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Innovation, What Made America Great is

Now Killing Her!


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Economics / US Economy Aug 13, 2010 - 06:43 AM

By: Gordon_T_Long

"Creative Destruction is Secular not Cyclical" - What made America great was her
unsurpassed ability to innovate.  Equally important was also her ability to rapidly
adapt to the change that this innovation fostered. For decades the combination has
been a self reinforcing growth dynamic with innovation offering a continuously
improving standard of living and higher corporate productivity levels, which the US
quickly embraced and adapted to. This in turn financed further innovation. No
country in the world could match the American culture that flourished on technology
advancements in all areas of human endeavor. However, something serious and major has
changed across America.  Daily, more and more are becoming acutely aware of this, but few
grasp exactly what it is.  It is called Creative Destruction. 

It turns out that what made America great is now killing her!
Our political leaders are presently addressing what they perceive as an intractable cyclical
recovery problem when in fact it is a structural problem that is secular in nature. Like generals
fighting the last war with outdated perceptions, we face a new and daunting challenge. A
challenge that needs to be addressed with the urgency and scope of a Marshall plan that saved
Europe from the ravages of a different type of destruction. We need a modern US centric
Marshall plan focused on growth, but orders of magnitude larger than the one in the 1940’s. A
plan even more brash than Kennedy’s plan in the 60’s to put a man of the moon by the end of the
decade. America needs to again think and act boldly. First however, we need to see the enemy.
As the great philosopher Pogo said: “I saw the enemy and it was I”.

THE  PROBLEM IS NOT CYCLICAL, IT IS SECULAR.

The dotcom bubble ushered in a change in America that is still reverberating through the nation
and around the globe. The Internet unleashed productivity opportunities of unprecedented
proportions in addition to new business models, new ways of doing business and completely new
and never before realized markets.  Ten years ago there was no such position as a Web Master;
having a home PC was primarily for doing word processing and creating spreadsheets; Apple
made MACs; and ordering on-line was a quaint experiment for risk takers.  The changes in ten
short years are so broad based that a whole article would be required to even frame the
magnitude of the changes. What needs to be understood is that this is precisely what is
destroying America. Let me explain.
The process of Creative Destruction is the essential fact of capitalism. It is what capitalism
consists in and what every capitalist concern must survive within. America as the birth place of
modern capitalism was rooted in a clear understanding of this process and the indisputable reality
of survival of the fittest. 

“CREATIVE DESTRUCTION: … the competition from the new commodity, the new
technology, the new source of supply, the new type of organization – competition which
commands a decisive cost or quality advantage and which strikes not at the margins of the profits
and the outputs of the existing firms but at their foundations and their very lives”.
Joseph A. Schumpeter 
From Capitalism, Socialism and Democracy (New York: Harper, 1975) [orig. pub. 1942], pp.
82-85:

In 1997 prior to the ‘go-go’ Dotcom era unfolding, America’s unemployment was less than half
of what it is today at 4.7%.  At that time the US added 3 Million net jobs which reflected the
creation of 33.4 Million new positions while obsolescing or cutting 30.4 Million old  positions.
Job losses occurred in old vocations such as typists, secretaries, filing clerks, switchboard
operators etc.  Hired were new occupations such as C++ programmers, web masters, database
managers, network analysts etc. 
As the chart above illustrates however, the additions have fallen off precipitously while the job
losses have stayed relatively flat. In 2009 job losses were 31.0M and only slightly larger than
1997 which would be expected with further internet application development. New job creation
however was only 24.7M which is dramatically lower than the 33.4 in 1997.

The result is 40.8M people on food stamps in the US, as seen to the right.   

This net creative destruction chart incidentally reflects closely the US economic output gap.
Employment levels at 58.5% are now near 30 year lows and do not show any signs of significant
improvement. This is despite nearly $13T in artificial stimulus to restart an economy that appears
to refuse to restart or unarguably is minimally a ‘jobless recovery’.

Once again Tyler Durden and the folks at Zero Hedge did an excellent analysis of the July
unemployment numbers by correctly adjusting for shifts in workforce participation. It is
surprising that no one other than Zero Hedge understands how to properly assess the monthly
labor rate. Their analysis, using government BLS numbers, is shown below and reflects an
unemployment rate of 14.7% adjusted for workforce participation.
Is it any wonder Christina Romer as head of Obama’s Council of Economic Advisors resigned
the day before the July Non-Farm Payroll numbers were released, when she once again would
have had to spin and justify the unemployment rate to the media?

ITS STRUCTURAL, NOT THE FAMILIAR CYCLICAL BUSINESS CYCLE

All the preceding graphics have been labeled with a December 1999 vertical bar. In every
instance it shows a major cusp occurring near that point in time. The dotcom market bubble
finally popped 3-4 months later. There are anomalies that create some distortions after this
period, such as the explosion in both the residential and commercial real estate sectors that
temporarily fostered massive hiring from brokers, agents, contractors, trades personnel,
developers, etc. Much of this has subsequently been pulled back. 

WHAT HAPPENED?

The short answer is the US is no longer innovating


fast enough. Innovation needs to sustain its
exponential growth to absorb the creative
destruction job losses.  It no longer can.
Mathematicians would have argued some time ago
this was a certainty to happen, but precisely when
this would occur however was the unknown.

We have been cutting Research and Development


expenditures in the US dramatically. I warned of
this in Feb 2010 in my article: America, Innovate or
Die! It has only gotten worse since.  Corporations
may be reflecting minor cuts on their balance sheets
in this area but it obscures the fact that the money is increasingly being re-allocated and spent
offshore. Jobs and innovation follow R&D.

The Financial Times in the UK featured this global analysis which to the best of my knowledge
never saw the light of day in any US publication. The rate of growth in research papers in the US
is not keeping up.

Total researcher share is shrinking and falling further behind as the chart below demonstrates.

