Wednesday, December 31, 2008

Trends for 2009: The Web Dismantles Old Media (Print, Music, Broadcast and Hollywood)

December 31, 2008

The World Wide Web and peer-to-peer networking have effectively dismantled the business models of Old Media: newspapers, magazines, publishing, music, network TV and Hollywood. As all media becomes either free, shared or low-cost, there is no way high fixed-cost Old Media can survive.

I received an education in the Web's dismantling of Old Media "in conversation with Richard Metzger." Richard and his partner started and operated a very successful book publishing and music distribution business in the late 90s. As peer-to-peer networks and the Web took hold, Richard noted that music CDs which had sold in the 10,000-unit range were now selling less than a 1,000 units. Similar drop-offs were observed in books.

Here is one of Richard's fascinating books: Disinformation: The Interviews

These trends are accelerating. Newspaper circulations are plummeting; few citizens under the age of 40 subscribe to a "dead tree" newspaper. Why pay $250+ a year for a subscription when all the valuable content is on the paper's website for free? (Here is the S.F. Chronicle's standard offer for home delivery: 8 weeks for $46 or $299/year.)

Magazine circulations are falling, as are ad pages and the sums advertisers are willing to pay for an advert. The news is old and the pundits often less insightful than those found for free in the blogosphere. (Most magazine content can be found on their websites for free as well.)

Network television continues to lose market share to the cable channels and TV as a whole is losing "mindshare" to the Web. The much-anticipated "convergence" is indeed occuring: everything is converging for free on the Web.

In the music industry, CDs which would have sold hundreds of thousands of units are now selling in the tens of thousands. The reason is painfully obvious: why pay $16 for a CD with one decent song and 12 mediocre tunes when you can buy the one good song for 99 cents on iTunes or download all the songs for free?

The same mechanisms are at play in the film industry. Why pay $10 to watch multiple ads in a theater when you can buy the pirated DVD for a few bucks from a street vendor anywhere in the world, or rent it from Netflix (and make a copy for friends) for $2, or download the film for free off peer-to-peer networks based in non-U.S. locales?

Richard has related many other telltale signs of revolution in the media: book advances are dwindling to zero for unknown authors, film studios are making far fewer costly "Hollywood features," etc.

Richard recently recommended this entry from a music industry insider's blog: Bob Lefsetz:

"You know physical retail is on its last legs when Bruce Springsteen creates a special product for Wal-Mart. It's like there's a flood and everyone has retreated to high ground. In this case, the one location that seems able to sell physical product. But it's really more like a drought. The consumer is no longer raining money. And it's even worse, there's not enough food at Wal-Mart. Bryan Adams' album didn't sell there. Not everything moves in the big box store. Not everything is moving period.

As for Web-craziness, Soulja Boy's album debuted at number 43, selling less than half of his previous effort, a measly 46,000 in total. AND THIS IS CHRISTMAS WEEK!

This is the end my friend. This is the last hurrah. And the record business does not employ enough people to warrant a government bailout. Sure, GM has been mismanaged for even a longer period of time, but by digital standards, the record companies were exposed to the canary in the coal mine first. But they'd listened to too many hard rock records to realize the chirping was gone, they only heard the tinnitus in their ears.

But musicians think they're immune. Very few remember the pre-Beatle days. When stardom did not mean vast riches, diamond selling albums, private jet lifestyles. They just can't believe they're not entitled to wealth. So, when record sales tanked, they just raised ticket prices, as if the public didn't notice. But it's interesting, people only want to pay a lot to see the legendary, classic acts. Or maybe the new ones once. We're not building any infrastructure. We're just throwing crap against the wall. And now our cupboards are bare. The audience has moved on. They'd rather buy wiis. They deliver more entertainment value.

Sales last week were off THIRTY THREE PERCENT from the equivalent week last year.

It's a new day. The future paradigm is how does one get people to listen to your tracks from the vast assembled multitude of music they pay very little for. It's a heyday for listeners, everything's at their fingertips. The labels could have monetized this acquisition, if only they'd owned up to reality. But if you never used Napster, how could you realize how great it was?"

What's true of pop music idols is also true of movie stars. How can a studio pay an actor/actress $40 million when the film may not even net that much?

I take no joy in addressing the demise of industries, be it the auto industry or the newspaper industry. The jobs lost mean real pain and suffering. I have earned a bit of money off the print media (newspaper and magazine) from 1988 to the present as a free-lancer. The pay was almost always abysmal because there is always a fresh horde of newly minted English grads/writers/artists etc. who will work for near-free for the byline or credit to "build their career."

