PARDON THE DISRUPTION - CHAPTER SIXTEEN

d. Government and the Social Contract

It was in 1845, when the potato famine – the same one that devastated the United Kingdom, especially Ireland, where a million people would die and nearly as many would emigrate to avoid starvation – hit France. The weakness of the potato crop caused people to lean on other sources of nutrition, driving up the cost of all foods, which put further financial pressure on poor workers. With more household resources going to simply feed the family, workers had to forego other customary purchases, leading to a downward spiral of factory shutdowns because people weren’t buying what they produced. This in turn put more people out of work, lowering the purchasing power in the economy… You get the picture.

French King Louis Phillippe had very recently gone on a spending spree to finance land purchases in advance of a major rail expansion. The rail expansion itself drove up the cost of iron, creating a market bubble which ultimately burst. Between these two factors the country’s coffers were empty, allowing little room for the government to help the poor and hungry. People were getting upset. As they had no rights and couldn’t vote, workers did the only thing they knew to do: they went on strike.

Prime Minister Francois Guizot, not fully appreciating the plight of the poor and miscalculating the depth of outrage in the people, responded to the strikes with military force. David Rothkopf: “Guizot’s position was that if agricultural conditions were bad, then people ought to find work elsewhere. He was similarly insensitive to complaints about insufficient food, arguing essentially that more prudent savings habits prior to the crisis would have avoided the problems now racking the country's underclass.“

Years of near-starvation and the political insensitivity of Louis Phillippe and Prime Minister Guizot had reached the boiling point. Soldiers’ attempts to break up gatherings of disgruntled citizens erupted in a series of small skirmishes in which scores of people were killed. Louis Philippe quickly fired Guizot, hoping to buy favor with the masses. It didn't work. Other attempts to placate the masses were equally unsuccessful and ultimately the king and his wife, disguised and discreet, escaped to England and went into exile. Mass uprisings over horrible economic conditions ultimately led to the overthrow of one of the most powerful governments on earth.

Not so terribly different from the pleas for assistance from mid-19th century impoverished French citizens are the same pleas – expectations, even – of today’s American populace that the government address rampant unemployment. Of course "rampant" is all relative; in the US today, unemployment mostly ranges from 8-10%, while Spain reached 25% unemployment in 2012, and the US suffered a nearly 30% rate in the last days of the Great Depression. Candidates for every level of public office routinely swear their undying conviction to do whatever it takes to lower the unemployment rate. If the human impact of joblessness wasn’t so severe, these sorts of responses from politicians would be laughable. It’s a norm for them to state with the utmost earnestness that they have a dependable plan to address employment – when, in fact, virtually none of them has a plan – or the basic capacity – to make anything but an infinitesimal impact on joblessness. In the past, before recent exponential advances in technology, before the Great Recession, and before employers had largely rejected the notion of taking on new personnel, the stimulus effect of increased government spending and lower interest rates made a difference. President George W. Bush sent tax rebates to many American households in an attempt to spur consumer spending. President Obama tried much the same by offering payroll tax cuts (increasing workers’ take home pay) and public works spending (increasing the number of federally subsidized jobs). The Federal Reserve conducted three rounds of quantitative easing and lowered the federal funds rate to 0-0.25% with a 0% outlook for the next three years. Folks, that's all there is. The U.S. government has now spent trillions on attempts to stimulate the domestic economy, with a net effect of little more than the maintenance of the status quo. It will be nigh near impossible for government action to achieve much more.

Again, the seriousness of our unemployment woes notwithstanding, there's a humorous irony in all the political and governmental talk about addressing unemployment. Americans will tell you with the deepest conviction that they live in a country with a free-market capitalist economy. They can recite examples of great, “only in America” business successes. But nothing could be less true. The fact that our government and its politicians spend so much time wringing their hands over labor markets and unemployment is proof of how far we’ve strayed from free-market capitalism. Even the most devout anti-government politicians, when they pour efforts into improving the job situation, are bordering on (dare I say the s-word?) socialism. Money invested in job training and retraining and workforce development is wonderful – but it’s socialistic. When President Obama promises to do all he can to reduce unemployment, while House Speaker John Boehner and Senate Minority Leader Mitch McConnell deride him as soft on joblessness, both parties have gone from a free-market capitalism to a socialism focus.

Perhaps that's not so bad. Certainly transitioning the US to a socialist economy would be terribly unwise – pure socialism has proven unsuccessful throughout history. But maybe we need to get away from lightning words that separate and vilify and accept that yes, it’s better if people are working, well and fed. When we decry the moving of American jobs abroad, when we curse technologies that put people out of work and "diminish" us, when we accept that it’s good thing to place a special emphasis on hiring veterans and ex-cons and the handicapped because we’re better people for having done so, then maybe we should get over the "S" word and refocus on the original characteristics that made America so great in the first place.