Even more alarming is the number of US patents being filed. Other than IBM and Microsoft the
numbers are stunningly small. It needs to be fully appreciated that both IBM and Microsoft now
have large numbers of major world class research facilities outside the US and the US filings
numbers below are likely reflecting this (see America, Innovate or Die!).
“The numbers of engineering graduates in China and India far outpace that of the United States.
In China, it is 600,000; in India, 350,000; in the United States, 70,000, and many of these are
foreign students who, more likely than not, will be returning to their home countries.”
Senator Edward Kennedy  -- 10-25-05 
 Testimony - Senate Record

Let me relate a personal story if I may. In the early 90’s I was a Vice President of Engineering
for a S&P 500 corporation in Massachusetts. This engineering facility in Massachusetts
consisted of over 900 engineers supporting an enterprise with 28 facilities and over 10,000
employees. Today it is all gone. The towns in the immediate area of this enterprise also had
major facilities of two other S&P 500 corporations. They are also both gone. There were
companies in Massachusetts at that time by the name of DEC, Data General, Prime, Wang to
name but four, that employed hundreds of thousands of highly skilled personnel. They are
likewise gone. So where are the jobs to replace them?
Communities in this area now reflect those who have temporarily found jobs as a result of the
over building of retail stores and malls during the last ten years in almost every available piece of
land that could conceivably be built on. I walked into yet another Home Depot and found one of
my former employees working in the electrical department who happened in the ‘90s to be one
of the world’s best power supply design engineers. He told me there was one other with him
from his old department. Both as I recall had Master’s degrees in electrical engineering.

The new technology in the area is now Bio-Tech. These new Bio-Technology corporations
however only employ in the 5 and 10 thousand range of employees. Not the 100s of thousands
that the four corporations I mentioned above once did.  These Bio-Tech players additionally have
an extremely high percentage of Master’s and PhD level employees. What about the high school
and/or college grads?  Few need apply. I personally see this demographic lined up for Dunkin
Donuts application forms each morning while relaxing after my morning jog. More also out of
work PhDs due to reduced teaching positions is not the solution. This is the state of affairs in
R&D that our politicians don’t see nor fully comprehend.

IS IT GOING TO CHANGE?

I told you the above personal story as a way of leading into one of my primary goals in the early
90s as VP of Engineering of this particular operation. It was something called Cycle Time
reduction. This is the process of shortening the time to market of products from concept to
revenue generation. The chart to the right shows a graphical representation of this.

We were so successful at reducing this through computerization such as the implementation of


CAAD-CAM-CIM, JIT, Kanban, TQM and a host of other acronyms that we were at levels
approaching 80% of the following years revenue being forecasted to be derived from products
still on the engineering concept boards. Margins and room for error were absolutely razor thin.
The strategy was like the old three legged race at the community picnic. The faster some tried to
run the more they tripped themselves up. It was a strategy where speeding up the process left
unprepared competitors with a fatal competitive disadvantage. The fight for market share was
intense. Though I had moved on, when the internet arrived and supply chain management was
reinvented and overlayed onto the previous advancements, the enterprise was rapidly shuttered
and moved to the far east. It is one, of no doubt, thousands of similar stories in America.
America’s ability to innovate and adjust to that innovation killed this American based
organizational unit. The highly skilled, intense and motivated employees innovated themselves
out of a job.

THE LESSON IS THIS

America used the rate of innovation as a foundation for its competitive advantage. Like the
tortoise and hare however, the US can no longer maintain this rate and hence the advantage has
temporarily shifted to the previous followers who are presently less impacted. America must
once again innovate and change but now in a manner more fitting for the realities of this new
decade.  

The product today is no longer the widget that comes off a manufacturing line and is stuffed into
a box to be shipped to distribution centers for sale. The product today with short product life
cycles and hundreds of new products is Intellectual Capital. Intellectual Capital is the knowledge
of knowing how to do something. How to design and build something – not the actual ‘doing of
it’. Until America forces corporations to account for Intellectual Property properly, the multi-
nationals will continue to fully exploit this tax loophole. Even worse, America’s innovation will
continue to be used against her. The cost of manufactured products today are less and less in
labor & production and increasingly in materials and innovation. Capital is likewise shifting to
be more intellectual versus financial. A major overhaul of accounting standards must be driven
by our legislators or it will not be changed. It is not to the multi-nationals advantage to allow
such a debate and shift to occur.

Unfortunately our law makers allowed this American asset to leave the US unrestricted, untaxed
and without recourse. It was America who knew how to design and build a PC. It is fine for the
product to be built where it is cheapest as part of free trade, but only when the cost of the
knowledge or Intellectual property is priced in. Amortization of research & development must
include the Intellectual property value as well. The Intellectual Capital was an American asset,
not a corporate asset which left. Massive royalties should now be flowing to the US taxpayer
today which would offset many state and local services cuts. Instead we are left with
underfunded corporate legacy pension plans that the government in the years to come will no
doubt pick up the tab for by likely hyperinflating the currency. Though it is too late to revisit the
horrendous US failure of public policy in the past, it is not too late to prepare for tomorrow.

A STARTING POINT FOR CHANGE – Gordon’s Top Ten

As I said in the beginning the US needs a bold new “Marshall” plan to fight the new destruction
of creative destruction. Here is a starting point for public debate:

1 – If we can spend $165B bailing out AIG, then we can spend $100B (4 years of college @
50K/year X 500,000 students) and guarantee everyone in America a college education to
compete in the 21st century. Parents will start to spend immediately instead of presently being
almost financially paralyzed with skyrocketing education costs.

2- Obama says we need to be leaders in Energy. OK. Where are the programs? Where are the
50,000 new university teaching and research positions ( 50,000 X 75K = $3.8B)? At $3.8B this
is a rounding error compared to the banks TARP program.

