of workers into Bangalore’s Hi-Tech Electronic City. Beside the roadway the ‘music of the streets’ is almost deafening; the drone of a 2-stroke 3 wheeled taxis is punctuated by incessant horn-beeping as workers pour into the city. It has an almost pleasant quality, it’s evocative of an India that combines the aggressive desire for modern growth and international stature with a people who have learned to live with whatever life deals them. It is a study in contrasts, magical and a little bizarre, where high-technology and poverty drive alongside one another on the way to work.

Phoenix, Arizona, U.S.A. April, 2009: Back in Phoenix, Arizona, we see a different picture; among the palm trees on the west side of town, the local strip malls surrounding one of the once-busy avionics engineering plants display 'For Lease' signs as does the once-busy avionics plant itself. The plant’s parking lot, once full of SUV’s and shiny new Honda Accords owned by legions of engineers, now sits empty. This plant location closed a couple of years ago, after many of its functions were moved to facilities in Bangalore, the Czech Republic and elsewhere. These high-tech jobs helped fuel Phoenix’s meteoric real estate appreciation in the bubble years, but recent events have been more unkind. Phoenix and Bangalore are poster children for this economic force we’re calling ‘Labor Shock’. This shock is happening because millions of new workers are arriving onto the world labor market, changing the relationship between supply and demand of labor, and drastically changing the societies on each side of that equation. Population, education, free flow of information, goods, and capital have all combined to intensify and accelerate the effects of the leveling of wages rates around the world.

The Economic Crisis Was Caused by Reduced Labor Income

This article argues that the bursting credit bubble is not the core reason for the advanced economies’ sudden reduction in spending. The credit bubble delayed that reduction, but can no longer prevent it. Rather, we assert that 1) the advanced economies are experiencing labor shock as they fail to adequately adjust to the changes in labor supply and demand, 2) that this shock is causing a severe wage income reduction in the developed economies, and 3) that the result of reduced income has been reduced demand from the West that is not being taken up in emerging markets, and therefore 4) that the reduction in developed economy labor income precipitated the credit collapse and is the fundamental cause of the current severe recession.

Global I.T. industry wages and supply 2006 - 2010 according to IBM Global Services Division

Global labor supply from export-oriented economies skyrocketed from 1980 - 2005

Shipping volume doubled in twenty years. Imagine what the information flow and financial transaction flow numbers look like!

In just twenty years, automation halved the number of workers required to manufacture a product in the U.S.

The Growth of Cheap Labor

Over the past few decades, the emerging economies have been furiously developing their labor forces in order to participate competitively in the world economy. Their efforts have paid off. The chart to the right (produced by IBM’s Global I.T. Services division in 2006) shows the enormous increase in I.T. workers in India and China and the huge disparity in wages between their wages and those of workers in the developed economies. To get a better picture of how effectively the emerging nations have targeted their labor development efforts, see the graph (supplied by the International Monetary Fund) that shows the growth of the labor supply that’s weighted (directed) toward exports. These emerging economies have done a magnificent job of aiming their strategic advantage (low labor cost) directly at the industries and labor categories in the advanced world which offer the greatest export earnings potential.

All that was needed was to increase the logistical capacity between the emerging and advanced economies, and the global income would come pouring in. The graph to the right, showing the doubling of sea-borne trade over the past twenty years, gives an index of how much the trade flows have increased.

The New Workforce is Highly Skilled

The skill level of the LDC worker has been growing very rapidly. In Bangalore, the engineers we visited are experts in their field. They run their software development organization at CMM Level 5, which is “world-class” by the standards of the Software Engineering Institute. These engineers are critical thinkers, challenging every assertion and filtering it through their knowledge and expertise. India has long had sophisticated defense and infrastructure capabilities, easily seen in such impressive facilities as the Indian Ministry of Information Technology building in Electronic City, which seems to sport more communications antennas than the Pentagon. India’s skill sets have not just come from free flow of information from the west. Considering their high skill level, the cost of labor here in India and from the other LDCs is a bargain. No wonder Western companies are flocking here to set up their software development operations.

Labor Shock: Not Only a Result of Increased Supply

Technology trends are also contributing significantly to the labor shock. Take a look at the Manufacturing Output per Labor Hour chart to the right. This chart shows that it takes only half as much labor to manufacture something in the United States as it did just twenty years ago. Half as many people! And that very same advanced manufacturing technology is being exported to China and the rest of the LDCs as fast as possible. What does that mean for future labor-demand growth? Technology is moving us toward the negation of the need for human labor across all industries and locations. More and more products and services can be generated without any increase in labor.