Um, what career? When everything is free, how do you make money? Well, the standard answer is you sell ads, and a few sites and blogs actually make a decent living off adverts--those with 1,000,000 visits a month or more. (Alas, not this site, which receives 120,000-150,000 visits a month.)

Newspapers and magazines also derive ad revenues from their sites, but it's on the order of 20% of their print ad revenues--not anywhere enough to fund their high fixed-cost business model. The same can be said of broadcast TV, the music industry and Hollywood.

Now comes the really bad news: standard advertising/marketing no longer works very well. I address this at some depth in my 73-page book Weblogs & New Media: Marketing in Crisis :

The two basic reasons are:

1. people with little disposable income can no longer respond to print/broadcast adverts
2. the entire reductionist edifice of Standard Model of Marketing (SMOM) has run its course.

My longtime friend G.F.B. and I were discussing these new realities recently (he makes his livelihood in broadcast/video/advertising) and he suggested that the new model is to sell 10,000 copies (of anything) at 99 cents rather than 400 copies at $25.

He proposed that if the cost is below the threshold of "impulse buy" then consumers will purchase the digital item without making a complex internal assessment as to the value. In other words, "Hey, for $1.29, I'll give this a look/listen/read, and if it's no good, oh well, no big deal." G.F.B. reckoned the "impulse buy" threshold is somewhere in the neighborhood of $ .99 to $1.29.
With this concept in mind, I recently made my novels available on Amazon's Kindle reader for the price of two iTunes, i.e. $1.98. The Amazon Kindle store helpfully discounted this modest sum down to a grand total of $1.58:

Of Two Minds and Kama Sutra Cadillac

Is this insane? I don't think so. There will always be a place for print books and media, but the assessment of value when digital resources are free has shifted. Is there value in a beautifully illustrated 400-page cookbook? If you actually cook and enjoy gazing at the photos and studying the recipes, then $30 is a fair price for the value you receive from the book.

A good softbound plumbing guide is still worth $15 to me, as the online resources are cumbersome to assemble. For someone lazy like myself, the book is actually more portable onsite than digital resources,even though they are free. Plumbing doesn't change much and the book will last decades, so $15 is a good value to people like me.

I also like autographed books, and prefer to pay money for a pocketbook when traveling over staring at a laptop. So yes, there will continue to be markets for books, films, music and even newspapers. But the days of people paying $300/year for a newspaper subscription, $25 for a hardbound novel that offers two hours of distraction, $15 for mostly mediocre music on a CD or $16 for a film DVD are passing.

Is it fair that I charge $14 for a print book when I'm willing to sell the digital version for $1.98? It seems to me G.F.B. is correct, and there are two markets for all media in the digital world: a "value assessment market" (VAM) in which consumers carefully weigh the relative value of $14 or $28 in terms of lasting utility or enjoyment, and the "impulse buy" of around a dollar or two for the more modest utility of paying the creator/distributor a small "rental fee" for the use of their creation on a computer or digital device.

To bemoan the emergence of this "impulse buy/small rental fee" market as a replacement of existing costly media is to miss three paradigmatic realities:

1. everything is free on the Web (other than the cost of the electricity and Web access)

2. the Web is a giant copying machine Is the Web a Giant Copy Machine? (March 4, 2006)

3. the market for books, CDs, DVDs, newspapers, TV networks, etc. will still exist, but only as a "value assessment market" (VAM) in which consumers will carefully weigh the value of the purchase against its free competitors and other sources of the same information/entertainment.

So it's not an either/or proposition: you can still try to sell 400 copies at $25, and also try to sell 10,000 copies for 99 cents. The markets are priced according to the costs of manufacture, distribution and size of the markets. Downloading an entire 100,000 word novel takes only a few moments and a few pennies of electricity and disk storage; it is as close to "free" as is possible.

Printing and shipping a book (or DVD, CD, Sunday newspaper, ad-larded magazine, etc.) costs much more and hence it must cost more.

No one knows exactly how the digital/web revolution will play out, but who's holding the buggy whips and who's producing the Model T's is already painfully visible.

NOTE: I will be visiting family until 1/4/09. Have a safe and Happy New Year!


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Tuesday, December 30, 2008

Trends for 2009: The Rise of Informal Work

December 30, 2008

The crushing costs of formal business (State and local government taxes and junk fees rising to pay for unaffordable pensions, etc.) and the implosion of the debt-bubble economy will drive millions into the informal economy of barter, trade and "underground" (cash) work.

As small businesses close their doors and corporations lay off thousands, the unemployed will of necessity shift their focus from finding a new formal job (essentially impossible for most) to fashioning a livelihood in the informal economy.