3- 99% of all jobs in America are created by small business with less than 500 employees. Stop
treating them like they are last on the ‘to help’ list after the banks, financial institutions and S&P
500 but first on the taxation list. S&P 500 paid almost net zero taxes, have reduced US hiring,
yet received the bulk of the governments bailouts. Small business is the golden goose that every
administration seems determine to cook. What has the government done for small business other
than burden them with Obamacare and the potential removal of the Bush tax cuts (most small
business are directly impacted proprietorships)? If you can’t immediately recite what the
government has done to help small business as THE US employer (versus what they have done
for the bank and financial lobby), then you understand the problem.

4- The number of Government


employees, in addition to their
salaries and benefits (federal, state
& local) can best be described as
out of control. According to a new
study from the Heritage
Foundation, U.S. government
workers earn 30 to 40 percent
more money than their private
sector counterparts on average. So,
in essence, the ‘servants’ make
substantially more money than the
taxpayers who employ them. Isn’t
the system great? In fact,
according to the study, if you add
in retirement and health care
benefits, the average federal employee now earns nearly twice as much as the average private
sector employee.

5- Make Social Security and Medicare financially sound so Americas can believe and budget that
it will be there for them. The public will spend and invest if they know they have a nest egg that
really exists. The government is fooling no one. Kids learn that Social Security and Medicare is
unfunded before their college freshman year today.

The stark reality of the shift from defined benefits to contributory benefits over the last decade is
just now sinking in with the US consumer. They now have no retirement like their parents had.
Retirement savings is something when added to college costs is leaving them frightened.
Worried people don't spend money and when the economy is 70% consumer spending you have
an economic crisis.  Political denial and the government attempting to paper it over with policies
of extend and pretend are misplaced and will make the inevitability even more difficult to
effectively address.

6- When did the American people decide to fund military operations in over 130 countries
around the world? With 40.8M people on food stamps, something is seriously out of balance
here but there is no public debate thought to be required by either party.

7- The US has no full scale strategic growth programs being initiated by the present
administration. We have only financial stimulus or austerity programs. There is a big difference
that seems wasted on Washington.

8- Washington and the lobbyists that control it have taken control of our government. Obama
campaigned to stop earmarks which ranged in the area of approximately 10,000 annually prior to
his presidency. In his first year they increased to the 11,000 range. This is not the change he
promised as more pork increasingly flows.

9- For those that actually read it, Obamacare is not a solution for healthcare. It is a stealth income
tax we will all soon get hit with. The Dodd-Frank Act is not a fix to what caused the 2008
financial crisis but rather is the most dramatic shift in centralized US government planning and
control since the 1930’s. Both these bills were over 2000 pages compared to landmark bills
historically being 25 – 45 pages. Indications are that few of our elected representatives actually
read either of these documents. They simply voted party lines. As Sarbanes-Oxley dictates,
CEOs must sign their corporate 10-Q reports to the government and are liable for it. It is a felony
not to. Every elected official should also sign that he or she has personally read the entire act
prior to being allowed to vote on it or it likewise will be a felony.

10- The Supreme Court recently over-turned major elements of the Campaign Contribution
Reform bill. Washington and the media have now gone completely mute on this subject as
politicians scramble for mid-term campaign money for media expense coverage. Maybe our
elected officials should vote with the same urgency on this matter as they are presently on giving
billions of ‘candy’ away almost daily to every financial disruption, state budget problem,
unemployment benefit problem or sign of increasing housing default and foreclosure rates during
this run up to the fall elections.
I could go on, but I think you get the message. America is afraid to be bold! We have no
strategy, no plan, no funding and no leadership! In my days as a VP of Engineering you were
fired for just one of these shortfalls.

Maybe we the public need to start doing some firing!

“The biggest political change in my lifetime is that Americans no longer assume that their
children will have it better than they did. This is a huge break with the past, with assumptions
and traditions that shaped us.”
Peggy Noonan: America Is at Risk of Boiling Over - WSJ.com
Feature Wall Street Journal Op-Ed Article – 08-07-10

For the complete research report go to: Tipping Points

Sign Up for the next release in the Preserve & Protect series:  Commentary

Gordon T Long   gtlong@comcast.net   Web: Tipping Points


Mr. Long is a former executive with IBM & Motorola, a principle in a high tech start-up and
founder of a private Venture Capital fund. He is presently involved in Private Equity Placements
Internationally in addition to proprietary trading that involves the development & application of
Chaos Theory and Mandelbrot Generator algorithms.

Gordon T Long is not a registered advisor and does not give investment advice. His comments
are an expression of opinion only and should not be construed in any manner whatsoever as
recommendations to buy or sell a stock, option, future, bond, commodity or any other financial
instrument at any time. While he believes his statements to be true, they always depend on the
reliability of his own credible sources. Of course, he recommends that you consult with a
qualified investment advisor, one licensed by appropriate regulatory agencies in your legal
jurisdiction, before making any investment decisions, and barring that, we encourage you
confirm the facts on your own before making important investment commitments.

© Copyright 2010 Gordon T Long. The information herein was obtained from sources which Mr.
Long believes reliable, but he does not guarantee its accuracy. None of the information,
advertisements, website links, or any opinions expressed constitutes a solicitation of the purchase
or sale of any securities or commodities. Please note that Mr. Long may already have invested or
may from time to time invest in securities that are recommended or otherwise covered on this
website. Mr. Long does not intend to disclose the extent of any current holdings or future
transactions with respect to any particular security. You should consider this possibility before
investing in any security based upon statements and information contained in any report, post,
comment or recommendation you receive from him.

http://www.marketoracle.co.uk/Article21864.html

Why This Fall and Winter Could Get Ugly


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September 10 2009

Since March of this year, we have seen growing consensus and excitement from the mainstream
media and government about an economic recovery underway. Scattered economic indicators are
released and spun in a positive light when they are proportionally minuscule improvements
compared to the declines already experienced for each given indicator. They typically use this
sugarcoated data and ignore reality to say “the worst is behind us, yet perhaps we’ll still see a 10-
15% correction in the markets, and growth might be slow for quite awhile”. In under six months
from the low, the markets have rallied over 45%. Yet this type of market move up hasn’t been
seen since the lead-up to the crash of October, 1987.