Enter the Platform Enterprise

In leveraging globalization, technology has also changed the structure and function of organizations. We now have an entirely new breed of world-wide economic actor: the “platform enterprise”. The Platform Enterprise is designed to leverage comparative advantage, to perform design, development, and manufacturing in the locale that’s best suited to deliver maximum value for each function across the entire supply chain from raw materials to finished product. A typical product development cycle might have the design and management team in one country, with engineering resources in another, lower cost location. Data can be shared worldwide, 24-7. When it comes time to manufacture, corporations today have raw resources such as steel, copper, or silicon wafers shipped from Africa or S. America to another part of the world to be molded, cut, or stamped. Foundries in Taiwan turn out chips that go into electronics built in Korea, Europe, the US, or anywhere else. The finished products are made available worldwide. The new platform enterprise exists to maximize their profits by arbitraging between global sources of material and labor. These platform companies accelerate the rate of labor shock by maximizing the speed and efficiency of flow between the global input suppliers.

Capitalism Responds To Globalization

Electronic City covers a vast 10-mile-square swath of Bangalore. Visitors are directed through the bewildering maze of streets by placards that list countless Indian firms and multinational giants. WIPRO, for example, is one of India's I.T. leaders. Passing its huge complex one can see the firm’s private fleet of busses which daily brings in workers. Electronic City has a 75,000 strong workforce that’s transformed itself into a world-class technology powerhouse. In the past decade, the IT and engineering skills concentrated here have become a part of a trend, whereby labor cost is a driving force in structuring businesses for maximum profitability. Simply put, if a region offers a competitive advantage, there’s a platform enterprise that will market that advantage to the rest of the world.

The realities of business in the 21st century have made this inevitable. When a business can reduce cost and increase margin, shareholders approve as profits increase. Investors allocate their capital where it can generate the highest returns. Today’s market trading technology and a hyperactive investment climate demands that capital allocations follow short-term results, and are not influenced by the effects of these investments upon the welfare of the workers in any particular region.

Labor Incomes Fall, Advanced Economies Contract

So the bottom line rules today’s global markets, and as the biggest expense for most companies is labor, the labor pool bears the brunt of cost cutting. Just because cheaper labor or the automated platform enterprise is available does not mean businesses have to use it. Businesses must make the choice to use this potential. However, in the business environment we have experienced the past few years, many have been forced to use this potential to stay afloat, and naturally, have responded with a vengeance. The increase in global trade patterns shows the extent to which non-raw materials have comprised an increasing percentage of trade. We have shifted to the platform enterprise, but the shift has had huge unintended consequences.

The term platform enterprise may excite Wall Street with dreams of ever-greater profits, but back in Phoenix, it has meant something completely different. Engineering jobs began to move offshore in the city’s avionics plants around the late 1990s. At first, the trend helped companies meet a constant demand for engineers. A few Indian engineers even began showing up in Phoenix from Bangalore, courtesy of H1B visas. Technical information flowed both ways. But gradually, as the aviation industry peaked, and times changed. Hiring freezes were put in place. New cost targets we established for software development which practically dictated that manpower could only be applied from offshore to stay within budget. Rates dropped in the local contract engineering community. Several rounds of layoffs in the past few years predated the current economic crisis. Now, as the economic storm has arrived in full force, the winds in Phoenix have been among the most severe. Hundreds if not thousands of qualified aviation engineers in the area now look for work alongside everyone else. A 10% across-the-board pay cut was recently announced at one company, and all contract engineers were let go on the same day. The collapse of the real estate bubble in Phoenix has been extreme, so that Phoenix leads the nation in home price depreciation and foreclosures. The effect of the Labor shock is stark and undeniable.

The Adjustment Process

The labor shift has been evident for over a decade now. It’s clear that the shift is good for Bangalore, but it’s hurting the people of Phoenix. Let’s take a look at what happens when a job is moved from an advanced to an emerging economy. The advanced economy must create not just a new job, but a new industry. If it makes sense to move one I.T. job to Bangalore, why not a million jobs? And that’s just what happens: a whole industry gets moved.

Jobs were moved from manufacturing to credit-bubble industries like retail, home construction and hospitality. Look at the anemic job growth in I.T. - the sector that was supposed to drive job formation for decades. Not!

Let’s take a look at how the U.S. coped with the loss of manufacturing and then I.T. jobs over the past decade. The table to the right shows the job losses in manufacturing, the anemic job growth in I.T., and the moderate job growth in health care, state and local government, home construction, finance and real estate, the hospitality industry, and retail. The only bright spot was the modest increase in technical service jobs. Health care is arguably consumption, state and local governments are consumption, and the finance, real estate, home construction, hospitality, and retail industries are substantially dependent upon credit, which has crashed. Because labor income is falling, consumption across the board is, and will continue to fall. The advanced economies have not generated new, defensible, wealth-producing industries at the same pace that their mainstays are moving to lower-input-cost regions of the world.

Won’t the Emerging Economies Make Up the Demand?

So as the advanced societies struggle to adapt, what of the LDCs who are gaining the jobs? Won’t their consumption increase to offset the demand drop in advanced economies? Economists, almost to a man, pin their hopes on increasing demand from LDCs. Look to the east, we are told, for they will lead us out of the downturn. This may happen, but it will not happen fast. To answer why, we can again return to the streets of Bangalore.