Maybe the private sector, with government support, can play an instrumental role in this. Earlier, I offered the example of a CEO who says, "I wake up every morning to do my best to try to create more jobs." We saw this thinking belied the tenets of free-market capitalism. A CEO’s role is not to exploit his company's resources and its investors’ money to do social good. But should it be? Could it be?

e. Changing the Old Ways Is Hard

“Certain things, they should stay the way they are. You ought to be able to stick them in one of those big glass cases and just leave them alone.”
–J.D. Salinger, The Catcher in the Rye

“Change happens very slow and very sudden.”
–Dorothy Bryant, The Kin of Ata Are Waiting for You

“It is not the strongest of the species that survives, nor the most intelligent, but the one most responsive to change.”
–Charles Darwin

“If you don’t like change, you’re going to like irrelevance even less.”
–General Eric Shinseki, retired Chief of Staff, U. S. Army

“If you're not confused, you're not paying attention.”
-Tom Peters

Somehow, way back when, everything seemed to work just fine, didn’t it? Back when you knew what to expect from your job, what schools your kids would go to, when dinner would be served. Back in our Ozzie and Harriet, white picket fence, homogeneous neighborhood settings. Back when you knew your neighbors and when there was a stranger in town – you know, they talked different and dressed funny. Back when eating Chinese meant buying the Chun King dinner pack off the shelf at the supermarket. And folks laughed at the store for stocking Mexican food because there were only a few Mexicans in town and why else would you put it on the shelves?

In those days, folks may have complained about their taxes being too high, but the trash got picked up and the schools stayed in pretty decent shape and even if we quibbled over who’d be on the town council, everyone seemed to be kind of on the same page and things seemed to work OK.

Now everything has changed! Nothing’s the same! Neighborhoods that used to be nice are filled with… them! Just drive by the high school and look at the kids. The way they dress is disgusting! You aren’t even safe in your own neighborhood. I called my doctor for an appointment and couldn’t get one for two months. I went to lunch and everyone was yacking on cell phones. People don't talk anymore. They spend their time on Facebook and doing that Twittering thing. Why did it have to change?

“My advice to you is to start drinking heavily.” – Bluto, Animal House

Any futurist worth his salt knows that, when evaluating any change or potential change, one rarely finds a single factor that can take all the credit or bare all the blame for anything. More often, there is a combination of factors that come together to disrupt the status quo. Whether we like it or not, government – national, state, and local – ‘R’ us. And economic, social, and technological change have at least as much impact on government – how it is funded and how money is allocated – as they do on us personally.

One corollary to the eternal growth theory is that "Growth pays for itself." And in America, that concept has generally proved true. It has worked because, with the exception of the bear market from 1964 to 1976, economic growth since World War II has stayed ahead of both inflation and the cost of municipal and county construction projects, for the debt service to undertake public projects was easy to cover. The economy was fine, suburbia was growing, families were buying cars and televisions, incomes were rising, and households in the homogeneous towns of America could make ends meet.

But when the economy turned downward, reality brought this type of thinking to a screeching halt because growth, in fact, is not on an eternally ascending path (at least not without significant periods of back-sliding). It's our own dim, time-specific view of the last 65 years that makes us think it so – and so it was only when the first real economic downturn occurred we saw the real truth. We have been fortunate to live in the greatest bull market/ economic growth period in the history of the world. Like the citizen who lamented “What happened to my local community?” we find ourselves suddenly bewildered by the national and world economies. And it doesn’t feel good. Many of us are frightened.

Until recently, local politicians, knowing full well that growth was eternal, played "keeping up with the Joneses" on a local-government scale, matching municipal facility with municipal facility, shiny new school with shiny new school.

But the fallout is beginning. After months of oversight by emergency financial manager Kevyn Orr, appointed by Michigan Governor Rick Snyder, Detroit and its $18 billion debt was declared so unmanageable that in July 2013 it became the largest city in US history to declare bankruptcy. Over 30 municipal operations, mostly utilities, have filed for bankruptcy in the last eighteen months, including seven towns and cities. The Chapter 9 filings of San Bernadino, Stockton, and Mammoth Lakes represent a rising tide of problems in California; Michigan has seven cities and school districts under consent agreements; others, like Harrisburg, Pennsylvania and Boise County, Idaho have had their bankruptcy claims rejected. As large, water-consuming manufacturing operations shutter their operations and small towns dependent on those manufacturing jobs to maintain their populations lose water meters, more and more small water utilities will become extremely hard-pressed to make bond payments on general indebtedness or revenue bond payments for the expansion of sewage and water systems. Pensions, retirement plans, and retiree healthcare continue to be huge financial stressors for municipalities that can only downsize their current operations – but not the number of longer-lived retirees. In those cities not currently enjoying growth, these problems are more extreme still.