It is extremely difficult to find a true bright spot in the economy that indicates improvement
enough to warrant such optimism. To begin, here is a brief update about the 4 key underlying
economic problems outlined within Arbitrary Vote’s original warning article:

1. Unprecedented, massive amounts of existing and coming national debt – U.S.


national debt has continued to increase and there is no sign of future debt letting up.
2. Foreign reluctance to fund U.S. debt – China, Russia, Brazil, etc continue to back away
from U.S. Treasurys, diversify into other investments, and make moves toward trade in
non-U.S. currency.
3. Declining productivity and indicators of poor future productivity – GDP has
continued to fall and unemployment has continued to rise. Recent political action, reform
currently on the table, and mounting taxation all point to future productivity damage.
4. Unprecedented, massive levels of money printing – The printing presses have been
running non-stop and there’s no real sign of them letting up. Much of the recovery hype
has stemmed from economic illusions caused by this temporary “fix”.

All of these factors have continued and mostly worsened since June. Each plays as significant a
role as ever in the near- and long-term direction of the economy.

The situation is worse than described by most mainstream sources, and because of developments
thus far this year and events unfolding in the near future, there are particular reasons to beware of
the months ahead.  A few communication sources are predicting stock market crashes and
corrections for the autumn of 2009, but rarely outline specifically what could be so dangerous
about this timing and potential big-picture implications.

A large segment of this analysis is devoted to outlining the near-term factors that could cause
serious economic and societal problems in the coming months. The outline of factors is broken
down as follows:

1. Current activities and conditions - Those activities and economic conditions that
continue to be underway and could lead to additional economic problems in the near-
term.
2. Scheduled near-term activities - Those activities that are scheduled to take place within
this autumn or winter and could lead to economic harm.
3. Uncertain near-term activities - Those activities that could happen within this autumn
or winter and could lead to economic harm.

After walking through the statistics and information under each of these three sections,
everything will be tied together to depict the overall impact on the economy.
Current Activities and Conditions

The following is an outline of activities and economic conditions that continue to be underway
and could lead to additional economic problems in the near-term.

Commercial real-estate

Many predict commercial real-estate to be the "next shoe to drop" in the economic crisis. We are
certainly seeing early signs that this is correct, and there is a lot more to come.

 Commercial real-estate mortgage maturities begin to ramp up in the 4th quarter of 2009.
There is an estimated $400 billion of commercial real-estate exposure for this year.
 So far this year, there have been defaults, foreclosure or bankruptcy on $83 billion of
office, retail, industrial and apartment properties. This number is expected to double by
the end of 2009. Lenders have foreclosed on less than 10 percent of defaulted loans.
 The Commercial Mortgage Backed Securities (CMBS) sector's delinquency rate was
3.14% in July, more than six times the level a year earlier.
 Banks hold $1.7 trillion of commercial mortgages and construction loans (different from
CMBS). Delinquencies on this debt already have contributed to the rise in bank failures
this year.
 Most of the $6.7 trillion in commercial real estate is privately owned
 Anecdotally, you can probably look around your neighborhood shopping centers, strips,
and malls and observe the difference in vacancy within recent months and over the past
year.

Residential real-estate

The subprime mortgage crash ignited the economic crisis. We are now faced with another
residential real-estate crisis just beginning to ramp up.

 The first significant wave of Alt-A and Option Adjustable Rate Mortgage (Option ARM)
resets are beginning, and there is $1.1 trillion to $2.6 trillion in estimated exposure over
the next couple of years. Exposure between these mortgage types and prime mortgages is
likely to be at least in the tens of billions over the next six months.
 As of August 20th, 13% of homeowners with a mortgage have fallen behind on their
payments or are in foreclosure.
 The portion of delinquent loans that return to current payment status each month (i.e. the
“cure rate”) is down to 4.3% from a 30.2% historical average for Alt-A, 6.6% from a
45% historical average for prime, and 5.3% from a 19.4% historical average for subprime
mortgages.
 California’s 90-day mortgage foreclosure moratorium expires in the middle of this
September. This will add to the rising tally of foreclosures.

Banking industry
Both commercial and residential real-estate problems will continue to build pressure on the
banking industry, which is already quite unhealthy.

 As of June 30th, there were 416 troubled banks (up from 305 in Q1) on the FDIC’s list;
Assets at troubled banks totaled $299.8 billion
 As of August 24th, banking analyst Richard Bove predicted 150-200 more bank failures
 As of August 21st, banking analyst Meredith Whitney predicted over 300 more bank
failures
 As of September 4th, a total of 89 banks had failed in 2009
 The FDIC reports that more than 1 in 4 banking institutions are unprofitable
 More than 150 publicly traded U.S. lenders own nonperforming loans that equal 5
percent or more of their holdings, a level that former regulators say can wipe out a bank’s
equity and threaten its survival.
 Large banks are under-capitalized unlike what the government has communicated:
o Bank of America – Loan value was $64.4 billion less than their balance sheet
indicated (58% of the bank’s Tier 1 common equity) as of June 30th
o Wells Fargo – Loan value was $34.3 billion less than their balance sheet indicated
(73% of the bank’s Tier 1 common equity) as of June 30th
 More foreclosures will likely surface now that the Making Home Affordable programs
are fully underway and all available options for modifications and other solutions are
exhausted.

As banks become more stressed because of growing problems in residential and commercial
real-estate, bank lending will become more restrained, but more importantly, bank failures will
become more likely. Depending on the size of the bank, the government will either offer a
bailout, nationalize the bank, or a combination of the two. Both do harm to the economy beyond
what would occur by allowing them to fail.