We discussed the challenges facing India today with an engineering manager for an avionics outsource company. He manages several dozen employees, the equivalent of a senior manager in a US company. He is proud of his Maruti hatchback, a small subcompact equivalent to a Chevrolet Aveo. Most of his engineers ride scooters and motorcycles, as they are much more affordable and bettter suited to commuting than cars. Average Indians (as opposed to Mumbai’s jet set as depicted in ‘Slumdog Millionaire’) are not prone to western style debt levels, so will consume only what they can afford. And this is much less than their advanced-economy counterparts.

Another factor limiting India’s consumption is the infrastructure. In many instances, the streets are relics of the distant past, with few signals, dirt patches, potholes and a wide array of obstacles such as pedestrians, bicycles, vegetable carts, and of course cows. India has the desire to put more automobiles on its roads, but the reality is they will struggle to do this. Another limiting factor is energy. Rolling blackouts plague Bangalore, including Electronic City, its economic flagship. India has nowhere near the power generation capacity required for its vast population. India simply can’t consume anywhere near the pace of an advanced economy; the infrastructure can’t deliver the necessary inputs. It’s going to be several decades before the developing economies can supply enough demand to compensate for the falling demand from the West.

Meeting the Challenge

The falling incomes in the advanced economies that result from Labor Shock pose serious challenges. While supply and demand imbalances have existed before, the scale and rapidity of the phenomena is daunting, and may well be unprecedented. Never before has it been possible for man’s labor to be so mobile and so sensitive to global wage and cost structures. The inevitable result of this would appear to be extreme deflationary pressure on wages, with severe ripple effects across the advanced economies, and coupling effects into the developing economies.

At some point in the future, global labor prices will reach near-parity. But the process of equalization is going to be painful. The question in many people’s minds is no longer “what’s happening”. Many of us have rejected the idea that turning on the credit spigot is the answer. We’re looking at incomes, specifically incomes from labor, and alternatives to labor income for those that made their living selling labor into this increasingly globalized market.

Alternative strategies for workers and affected businesses are not only possible, they are probable and are needed now. Look at what the emerging economies have accomplished in just the past twenty years. Why can’t the advanced economies develop and promulgate new industries, just as the emerging economies did?

There is certainly a big difference between moving some jobs between locales and creating a brand new industry. But that is the task that confronts the advanced economies: to create new industries faster than they’re being lost to wage arbitrage and automation. So far, we’re losing the race, and that is the fundamental reason that we’re in a recession.

Change From the Bottom

It is highly unlikely that the innovation and entrepreneurship that creates industries can come top-down. This is why Washington and Wall Street, and the investor-class in general can’t solve what ails the advanced economies. At RealEconomy.Org, we think the solution will come from the bottom up, and will take the form of massive peer-to-peer collaboration directed toward business formation and entrepreneurship.

This article was a collaboration from RealEconomy and authored/edited by contributors there including ex VRWC

Baby Boomer Generation - RealEconomy.org

Baby Boomer Generation


A Generational Tide Has Crested

The baby Boomer economic tide is going out. Boomers have been a major economic force for the past half a century. This population surge, composed of the 78.2 million Americans born between 1946 and 1964 has virtual control over the U.S. economy, which currently accounts for almost 25 percent of worldwide gross product. Beginning after the Second World War, the generations that followed have transformed the economic landscape of the world. Spawned with a keen desire for education, growth, and opportunity, the Boomer generation rebuilt the world, and brought it into the twenty first century. It was always understood that this generation would mark a high tide someday. What has become clear in the past few years is that this high tide was artificially made higher by a credit boom and bubble cycles. And this tide is now going out with a vengeance. This fact – the baby boomers bust cycle - will be a dominant economic factor for the next several years.

After Unimaginable Tragedy – Boundless Growth

Most people agree that the Boomer generation has been an economic force since they were conceived at the end of the most devastating half-century of war in history. This was the generation of American opportunity, an expansive time buoyed by the Marshall Plan and the ascendancy of a U.S. flush with victory and eager for expansion. With much of Europe and Asia devastated by war and only one industrial power left standing, this was a uniquely favorable moment for the U.S. in world history.

The Boomers were the first generation in American history to have significant numbers college-educated, with many advanced degrees fueled by programs like the G.I. Bill. As the first generation to have such access to education, the Boomers invented and expanded the boundaries of everything. They also bought what they wanted with their increased earning power and when that wasn’t adequate, they borrowed, especially in recent years. Boomers felt they had no boundaries and they changed the world in ways unimagined by previous generations.