One example of the informal economy is online businesses--people who make a living selling used items on eBay and other venues. Such businesses can be operated at home and do not require storefronts, rent to commercial landlords, employees, etc., and because they don't require a formal presence then they also fly beneath all the government junk fees imposed on formal businesses.

I have mentioned such informal businesses recently, and the easiest way to grasp the range of possibilities is this: whatever someone did formally, they can do informally.

Chef had a high fixed-cost restaurant which bankrupted him/her? Now he/she prepares meals at home and delivers them to neighbors/old customers for cash. No restaurant, no skyhigh rent, no employees, no payroll taxes, no business licenses, inspection fees, no sales tax, etc. Every dime beyond the cost of food and utilities to prepare the meals stays in Chef's pocket rather than going to the commercial landlords and local government via taxes and fees.

All the customers who couldn't afford $30 meals at the restaurant can afford $10. Everybody wins except commercial landlords (soon to be bankrupt) and local government (soon to be insolvent). How can you bankrupt all the businesses and not go bankrupt yourself?

As long as Chef reports net income on Schedule C, he/she is good to go with Federal and State tax authorities.

Now run the same scenario for mechanics, accountants, therapists, even auto sales--just rent a house with a big yard or an apartment with a big parking lot and away you go; the savvy entrepreneur who moves his/her inventory can stock a few vehicles at a time. No need for a huge lot, high overhead, employees or junk fees. It's cash and carry.

Lumber yard? Come to my backyard lot. Whatever I don't have I can order from a jobber and have delivered to your site.

This is the result of raising the fixed costs of starting and running a small business to such a backbreaking level that few formal businesses can survive.

One example of hundreds/thousands: 20 years ago I paid about $200 for a building permit for a $40,000 starter home. (Not in California, in Hawaii.) Locally in California you pay $350 just to have a staffer "review" your plans--even for a modest bathroom renovation. If they reject your plan for some reason, you still pay the fee. If they approve your project, the permit is much, much more. Oh, and they charge you for the electrical and plumbing permits, too.

Yes, I understand the movement to charge end users of government services; those who use the services should pay. Fair enough. But then what's happening to the 8.5% sales tax we pay, the $10,000 property taxes we pay, and the hundreds or thousands in other fees and income taxes we pay? Why don't those taxes go down if end users are picking up the tabs for "government services"?

Why have state and local government budgets all climbed by 30%-50% in a mere decade?

In a way, it doesn't matter; very few can operate a formal business profitably, and so they close their doors and scrape up a living in the informal cash economy. Local government will see its revenues wither and eventually insolvency will force a radical re-thinking of government revenues, expenses and services.

Until then, watch for the informal economy to grow and the formal economy to wither.

Until recently, the "growth sectors" of the U.S. economy were government and healthcare a.k.a. sick-care. As tax revenues plummet, then all government hiring below the Federal level will reverse into lay-offs. As for healthcare: as formal employment declines, so too will the funds flowing into insurance and healthcare via employers. As employers go belly up, the torrent of money flowing into healthcare will dry up.

Never mind that people want and need care; they can't afford $50,000 for tests and a few visits, or $120,000 for a procedure. Once employers stop paying premiums, then the healthcare industry will find its non-Medicaid/Medicare revenues declining. The future in healthcare is cash and carry, too; few recognize that yet, but more will as the formal economy continues down its high-fixed cost/debt-implosion death-spiral.

Those who survived the collapse of the Soviet Empire have experience with informal economies. Many of you have heard of Dmitri Orlov's Reinventing Collapse: The Soviet Example and American Prospects . We turn now to correspondent A.C.'s commentary on the informal economy in Eastern Europe after the Iron Curtain fell. (A.C. was responding to a previous entry, End of Work, End of Affluence III: The Rise of Informal Businesses, December 10, 2008).

"I greatly enjoyed your post on the rise of informal businesses. Having grown up during the post-communism collapse in Romania, I say that yes, you are right, this is how the things play out.

One observation: government fees/taxes are a fixed cost to businesses, but the government has fixed costs too. Yes, it can downsize some employees, but usually not too much. Also, people react quite vehemently to forced pay cuts. So the solution is monetizing the debt -- printing money (yes, only the Federal gov can do that but they will likely do it because of Social Security and Medicare). Then just lie in statistics about inflation.

Government employees end up being paid a pittance in terms of purchasing power, and then they also joyfully join the informal economy, under the form of corruption. I often see comparisons between the rate of corruption in the developed world, and the rate in the developing world, but I would like to see how the comparison will look like when government officials cannot afford both housing and food from their salary.