The next topic is about the state of the FDIC, which covers the government's potential route to
bank bailouts more clearly.

Federal Deposit Insurance Corporation (FDIC)

Government money is provided to replenish failed banks’ balance sheets and/or facilitate
acquisitions of these banks by healthier banks. Historically, the FDIC is the vehicle to do this,
although the government has recently used other means in addition to the FDIC.

The FDIC is an organization that was created to give citizens the comfort that their bank deposits
are safe and fully backed by the U.S. government.

Here is the current state of the FDIC:

 The FDIC's fund has dropped to 0.22 percent of insured deposits, below a
Congressionally mandated minimum of 1.15 percent.
 Falling from $45.2 billion in the second quarter of 2008 and $13 billion at the end of
March 2009, the fund is now at $10.4 billion.
 Excluding the stress-test list, banks with non-performers above 5 percent had combined
deposits of $193 billion, according to Bloomberg data. That is now almost 19 times the
size of the FDIC’s deposit insurance fund.
 Assets of the FDIC’s list of 416 troubled banks total 29 times the size of the fund.
 1% of all money deposited under $250k (i.e. the FDIC insured level) totals $700 billion
 The FDIC has a credit line with the U.S. Treasury of up to $500 billion if needed. This
money, and anything needed beyond it, is obviously printed.

State budgets

States pay the paychecks of their government’s employees, supply many vendors with contracted
business, and fund many programs that offer welfare and support to their citizens. Stress in state
governments’ budgets is stress on states’ economies.

 State tax revenues had declined almost 12% in the first 3 months of 2009. This is the
largest decline in the 46 years the data has been collected by the Nelson A. Rockefeller
Institute of Government.
 According to the Center on Budget and Policy Priorities, 48 states addressed or were
facing budget deficits totaling $166 billion as of July 2009.
 There are 28 states that have had budget shortfalls greater than $1 billion just before or
since their most recent budget was adopted.
 As of the end of this past July:
o 23 states have a budget gap over 0% and under 10% of the state’s general fund
o 14 states have a budget gap between 10% to 15% of the state’s general fund
o 7 states have a budget gap greater than 15% of the state’s general fund
 Because of budget shortfalls, some form of government shutdown is occurring in many
states including California, Michigan, Rhode Island, Maine, Maryland, Wisconsin,
Colorado, Alabama, Georgia, Arizona, etc.
 It is likely that California will revisit their budget woes in the near future. The state’s
government has continuously made poor judgments on expected revenue and
expenditures. Continued budget problems and current and future cuts will stress the
state’s economy as fewer state vendors will get paid, layoffs and furloughs will stress
citizens, and businesses will flee the state due to tax hikes and poor economic climate
compared to other parts of the U.S. and world. One recent significant example is Toyota
closing a major CA factory to move elsewhere.

Also, in late September, California will begin selling $10.5 billion of revenue anticipation notes
(RANs) to mature in the spring. The expectation is that investors will gobble up these notes
because of their competitive return. It may be worth observing the actual results. California is the
9th largest economy in the world and makes up 13% of U.S. GDP.

Retail and automotives

The retail and automotive sectors are vital to the U.S. economy. Below are recent statistics and
information about both industries.
 Sales at privately held retailers fell 3.63 percent on average for the first seven months of
2009
 Publicly traded retailers' sales fell at 1.34 percent on average for the first seven months of
2009
 U.S. Census Bureau calculated retail and food services sales are down 8.3% from July of
2008. Sales were down 0.1% in July alone and that includes the boost of sales from the
Cash for Clunkers program.
 Thompson Reuters reported a 5.1% July drop in retail sales based on a survey of 30
major retail chains.
 Retail professionals are predicting the worst back-to-school season in a decade. Back-to-
school season is the second largest retail season of the year behind Christmas.
 Citigroup analysts estimate same-store August to September sales to fall 3-4%.
 As a recent indicator of back-to-school sales potential, chain store sales were down 0.5%
for the August 29 week according to ICSC-Goldman reporting.
 The Michigan consumer sentiment poll continues to decline and is at its lowest level
since March. The conference board consumer confidence index shows confidence as
slightly up, but had little improvement in an already low measurement of income
expectations, which likely translates to light spending due to uncertainty.
 Major short-term retail financier, CIT Group, has closely avoided bankruptcy and is
likely to continue to struggle with liquidity issues as more of their lent debt is due to
mature next year. Retailers will have difficulty funding inventory and other operations
through borrowing as CIT and others in the space are feeling stress. This can be
exacerbated during the holiday retail season.
 Of the top 10 most sold car brands through the recent Cash for Clunkers program, two
were American car brands.
 Auto sales for August will likely come in quite high, but will likely see a strong drop-off
shortly thereafter as Cash for Clunkers was the short-term cause of the spike.

Slower near-term sales within the retail and automotive sectors can cause additional bankruptcies
in already pained industries. Another important sector to keep an eye on is the airline industry.
Although, the breaking point for many airlines is projected to be more around the spring of 2010.
Unemployment

Unemployment continues to rise and plague consumers. The unemployment situation is actually
worse  than that openly described by the mainstream media and government.