A Generation of Expansionist Monetary Policy

The economic and financial landscape of the Boomer generation was a Keynesian one, wherein interest rates were quite effectively manipulated to produce high employment rates and consistent growth. Savings became passe; everyone knew that the inflation rate exceeded the interest rate on a savings account! The tax subsidies to investment, begun under the Reagan administration, quickly changed how people “saved” for the future. Responding to government policy, Boomers shifted from savers to investors. 'Savings' became at-risk investments in the stock market. This was a strategic and fundamental shift, and it propelled world economies forward for a few decades after the flush of post-world-war growth abated.

As Boomers headed into their peak earnings years, they poured money into 401(k)’s and mutual funds and bigger and better housing . Housing was was an “investment” too – all done in hopes of “selling high, and retiring someday”. Investment became less about long term growth and more about “leverage”. Leveraging someone else’s savings to overcome shortfalls of one's own.. In the past decade, Boomers ran pell-mell into the leverage game, until the bottom dropped out. Real incomes stopped growing, and Boomers couldn't borrow to cover the difference between what they earned and what they spent. The fundamental assumption that growth could continue indefinitely was now under serious challenge.

Buying Power Implodes

The end of an uptrend is never as clear or easy as its beginning, and this is true of the Boomer generation as well. In the case of the Boomers, the attempts to continue the upward trend have clearly led to our current bubble economy. But bubbles are always unsustainable, and the massive contraction in spending that happened when the debt bubble finally began deflating has been devastating. We have seen a crash in home prices, asset price volatility, a secular bear market, and deleveraging on a massive scale. For many it has shaken their entire economic foundation, and many people are realizing that their dreams of retirement have vanished - they may not be able to retire, ever! Boomers have lost a large percentage their on-paper wealth. Many have lost over 50% of home values and 40% of portfolio values.

Why Buying Power Collapsed

Before we examine the effect of the Boomer’s plight, let’s make sure we’re not exaggerating it. In June of 2008, the McKinsey Global Institute published a report before anyone realized the extent of the housing slump and before the stock market crashed. Boomers were already in serious trouble. By June 2008 less than a third of Boomers had enough savings or equity to even contemplate retirement. Since then things have gotten much worse.

Another, more recent report which corroborates and updates the McKinsey report was released in February 2009 by the Center for Economic Policy Research. This report presents the Boomers' financial situation in early 2009 and projects that situation into the coming decades. This research shows most Boomers don't have enough savings to even contemplate retirement, and that only about ten percent have adequate resources to maintain their current lifestyles into retirement. Many retirees will live well below the standard of living they enjoyed while working. Over half will only have social security to live on.

The result of this huge loss was an immediate demand retrenchment. Take a look at the recent contraction in spending. This is a graph sourced from CalculatedRisk Blog, depicting the annual change in retail sales over the past 15 years.

Surely someone will say “but that contraction is due to global sentiment. The Boomers are a U.S. phenomenon”. Surely you’ve heard of the concept of “coupling”? By that expression, we mean the close-coupling of global economies, and the unfortunate reality is that the U.S. consumer provided most of the demand for export products from around the world, so long as the Ponzi-Economy Myth remained un-contested.

Now the Boomers’ wealth-effect consumption has stopped, cold. The world economy may well take decades to recover from the sudden removal of this demand. Whatever the effect of the Ponzi-collapse on the world economy, the effect on the Boomers themselves has been shattering. For many it has shaken their entire economic foundation, and many people are realizing that their dreams of retirement have vanished - they may not be able to retire, ever!

The Future of the Boomers – the Bust Generation

No matter what happens in the economy, Boomers will need to live and will have the political influence to impel other generations into supporting them, in some way or another. Boomers are aging, and that means they'll need ever increasing health care. This is an interesting paradox for Boomers and the entire country. The common assumption is that aging Boomers will cause the health care system to expand and there will be lots of money to be made. The reality is that Boomers may drive up the demand but have few resources to pay for all this demand. Where is the money going to come from, especially when governments are already running huge deficits that will have to be repaid by the younger generations? How can the advanced economies governments take on ever more entitlements in a time of decreasing tax revenues and spiraling deficits. Something will have to give, and it will.

Many Boomers are relying on pensions and government Social Security programs. They face longer life spans, but this also comes with increased costs in later life. They will be collecting, not contributing. And why shouldn’t they – they built the economy and they feel they deserve to bask in their twilight. Unfortunately, the economic realities are very different from the way it should be.

The Boomer’s demand has been severely curtailed, much earlier than many of them expected. With 401K’s and home equity gone, with pensions suspect and Social Security a ticking time bomb, Boomers are cutting back. A natural part of aging – the desire to simplify, has been brought front and center into the Boomer’s consciousness. They realize their jeopardy and they are reacting. The transformation is not an unnatural one. Aging people naturally want less and less to take care of. Less yard work, less responsibility, fewer consumer goods, less gadgets, more simplified lives. This is a normal part of aging for most people. We have seen it happen in all generations as they age. Retirement villages will grow or families will go back to multi generational configurations like in past generations and in many other countries.

What Does It Mean for the Economy of Tomorrow?