This last area – pensions, retirement plans and retiree healthcare – may very well prove the straw that breaks the back of state and local governments. Local governments are now required to calculate the future cost of OPEB – Other Post-Employment Benefits – owed to the increasing numbers of people vested in their retirement systems. The figures are staggering – so large that they seem somehow illegitimate. But in many cases, the retirement indebtedness is fully 100% of the annual budget – and climbing. More alarming still are shortfalls in funding for state retirement plans. And again, the problem seems so insurmountable that it is being ignored because addressing it in current budgeting would wreak immediate havoc (as opposed to kicking this giant can down the road).

For years I have enjoyed the economic and investment writings of John Mauldin. I always find his articles to be well-written, and he also circulates newsletters from other distinguished authors. I appreciate his approach of sharing this information so generously. John’s “Thoughts from the Frontline” newsletter of February 13, 2013 was particularly insightful regarding this shortfall in pension funding and poor managerial assumptions that have made the problem worse. Comparing the current situation to that of Greece, he made the following observations, first about CalPERS (California Public Employees’ Retirement System – the largest of its kind in the U.S.):

“CalPERS manages $230 billion. The fund now calculates that it is underfunded by $80 billion. The management arrives at this number by assuming they will make 7.5% (which they only recently dropped from 7.75%). In 2009, they estimated that the fund was underfunded by only $49 billion. That means they missed their targets by $30 billion in a roaring bull market.

“In a December 2011 study, former Democratic assemblyman Joe Nation, a public finance expert at Stanford University, estimated that CalPERS’s long-term pension debt is a sizable $170 billion if CalPERS achieves an average annual investment return of 6.2 percent in years to come. If the return is just 4.5 percent annually – a rate close to what more conservative private pensions often shoot for – the fund’s long-term liability rises to a forbidding $290 billion. (Malanga)”

The sad thing is that they arrive at that huge deficiency at a 4.5% return. In fact, the return was less than 1% last year (in a good stock market) – but that has been their average return for the last five years! This amounts to a $290 billion deficiency in the largest state in the U.S., whose state operating budget is $100 billion. These numbers are staggering. “Illinois has a $33 billion state budget – and five pension funds that are officially underfunded by almost $100 billion. Remember that sky-high projection of investment returns by CalPERS? Illinois pension funds estimate they will earn anywhere from 7.5% to as much as 8.5%. But the state-employee fund made less than 0.1% last year, barely beating out CalPERS.” Not to be outdone, most of Texas’s retirement accounts are counting on an 8% return; the Houston Firefighters are counting on 8.5% return. John continues: “Without 8% returns, the shortfall for the Texas Employees Retirement System (ERS) could be twice the current projections. The system is scheduled to pay out $133 billion between now and 2045. It has $11 billion. For these assets to cover future payouts, ERS would need to see average investment returns of 21.5% per year – or see big-time payouts from the government budget. Think they can find an extra $5 billion a year for the next 20 years? From a $30 billion budget? And get 8%?” (Find your state in the January 2013 NASRA Issue Brief). (I covered much of this in an article in The Futurist magazine in 2013; Courtesy of the World Future Society.)

The other factor that intertwines with the myth of eternal growth and the "growth pays for itself" mindset is that we will always have inflation. There may be slight inflation or dramatic inflation, but inflation is a fact of life. Again, like the growth scenario, inflation arises from the policies of its time – in our case, a fiat money system and easy credit. This is all we’ve known for the past 65 years, but, again, this is a mere snapshot on the scale of history. Though there is some evidence of disinflation (Robert Prechter, for one, asserts that the US has been in disinflation since year 2000), the US has successfully avoided deflation – a drop in value of all tangible property – since the Great Depression. Prechter, whose work I greatly respect (most notably for his work on the importance of social mood; market forecasting; debt; and deflation), defines deflation this way:

“Deflation is a contraction in the overall supply of money and credit. Why must deflation occur? Answer: There is too much unpayable debt in the world.”

Judging by the European sovereign debt crisis and our domestic real estate, credit card, and student loan indebtedness, as well as retirement plan underfunding, his well-stated case for a forthcoming deflationary environment may be more urgent than we think.