 The official Bureau of Labor Statistics (BLS) unemployment rate (U-3) is 9.7%, the
highest rate in 26 years.
 The BLS U-6 measure has unemployment at 16.8%. This measure includes those who
have given up looking for work, marginally attached workers, and those employed part-
time for economic reasons.
 The Shadow Government Statistics organization uses U-6 plus an estimate of those who
have not looked for work in over a year (defined away during the Clinton administration)
to calculate a current unemployment rate of 20.6% (using July as latest data).
 There are now 19 metropolitan areas with U-3 unemployment above 15%, the highest of
which is El Centro, California with 30.2% unemployment.
 Personal income is down approximately 11.5% since its peak in 2006 and 8.5% since the
beginning of the recession. Hours worked has fallen at a 7.6% annualized pace for the
last six quarters and a 9% pace since the first quarter of this year. Statistics like these act
as additional hidden unemployment.
 New jobless claims are still at 550k+ levels each week. The continuing claims tally
recently rose to 6.23 million. The key reason for recent occasional dips in continuing
claims is because of the number of people falling off of the government’s standard 26-
week benefits period and onto extended benefits, which are not classified as continuing
claims.
 The National Employment Law Project estimates that 540,000 Americans will exhaust
their unemployment insurance benefits by the end of this September, and 1.5 million will
run out of coverage by year end.
 This fall congress is likely to pass a bill aimed at offering various unemployment
insurance extensions through 2010. This would still leave large numbers of people with
extremely low, if any, income or ability to make purchases. Additionally, the money to
cover such extended programs will be coming from the federal government, which means
more printing.

Confidence

Confidence is an extremely important factor in maintaining political and economic stability.


Current trends are pointing to a broad decline in confidence.

 As we move into the autumn and winter months, there is risk of a dire realization by
Americans. People may begin to see that despite a few sugarcoated government statistics,
the build-up of bad statistics and painful firsthand experiences will reveal that things are
not actually getting better, government measures are not working, and the printing of
anymore money for bailouts will only cause further harm to the economy. This
realization and resulting loss of confidence among consumers and business is a key factor
in decisions around investing in U.S. stock markets and the U.S. dollar.
 President Obama’s job approval ratings have been declining at one of the fastest paces of
any American president at this point into their presidency. In additional to the trend
toward a crossover to the downside of approval and disapproval averages among polls,
one of the historically most accurate polls (i.e. Rassmusen) shows that the crossover has
already taken place. A continued decline in confidence in the president reflects declining
confidence in the government and economy.
 During Congress’ recess (through Labor Day) there have been many intense town hall
meetings and mounting protests around health care reform, taxes, and the government’s
general policy direction. It is apparent that people are growing upset with state of the
country and government.

Foreign diversification

Foreign movement away from dependence on the U.S. dollar and economy continues.

 Instances of cross-border trade historically transacted using the U.S. dollar are recently
being conducted through other currencies.
 China and Hong Kong covered more than half of the increase in U.S. Treasurys sold to
the public in 2006. In 2008, they covered 22%, and in the first half of 2009 the figure is
down to 9%.
 As of September 2nd, China had signed an agreement to purchase $50 billion of
International Monetary Fund (IMF) issued notes. This is the first time a purchase like this
has been made. This type of note has recently been promoted by China as an eventual
replacement for the U.S. dollar.
 Recently a top China banker called for sales of bonds denominated in Yuan rather than
U.S. dollars. A move to sell U.S. bonds denominated in other countries' currencies where
the U.S. has a trade deficit would currently require the printing of money, which would
result in the devaluation of the U.S. dollar.
 In August, Japan’s election was won by the Democratic Party of Japan, which is the
opposition to the party that has held office for the last 54 years. In May, the Democratic
Party of Japan stated that if elected they would continue to buy U.S. bonds only if they
were denominated in Yen.

Scheduled Near-term Activities

The following is an outline of activities that are scheduled to take place within this autumn or
winter and could lead to economic harm.

U.S. fiscal year-end

The U.S. fiscal year ends on September 30, 2009. This timing could have significance in a
couple of ways:
 The U.S. government financial statement for fiscal 2009 is due to be released in
December. The government's previous estimates and public’s expectations compared to
actual results of the financial state of the country could have significant impact on
confidence domestically and internationally.
 Treasury Auctions in July totaled $725 billion. Auctions in August totaled $782 billion.
September is likely to be another heavy auction month. The performance of Treasury
auctions during the autumn should be closely watched as the U.S. rolls over debt, adds
new debt, and moves into a new fiscal year’s budget.

Expiration of Fed programs

The Fed’s $1.75 trillion quantitative easing (QE) programs expire this October and December.
Up to $300 billion in Treasury purchases expire by the end of October. Up to $200 billion of
agency purchases and up to $1.25 trillion of mortgage back security agency purchases will expire
at the end of December 2009. The expiration of these programs could be a double-edged sword.
On one side, allowing them to expire could cause interest rates to move up significantly and
propped asset classes to fall. Extending these programs, or increasing their dollar values and
extending them, would send a damaging message that the economy is still in bad shape while
adding to future inflation risk.

New regulation

There are a few significant pieces of legislation moving through to vote this fall, all of which can
have an impact on the economy.

 The Obama administration’s push for dramatic health care reform is expected to
culminate in a vote on October 15th. Health care makes up about 17% of U.S. GDP.
Significant levels of business activity have been slowed or halted due to the uncertainty
of health care direction in the country. Also, depending on how quickly the ensuing
changes would occur, the economic impact from poor change decisions and inefficient
implementation could be harmful in the following months after passing.
 Ron Paul’s Fed audit bill is to be incorporated into broader financial legislation expected
to pass in October. Depending on how accurately the bill matches Ron Paul’s original
intentions, the opening of Fed books could reveal information of significant concern to
domestic and international investors.
 Treasury Secretary Tim Geithner recently requested that Congress increase the federal
debt ceiling. He said that the country is likely to reach its debt limit as soon as mid-
October. This is not likely to be a big issue to get through Congress, but if it becomes an
issue in the public eye at a time when the perception of a growing debt-load is quite
negative, investor confidence could be harmed.

Iran deadline

Depending on Iran's response, the September deadline for them to respond to demands of halting
its nuclear program could ignite domestic and international tensions contributing negatively to
the economy.
Uncertain Near-term Activities

The following is an outline of activities that could happen within this autumn or winter and could
lead to economic harm.