The trend for the Boomer’s economic tide is clear – it’s going out. The trend of the underlying economic math is also clear – it doesn’t work. When economists build their projections for future growth assuming trendlines will move as they have in the past, they risk missing this important generational wave. The Boomer bubble will not be reflated; our nation's current economic policies are pushing on a string. The assumptions of economists and policy makers will almost certainly prove to be too optimistic. As in other things that need ‘fixing’ in the global ecomony, the fixes will have to come, bottom up, from the next generation and from Boomers working from a new foundation with an entirely new set of assumptions. The future is not going to look or act like the recent past because the Boomers are now bust. Now we must deal with the consequences.

This article was a collaboration from RealEconomy and authored/edited by contributors there including ex VRWC

Free Flow Of Information - RealEconomy.org

Information Flow is Changing the Economic Landscape

The Internet has radically changed the availability and cost of information. The Internet isn't just moving advanced technology across town, or across the nation. It's moving it from one nation to another, from areas of high concentration of technology to areas of low concentration. It is leveling the playing field.

This revolution of information access is at least as important as the other major revolutions, such as the Industrial Revolution of the late 19th century. The graph below shows the exponential growth in access to information via the Internet:

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It's an Economic Earthquake

Free flow information isn't simply a technological change. It represents a fundamental and massive economic force. The economy cannot remain static in the presence of such a powerful shift. The strategies that will work in tomorrow’s economy must take this revolution into account. They must recognize the effects and harness the power of this force in order to be successful.

What is the economic impact of free flow of information? How does it affect today’s business climate? How does it affect your job? What should be our national policy on information flow in the years ahead? Let's explore these questions in detail.

The Economic Impact of Free Flowing Information

Let's examine how the flows of information have changed in the past 15 years. Think of outsourced software development, and global supply-chain management, and online patent databases, open-source software projects, and Wikipedia. Think about AliBaba, the web-based global marketplace for manufactured items. Everyone has nearly equal access to the latest technological information, regardless of which society created that knowledge. This has produced a sudden and accelerating shift in the relative capabilities of whole nations, and has moved entire economies away from certain kinds of economic activity and toward others. Manufacturing has moved to emerging economies. Technical skill has followed via the outsourcing boom. If manufacturing know-how and technical know-how has flowed around the world, can other forms of know-how be far behind?

In addition to changing the worldwide competitive-advantage landscape, the Internet has clearly transformed many areas of our society, such as media, entertainment, commerce, and the retail shopping experience. The presence of a mechanism to quickly comparison shop prices and get the lowest one, or even to conduct online auctions has meant a huge shift toward online shopping, at the expense of local retailers and, of course, jobs. But the elimination of retail and other service sector jobs has not been the only result of the internet explosion. The internet has also had a fundamental impact on other forms of employment as well.

Leveling World Wage-Rates

Most studies place the percentage of workers that are classified as knowledge workers anywhere from 30-50% of the workforce in the most service-oriented economies, such as the UK and US economy. A knowledge worker is one whose contributions depend on the development and synthesis of ideas. While knowledge work has expanded and is expected continue expanding, knowledge workers in the developed world are facing fierce price competition from the places where the information is now more freely flowing. This isn't your ordinary price competition, though. A software engineer’s salary in an emerging market can be 10% of the salary in a developed country. In other words, an engineer in India may make $7,000, while his U.S. counterpart expects to make $70,000. In a globalized economy, who will win this price war?

Opening the Floodgates – Open versus Closed Intellectual Property (IP)

On a recent trip to an aerospace museum in Tucson, Arizona, I was standing in front of a Kaman HOK-1 Twin Rotor helicopter when I met a man with an interesting story to tell. As I studied the design of the helicopter and commented on it, the retired engineer standing next to me told me what really impressed him about Kaman. It wasn’t their helicopters, it was their bearings. He told me the story of his days designing landing gear for companies such as Boeing, and how no company could match the Kaman self-lubricating bearing products. Nobody knew what was inside, and for the longest time, Kaman would not even file a patent on their technology, because that would mean they would have to disclose how they did it. Kaman shut others out of their market for years and successfully deployed their bearings on many aircraft platforms. (http://www.kaman.com/history/history_p.html) Kaman’s approach to information flow was simple – trust no one because then no one can duplicate what you do.

In today’s economic landscape, Kaman’s approach to IP protection and business building is a relic from the past. Today’s corporate strategy is usually built around a different set of criteria. Instead of building basic technology and creating a product line around it, today’s corporations add value to technology they buy. They may develop a market by integrating hardware, and software and meeting an end user need. Instead of technology differentiation, what is more important is time-to-market, head-to-head price competition, and being in the right place at the right time. What becomes deemphasized is the traditional model of building a product line from company owned technology and owning the market because your engineering and know-how is fundamentally just better. One clear culprit in this changing landscape is the free flow of information.