Deflation does other things as well. The scarcity model of economics, where the values of products and items are dependent on traditional supply and demand is (at least temporarily) suspended. Nearly everything falls in value. Unlike inflation, where buying something early – whether it be a food product or highway paving – proves advantageous because prices will always be higher if you wait, deflation produces the opposite situation. There is no reason to purchase anything inessential – it will be cheaper tomorrow and even more so the next day. Deflation is commonly paired with the Paradox of Thrift, which states that if everyone tries to spend less (and save more), cumulative demand will fall and depress the economy.

Growth is not eternal; from time to time recessions and depressions retrace much of the gain. Growth pays for itself only when those who represent that growth are contributing more than the cost of their presence – sometimes through periods of high unemployment and need for social services. Inflation is a by-product of growth and has many causes: increased money supply, relative ease of credit, higher demand for goods and services, costs of production. Inflation (with a few flourishes of well-disguised disinflation) is all the U.S. has known for the last 65 years. That doesn’t mean it has always existed, or always will. Inflation reduces purchasing power, and that can be painful to those who do not have the means to increase their income or wealth.

But deflation is far crueler and more devastating to most people. It reduces the value of every physical asset – art, collectables, homes, cars, buildings, equipment, and the assets of companies (think that might affect the stock market?). Debt on deflated assets is a problem that compounds itself horribly. Deflation and a massive credit crunch were two root causes of the Great Depression. Sound familiar?

The Federal Reserve has recently made some interesting moves in this realm that deserve attention. In December 2012, the Fed announced that, in order to provide a maximum amount of liquidity in the economy and keep interest rates low, it would buy $45 billion in U.S. Treasuries each month in addition to the previously-announced $40 billion in mortgages it would buy each month. This doubles the rate of asset purchases since mid-2008. These moves are in addition to attempts at lowering interest rates through “Operation Twist,” where the Fed sold lower-yielding short-term treasuries and invested in longer-term treasuries.

The more recent decisions – buying up treasuries and mortgage bonds – represent extreme moves that try to stimulate the economy by making sure borrowing costs stay low. “Moderate” long-term interest rates fall under the “dual mandate” of the Fed – low unemployment and stable prices. The Fed has announced that these moves will stay in effect (with only modest hedging) until the U.S. unemployment rate falls to 6.5% (with some accommodation for a rise in inflation).

These moves are ill-advised and scary on many fronts. The purchases of the treasuries are simply a scheme to inject liquidity into the financial markets. Mortgage bonds are backed with the hope that the current slate of American homeowners will pay their mortgages with greater reliability than those of five years ago, many of whom defaulted. If we are not totally confident that the current mortgages are backed by homes worth more than these outstanding loans, we are at the mercy of government guarantees of repayment. So in the case of a default, we have one government agency paying on the paper owned by another, quasi-governmental organization. So just who is providing the funds behind the guarantee? Feeling better yet?

Beyond the direct moves made by the Fed to keep interest rates low lies another issue that reflects a changed economy – and shows why this plan likely won’t move the needle (again). The basic concept the Fed is relying on is that the pumping of huge dollars into the economy provides the liquidity and low rates that businesses need to grow and that that will spur hiring, lowering the unemployment rate. This is in line with the past century of monetary policy. But things have changed. The Great Recession allowed American businesses to see how deeply they could cut their workforces while remaining profitable. The combination of savvy personnel moves and the adoption of high-productivity technology have shown them that in most cases they can operate just fine with smaller staffs. They have made it abundantly clear that only in the rarest of positive economic situations will they be willing to hire people – rendering all these market machinations moot in terms of unemployment reduction. Lower interest rates don’t mean that there is demand for the money. That is part of the disconnect in the traditional monetary methodology being practiced now.

Now, a test for you:
If you were given the opportunity to borrow $10 million at zero interest (and couldn’t play some interest rate or investment spread), but absolutely had to pay the money back in three to ten years (under some horrendous penalty – let’s say the abduction of your beloved poodle Fifi) – what would you invest in? Remember, just sticking it in a higher yield investment doesn’t count. Pay it all back or Fifi sleeps with the fishes.

All the political rhetoric about tax rates, fiscal cliffs, and Obamacare “uncertainty,” amounts to little more than a list of excuses. A good business idea works despite all of that. So what industry do you believe in strongly enough to start or expand a business at significant expense, with serious consequences for failure?

For most, the answer is real hard to come by. Trillions of dollars are sitting on the sidelines, held by would-be investors with the same blank answer. Publicly traded corporations can find nowhere better to put their money than in the current record level of stock buy-backs at the all-time stock market peak. And the low interest rates the Fed is jumping through so many hoops to achieve will not impact unemployment until there is reason for increased demand for money and that investment answer changes.