Oil price pressure

The price of oil has pushed $75 a barrel fluctuating between $60 and $75. If it breaks above $80,
the resulting increase in gas prices could have considerable impact on consumers' and business's
wallets

 Production is falling in Mexico, the U.S.’s third largest supplier. Pemex’s (Mexico’s
national oil company) output fell 7.1% in July, the fastest drop since 1942. Yields from
Mexico’s largest oil field, Cantarell, have been dropping by annualized rates of more than
35% in recent months.
 As of June, Saudi Arabia, the U.S.’s second largest supplier, cut its oil production by
nearly 16% from less than a year earlier.
 The count of U.S. oil rigs has fallen from above 2000 this time last year to below 1000.
While oil production in the U.S. is recently up, demand is rising again as well.
 Oil imports to China jumped 18% from July to August and China car sales rose 48% in
June from a year earlier.

All of these factors put pressure on the price of oil and are reasons for economic concern in the
coming months.

Interest rate pressure

The interest rate on the 10-year Treasury bond hit nearly 4% and has been fluctuating between
3.3% and 4% since late May. A strong move past 4% will cause additional stress on home
purchasers and mortgage companies. Further upward movement can cause stress for many other
sectors of the economy. A spike of 50 basis points or so in a single day could cause panic among
foreign and domestic investors.

Factors influencing interest rates in the near-term are:

 Massive levels of U.S. debt that continues to rise


 Foreign diversification out of U.S. Treasurys
 Expiration of Fed quantitative easing programs
 Potential fading confidence in U.S. Treasurys

Food price pressure

Weather problems (mostly droughts) last year and this year in major agricultural centers across
the globe are straining crops and their output. A few examples of trouble with food supplies are:
 California – (#1 in U.S. in crop production) Due to drought, government water
restrictions, and low demand from the crisis, 260,000 of the 600,000 acres that normally
grow tomatoes, lettuce and other crops have been removed from production this year.
 Texas – (#2 in U.S. in crop production) A severe drought in Texas has resulted in $3.6
billion of crop and livestock losses since November of ’08. As of August of 2009,
estimates say losses could surpass $4 billion by year-end.
 India – A weak monsoon has caused a rain shortfall of 8% and an expected shortfall of
15% for the quarter ending in September. About 60% of India’s crop land is dependent
on rain water as opposed to irrigation. Food grain shortages are expected in 2010.
 China – As of August, a severe drought in China has affected 11.3 million hectares of
grain crops making up 30% of China’s autumn grain output.
 Sugar - Raw sugar prices have risen the most in 28 years because of production shortfalls
in Brazil and India. Large U.S. food companies have been warning that the U.S. could
run out of sugar given the administration’s current import restrictions and rising sugar
prices.
 Soybeans – The U.S. got a late start to soybean planting this summer and pod-setting is
behind average by 7% (14-22% behind in key areas). The U.S. soybean stockpile is at a
32-year low and China has increased its soybean purchases by 70% in the last year.
Farmers are dreading the possibility of an early frost that would kill off significant
portions of the harvest.
 Wheat fungus – The Ug99 fungus poses a major threat to world wheat crops. It is
estimated that up to 80% of world wheat crops could be destroyed from this fungus and
19% (in Asia and Africa) are in imminent danger.

All of these existing problems and potential threats increase commodity prices and thus the price
of food for the consumer.

U.S. stock markets pressure

The U.S. stock markets can impact consumers' financial positions and confidence. Stock market
performance can also directly affect businesses.

 As of the latest compiled data, the trailing 12-month PE ratio for the S&P 500 is 129.19.
As of the end of August, the S&P 500 index’s PE ratio based on the average inflation-
adjusted earnings over the last 10 years (different from trailing PE, which is over the last
12 months) is 17.67. This is compared to a stock market average of 16.3 over the past 140
years according to a stock market database by Yale University’s Robert Shiller. Either
method of calculating PE ratios indicates that the stock market is significantly
overvalued.
 Recent futures prices indicated that the VIX, a gauge of expected stock swings, is likely
to increase significantly in the next several weeks. This indicates potential strong moves
in the market one way or the other. Given the market’s overvalued status, a move down is
the likely direction.
 Since the Dow Jones was created 115 years ago, the month of September has returned an
average of -1.2%, making it the worst performing month of the year with no other month
coming close. During September, the S&P 500 has returned an average of -1.3% since
1929 and it is the only month to fall 50% of the time. There are several studies and
theories that try to explain the reason for this phenomenon; however, there is no proof of
a cause. Nonetheless, the long-term historical data speaks for itself and offers reason for
caution moving into the autumn.
 Sales of company stock by company insiders has risen to 30.6 times the level of insider
stock purchases, the highest level since TrimTabs began tracking the data in 2004. This
could signal that the management of many businesses believe the stock market and their
own stock prices are overvalued.
 The Baltic Dry Index (BDI) has declined 44% over the last 3 months and 31% in the last
month. The BDI, based on worldwide shipping prices of raw materials, is closely traced
by the Dow Jones and FTSE 100 with the two indexes time-lagging behind the BDI - In
other words, the BDI points to an approaching decline in stock markets.

China credit bubble

Many report that there is a credit bubble forming in China from a $1.1 trillion (i.e. about 25% of
the country’s GDP) increase in lending in the first half of 2009 to compensate for their dramatic
decline in export demand. Commercial and residential real-estate in China is currently
overvalued, and manufacturing has over-expanded given the real lack of demand. A bursting of
this bubble would cause economic waves across the globe.

Swine flu

A top presidential panel is estimating that this autumn the swine flu could infect 30-50% of the
U.S. population. The panel projects 30,000 to 90,000 deaths and up to 1.8 million hospital visits.
The government has been flat wrong about statistics like these in the past; however, if we even
approach the low end of these levels, the economic impact will be quite harmful.