Open development. Open Source. Open Access. Open Architecture. Open Standards. The Open movement has elicited fundamental changes in the way information is shared, especially in the technology industry. The growth of open source software projects, for instance, has been exponential in the past decade. What is interesting is to compare the graph below to the growth of the internet. Clearly, the more information flows, the more collaboration between people occurs. This is very evident in the open source world.

Source: The Total Growth of Open Source Amit Deshpande and Dirk Riehle Proceedings of the Fourth Conference on Open Source Systems (OSS 2008). Springer Verlag, 2008. Page 197-209.

While it can be difficult to assess the impact of open source on, say, overall software employment levels in the US, it suffices to point out that, overall, open source tends to move the software talent pool away from fundamental technology development and toward a value-add support model instead.

While the software industry has been significantly impacted by the free-flow of information, the domain of computer circuit design has proven much more resistant to this free information flow. So called IP cores (blocks of hardware logic) have been a fixture of the hardware design industry for some time, they are much harder to use in an open development process. In the hardware arena, the notion of selling IP (in the form of IP cores, Application Specific Integrated Circuits (ASICs) and silicon chips) is much more developed. A well known example of IP reuse illustrates this point. Consider the the graphics engine first introduced to the world via the Sega Dreamcast.

Sega’s Dreamcast game console has been called many things, but a roaring commercial success is not among the terms commonly used. However, the PowerVR 3D graphics engine found in the Dreamcast has had an illustrious history. Eventually taken over by silicon IP vendor Imagination Technologies, the PowerVR IP now powers most mobile 3D applications on cellular phones, including Apple’s phenomenally successful iPhone. In this case, the same IP resulted in two very divergent commercial products, but the technology's creators were able to retain control, and benefited from the investment in basic technology that they created.

Whether for hardware or software, openness is here to stay. Are business models that stress value add, support, agile development, time to market, and customization the wave of the future? Will we lose our capacity for innovative development in basic technology because no one wants to risk capital developing a technology that everyone can use for free? The mechanisms by which innovation is grown, nurtured, and eventually turned into commercial success are key to tomorrow’s economy. How should we prepare ourselves to compete in a world where everyone's got equal access to information?

Innovation – Relic of a By-Gone Era?

Not long ago, I had lunch with the CEO of the company where I work. He's in regular contact with the venture capital (VC) community, and during our conversation the subject turned to the current climate for VCs in Silicon Valley. The picture he painted was pretty dark. “Nobody is investing in tech right now. They are all in safe investments with known returns, such as real-estate”. His message was clear – we better be prepared to live – and innovate- off of operating revenues if we were to survive. Funds to grow and innovate were going to be scarce for quite some time.

Venture capital is not the only means by which innovation occurs in advanced economy. Innovation has always been what drives advanced economies such as the US forward. On a recent visit to China, I had this pointed out to me. The Chinese, it seems, have a view of America that many Americans themselves no longer seem to believe in. They see America as a shining city on the hill - of technology and innovation. A conversation with my Chinese host was eye-opening. "We need to work with Americans to get the high tech. We are not so strong in this", she said. "In China, we have many engineers, but not so many who now how to build the whole system, to design it".

So, if innovation is the basis of advanced economies strength, but innovation funding is being cut in a risk averse capital environment, where will futire innovation come from especially in the era of free-flow of information? There is no easy answers, but there are some helpful ideas. There are other avenues for innovation funding to take place, such as the U.S. Governments Small Business Innovative Research (or SBIR) program, whereby the U.S. Government conducts targeted research via small businesses to help it solve problems in many areas, especially military technology, and supports commercialization of the developed technology. But relying on government will not be enough. Instead, the new global economy needs a bottom-up approach to nurturing innovation and creating viable businesses incorporating it.

Bottom-Up Transformation and the Information-Enabled Globe

Clearly, we need to adjust to new economic reality. Forces such as the free flow of information are fundamentally changing the economic landscape in ways we are only beginning to understand. The current top-down mechanisms being tried by governments and central banks to restore the economy of yesterday cannot address the long term changes being wrought by these underlying economic forces. Advanced economies are being hollowed out. Their capacity for leadership and growth is being whittled away, while too much treasure, too many resources, and valuable brainpower is being allocated to areas of the economy that may be prifitable but do not further the collective good. The global challenges are great. We can no longer afford to let the situation deteriorate. We need to somehow turn the tables – to harness free flow of information to remake the economy of tomorrow. It will take a bottom-up approach and free-flow of information can be an ally in this endeavor.

How do we do that? We get everyone involved in innovation. We use that free flow of information to equip ourselves to innovate and especially to collaborate. We take innovation to the next level, and we apply it to world-wide problems.

Raising the Level of the Level

Free flow of information is the great income leveller. But it does not have to mean we all are dragged down. Freely flowing information could and should function as an upward leveller. As more knowledge is distributed to more places, the information will begin to elevate areas of the world where future demand must come from. Information can expand knowledge to allow more minds to meet the challenges we all globally face. What must we do? We must learn to better collaborate and exchange information with real problems in mind. Rather than building hundreds of businesses whose goal is to make a cheaper cell phone or different ways to loan money, how about hundreds of businesses whose goal is to make smarter use of agricultural resources? How about smart technology for tomorrow’s farms, or tomorrow’s energy grid? How about low-cost delivery of medical information, in the language it is needed, at the right level, where is it needed? All of these things can be beneficiaries of free flow of information, if we only put it to good use. This is how this massive economic force, the free-flow of information, can be used to create a better world.

This article was a collaboration from RealEconomy and authored/edited by contributors there including ex VRWC

The Great Credit Shaft

listen and I hear commmentator after commentator say 'we need a healthy banking system' and 'we need liquidity' in order to justify channeling all bailout money through megabanks. I observe the politicians worldwide now trying to build support for their next giveaway to the banks in the name of 'keeping the credit system healthy'. It seems that the only way for a business or a consumer to benefit from all this stimulus is to take on more debt. Then it hit me (I know I am slow). The government wants all money to funnel through the credit system because that has become its chief mechanism for attempting to control the economy. Simply put, the government wants to keep you in debt so it can benefit itself and its favored ones, and so it can prevent (or try to prevent) politically unpopular natural economic cycles. And now, in the hour of greatest need, governments can see no further than to continue this system, even while the consequences of its failure ravage economies worldwide.

This of course sets up another of the great dramas of this age, that of the retrenching, credit averse consumer/business versus the governments and bankers, who are intent on preserving their credit-based economic control mechanisms at all costs. When you, the consumer or business CFO, refuse to take on more debt, you deal another blow to this pernicious system because you lessen their control and refuse to play the game. This of course is bad for them, because they are piling every chip in the house on restarting the credit engine, and keeping the Great Credit Shaft going.

Obviously, then, we are witnessing the government not acting in the best interests of its citizens by their continuance this Great Credit Shaft. How do we collectively fight back? An Idea I have championed before here is that we start to explore alternative means of investing and borrowing money. For instance, there is a potential for the formation of loose economic cooperatives based on people banding together with a common economic purpose. The money now 'invested' in the equity markets in 401K's, or in US Government instruments, for instance, could just as well be invested in your local community. Why invest it in the government who will only dole it back out to you on usury terms through the megabanks it uses as its tools? Why invest it in the equities markets that benefit mega corporations that drain wealth from the local communities and who will lay off thousands at the drop of a hat to preserve their bottom line and maintain their unsustainable growth? Why not instead have a local bank or credit union where we all invest in our local communities and businesses? Why not build things through networks of small businesses, banded together in ways that can attain great things?

Let's reinvent the economy with a localized, realistic focus by voting with our remaining money. Let’s check out of the debt and credit machine that is draining our lifeblood. Let’s find ways to unite as communities with our dollars as well as with our hearts and minds and our work. This is the way we fight back, by breaking free. It will have better consequenses than tax revolt or other kinds of unrest. It can be done, and we can start doing it today.

On Financial Engineering

I spend a lot of time listening to what I will term as 'financial engineers'. As a practicing engineer, I find the field fascinating. But something always bothers me about what I hear. I hear so many terms that sound virtuous or impressive. Financial engineers use terms like 'invest', and 'managing risk'. They speak of disciplines they follow, like 'Fibonacci retracement', 'point and figure', 'value at risk' and other financial prediction systems. Notwithstanding the fact that these financial engineers are ofter spectacularly wrong, there is a deeper, more fundamental objection that nags at me as I hear them talk. And that objection is that financial engineers are not engineers at all. They are not building or creating anything of value to society. Simply put, their 'discipline' is of little more value to society that a 'discipline' to win at a craps or blackjack table by gaming the system to play the odds. It may make money for some, but it serves society poorly. And we, as individuals and as a society, have placed our financial welfare entirely too much in their hands. How did we get there?

Good Investment

Consider a simple financial system consisting of you and I. I could loan money to you in order to help you gain a return. I could charge you interest, or I could help you establish an enterprise and share in its profits. In each case, the investment is designed to allow growth to occur that otherwise could not absent the investment. But, in this simple system, there is no possible context for me to gain when you or your enterprise fails. I can loan you money, but I cannot 'short' you in any real world context. There is also no notion of a 'trader', who gains when my investment in you does better than I expect. This system can be scaled up. A system of organized credit and equity markets is possible by scaling this simple idea. Some financial innovations made in the past few decades were quite beneficial.

There is much to be said for the systems that allow small investors to pool their money in order to provide capital to large enterprises. This is at the core of mutual funds, for instance. Mutual funds, as originally concieved by financial engineers, gave investors the means to invest their money in the equities and bonds of several corporations. The original intent was to allow investors to participate in the growth of corporations. This was a beneficial goal, because it fostered collective economic growth, and allowed returns generated by large enterprises to be shared. Similarly, a system of credit is also beneficial, when it is used to foster growth that could not otherwise be attained, or to enable the acquisition of valuable posessions, such as homes, that cannot realistically be acquired through savings.