 Hospital resources will be strained by a spike in demand and recently downsized capacity
 State and local budgets will be strained
 People that are infected will be less likely to work or shop during the time they are
infected
 Many that are not sick will be less likely to participate in economic activity away from
home (e.g. shopping, dining out, etc) for fear of getting sick

Natural disaster

Natural disasters are unknown events that can negatively impact an economy, especially when
the economy is already in a fragile state. Hurricane season peaks in September and ends on
November 30th. Florida is one example of a state where the economic impact (e.g. insurance
costs, tourism, etc.) of a single destructive hurricane would be quite devastating given the timing.
California’s continued drought causes economic problems directly, but also indirectly through
offering a productive environment for massive forest fires.

Resulting Economic Impact


All of the factors described to this point have developed throughout this year or are developing
this fall and winter. Each factor alone is reason for concern. However, they all interlink
throughout the economy to put us in a questionable and potentially dangerous situation for the
near-term. Below is a diagram to depict the relationships between the aforementioned problems
we face and their impact on stock markets, the value of the dollar, and ultimately, you. Each
issue described above fits in one way or another into at least one of the blue boxes within this
diagram.

The boxes stacked on the left side of the diagram are the problems we have been facing or will
likely face within the coming months. The arrows show what areas of the economy these
problems will negatively impact. The degree of negative impact is assumed uncertain. You may
notice relationships that are not indicated on the diagram, such as the negative impact of
struggling business on unemployment; however, this type of impact is assumed given that
unemployment is listed as a growing problem we face in the near future.

“Pre-existing issues” are those issues which have already transpired over the last couple of years
that have made the economy vulnerable and continue to cause trouble. A few examples are:
businesses continue to deal with poor borrowing conditions and inventory problems, consumers
are struggling with unemployment and personal debt, both are getting hammered by added
taxation, and residential and commercial real estate are still marred by rising defaults and lending
problems. "Unknowns" are negative economic results from scheduled or uncertain near-term
activities, such as what might happen if the Iran deadline causes international tension or if the
supposed China credit bubble bursts.

To sum it up in a nutshell, the problems we face this fall and winter could translate into problems
with your stock investments, employment security, pension, fixed income investments, and
potentially every U.S. dollar you possess.

Impact on the Dollar

A major question to ask (indicated by the only gray arrow on the diagram) when thinking about
the consequences of these economic activities is, how will the dollar fare if there is another
panicked leg down in the markets? While money printing and foreign diversification will
continue to impact the dollar negatively, a perception that the dollar is still a safe-haven could
help it weather another powerful market drop.

During the crisis panic last fall, there was a flight to safety with strong investment in U.S.
Treasurys and the U.S. dollar. What will be the reaction the next time around? Are people still
confident in U.S. debt after seeing the massive budget deficit on the year coupled with White
House projections of $9 trillion in deficits (with a likelihood of being higher) to come over the
next 10 years - and especially given the nearly $11.8 trillion of existing debt and the many tens
of trillions in debt already anticipated from Social Security and Medicare?

There are arguments circulating the web that as we reduce our trade deficit, the need for foreign
U.S. Treasury purchases will diminish as it will be absorbed by America's purchases. Can this be
something that we can rely on? Aside from federal intragovernmental holdings and Fed
interventions, it is difficult to envision capable and willing buyers in America. Some of the
largest groups of American purchasers simply can't afford it. For example, state and local
governments have their own deficit and debt problems, public and private pension funds are
about to collapse, and what individual American or business would want to put their money into
a “safe" debt investment that they know will be severely deluded in value at its point of
maturity? With a dramatically growing Treasury supply and stagnating or declining purchase
capacity from American purchasers, relying on our own country to bail us out is not a safe bet.

Additionally, while in the short-term it is advantageous for foreign holders of U.S. debt to stay
invested, they continue to gradually diversify out of this position to minimize their vulnerability.
A dramatic move to dump the dollar at some point will likely be less harmful to them than it
once was, especially considering the harm that would be caused by remaining a holder.

A related continuing argument circulating the web and mainstream is the question of inflation or
deflation. We may still be going through a powerful period of deflation given the level of debt
contraction still unfolding. That does not mean that the money supply cannot rise while many
prices fall. This occurred in Weimar Germany during their hyperinflation. It also does not mean
that critical resources (e.g. energy and food) cannot rise in price and cause additional economic
harm.

Also, just because price inflation has not spiked yet, doesn’t mean it won’t. The economy and
dollar are both fragile and vulnerable, and the Fed continues to have an inflationary policy
mindset. It is also possible that a significant move up in price inflation could still be a ways
down the road - perhaps several years. Nonetheless, deflation can precede hyperinflation.

With no guaranteed answer for timing and magnitude of either economic direction, why not be
prepared for both? In such a time of uncertainty, one can hopefully diversify investments to
hedge and gradually make adjustments as new information reveals reality. As for the social
consequences of a given economic path considering the circumstances, the eventual result is
pain. Being mentally and physically ready for a potential economic collapse is key to surviving
it. Read suggestions about preparation as well as a discussion of the broader economic outlook in
Arbitrary Vote’s original warning article, but also take the initiative to do an analysis yourself.

Over the coming fall and winter months, we face many significant threats to an already
vulnerable economy. The chances are quite high for another considerable dip in the stock
markets due to negative economic forces. If another big drop occurs, there is a reasonable chance
that a dramatic move out of the dollar could be made and one of the harmful scenarios outlined
in the main Arbitrary Vote warning article could come to fruition. My hunch is that for one more
round, the dollar will again be viewed as a safe-haven and a collapse larger than the magnitude
we saw in the autumn of ’08 will be pushed out awhile longer. However, the conditions are
fragile and critical enough to keep a serious watch and be prepared for the worst.

Arbitrary Vote is not attempting to make an economic prediction, but instead wishes to arm you
with information so that you may make your own judgments and preparations for the future.
View a list of many of the sources used for this article, and monitor events of the approaching
fall and winter months.
 

http://www.arbitraryvote.com/warning/231-update91009

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