The Growth of Investment as a 'Discipline'

Somewhere along the way, however, the systems of investment and credit designed by financial engineers morphed. The pursuit of the best returns and the best gains on investors money trumped the original goal of investors sharing in growth. Financial engineers became traders. Even todays so called financial 'professionals', in many cases, merely follow trading disciplines. Innovations like short selling, hedging, market timing, and buying and selling disciplines grew as financial engineers began to find more and more ways to attempt to gain returns. The goal of financial engineers, which was to make the best return for their investors, crossed a line, and became blind to the interests of society. Due to blind pursuit of returns, what began as a beneficial way to pool capital became 'the market', and the ones charged with managing 'investment' in the market morphed into nothing more than casino gamblers following a system to make money. In a similar fashion, the goal of credit also morphed. Instead of being used as a beneficial tool of society, credit became a way to live beyond ones means - to circumvent hard financial choices and discipline. And the two systems (markets and credit) became intertwined, and began to feed off of one another in a blind, upward spiral.

You might object. After all, what is wrong with seeking the best returns? Or with getting what you want without waiting? What could be wrong with 'managing money' in an attempt to provide a secure retirement, or money for your kid's college? Isn't it just being a wise investor? What is wrong is that the financial system as it works today is the wrong means to these ends. For many, it may help these goals be met, but collectively, in its current form, it cannot meet the goals for everyone. There will inevitably be those for whom the system fails, or who will be left out. And the system will not serve the overall interests of society at all. Because, fundamentally, a society must be about more than just money. But our financial system is only about money. The financial system does not react to the true economy. Rather it drives the economy.

Misallocation

An investment system that seeks only returns will inevitably result in a misallocation of capital. This is because the best returns will by nature be found in the areas where growth is strongest. Take real estate, for instance. If real estate is on the upswing, more money will be allocated to real estate by the financial system in blind pursuit of returns. This will be true even if real estate investment is not needed. Once the needs of an economy for housing, commercial buildings, and so forth are met, excess capital will merely drive prices upwards, resulting in bubbles. Over the past 20-30 years, financial engineers and the blind pursuit of returns have blown up bubble after bubble, inventing more and more ways to make money. These bubbles have occupied overly large segments of the economy, obscuring what in reality was a deteriorating fundamental picture. This has corresponded with so called 'financial democratization' or the advent of increased ability to 'trade' rather than invest long term by most players in the financial system.

Goind hand in hand with this bubble creation by the investment system was the credit system, which was used to provide the funds needed to keep a cycle going and the bubbles blowing. Easy credit made it possible for bubbles to grow well past the point where the growth was necessary or beneficial to society. But the use of credit is a two edged sword. It cuts going up and going down. As a result of this increased leverage made possible by credit, the system must rely upon ever increasing asset valuations, or constant growth, to survive. Not only constant growth, but exponential growth is necessary, because the system as it grows favors non productive activities in many cases, including the growth of the financial industry itself. And when the system, so highly leveraged, begins a natural decline, the deleveraging of credit on the way down is as powerful as was the growth on the way up. Except far more destructive.

Collapse and Lessons for Tomorrow

Now we are observing the apparent end of this system built by financial engineers. The engineers at the top (central banks and governments worldwide, advised by economists) are attempting to manipulate the system with more and more innovation to somehow escape the inevitable conclusion - the system has failed. The system has failed because it was flawed at its core. It was based on a false assumption - that moneymaking alone could be the basis for the system. It was flawed at its core because it relied upon leverage and credit, which requires constant growth, and a constant beneficial operating environment. The system was not built to withstand adversity, or so called 'Black Swan' events that perturb it. And, as the system struggles, the financial engineers tell now tell us that 'buy and hold is dead'. And that 'active portfolio management' is now needed to enable you to 'meet your financial goals' especially in a down market. They are proposing to continue the failed sytem, and to make it even more prone to capital misallocation and eventual failure. This time, however, the game is up. There is no more capacity in the system for continuation. As the credit that enabled the blind upward spiral defaults, the downward spiral is only accelerating. Like engineers that build a faulty bridge that eventually collapses, our financial engineers have built a financial system that has now failed and is collapsing before our eyes.

The changes that will be wrought by the collapse of the system built by today's financial engineers will be great. The world of tomorrow in many ways will be fundamentally changed. The financial engineers of tomorrow must learn from the mistakes of those of today. We must go back to basics, and build a new system while avoiding the cardinal sins of the old. We must build means of capital allocation that benefit society. Somehow, we as a society must cross this threshhold. We cannot base financial engineering solely on financial gain. Somehow financial engineers must figure out how society can employ credit wisely. The lessons we will all be forced to learn in the next few years will be very expensive and painful ones. But the financial systems of tomorrow and our society will be better for it. This, at least, is a dim and distant silver lining.