Such corruption does not take the form of an outright request for money, just that processing of papers, etc. will take a really looong time, but somehow gets done immediately if the client shows up by chance with a handbag that is placed quite ostensibly far away from the place where he is sitting. The policeman at a traffic stop finds some banknotes mixed in the insurance papers -- the motorist cannot be accused of anything, who is to blame for mixing some papers? and so on.

Another thing to expect is a much higher petty crime rate. A few years ago I was talking to a policewoman in Palo Alto, who was telling me of how the crime rate has risen in the past recession when unemployment increased by a few percentage point. I heartily laughed, and asked her to imagine how it was in mono-industrial towns in Eastern Europe where unemployment went from 0 to 60% in a few months.

The good thing is that the largest increases in this situation are in nonviolent crime, as most "marginally criminal" people (i.e. who would consider turning to crime when no other options are available) do not have a murderer's mindset. The basic rule is that anything not bolted down gets stolen. Kids were stealing flowers and vegetables from our garden to go sell them in the marketplace. Wheels got stolen from cars quite frequently, and once someone stole a fencepost from our yard.

On a weekend, we planted some small young fruit trees on a piece of land that we had on the outskirts of the city... I hauled water all day uphill while my father was digging the holes. Came back the following weekend to see how the trees were doing... they had been dug out and stolen. Unsurprisingly, the crime rate came down dramatically as the economy improved.

If any of your readers make plans to buy a house a year or two from now when prices will hit bottom, they should make sure that it is not in an area governed by a Home Owner's Association (HOA). Want to have a vegetable garden? Not possible, you are supposed to have an expensive and useless lawn. Want to raise small animals (rabbits, chicken, maybe buy a piglet and fatten it for a few months? Not allowed. Need a fence to diminish the likelyhood of stuff getting stolen and to make sure kids don't play in the street? Not allowed. Want to run a home-based business? Nope. Need/want to have tenants for an extra buck? Verboten. Want to build/remodel a house to be as energy-efficient as possible? Don't even think about it.

Right now all the above things are probably possible in the countryside, but most people live in large cities because that's where the jobs are. It's easy to say "just move to the country", but then how will you set aside money for children's college and for a proper retirement?

By the way of retirement :-) In order to avoid a very quick monetization of debt, when it comes to Social Security, the government has one more option --- nationalize individual retirement accounts (done in Argentina a month or so ago). Your IRA/401(k) savings are replaced with a special government bond with a generous inflation-indexed interest rate, which starts being payable at the date of retirement. The actual money in your account is used to fund the current government obligations. By the time you retired, real inflation will have eaten away most of the bond payments' purchasing power.

America does have, however, one thing going strong for it, that Eastern European countries did not: for most Americans, immigrating elsewhere is not an option. This means that the brightest and the most enterprising folk will stay in the country and try to improve things, as opposed to just leaving. That makes for high unemployment in the short run, but for a quicker recovery in the long run.

As for the cost/value of used goods: you may also consider that in very hard times the sale value of a stolen or even garage sale item is not related to the price at which a new good would sell, but to whatever the thief/seller can unload it for, even if that is a total pittance. Pair of good skis for 30$? Hey, that's food for a couple of days, so what if a practically similar pair can be found in the store for $200 (which would itself be a 60% discount from the previous year).

Why would the price in the store be $200 and not come down to $30, even if that means pitifully low sale volumes and most stores going out of business? There is an answer to that:

While the price of commodities and new manufactured goods will decline, they cannot really stay for a long time under the production cost, because then production facilities (factories/mines/oil wells) get shut down (unless they are subsidized by some government). When the price you get for products is under the cost of raw material inputs, you shut down the production facility (even if you may keep paying part of workers to stay idle, if you are lucky to get some government subsidies).

So a lot of production facilities may go bankrupt, and supply can diminish drastically until it meets demand, but the price would still not fall below the price of raw materials + transport + packaging. Existing stocks of products may be unloaded at a loss, but production facilities cannot function permanently this way. On the other hand, wages can fall to almost zero, with wages of service sector workers falling with them too. So this is why in Eastern Europe in the early 1990s you saw simultaneously:

(1) very low wages and high unemployment;

(2) very low service sector prices, i.e. a few cents/dollars for a hairdo / nail job / dentist visit, as the service sector people cannot go into hibernation to stop eating and diminish production;

(3) prices for new/imported manufactured goods that were very cheap compared to what they would sell in the West (global market segmentation), but EXPENSIVE in terms of local incomes (price cannot fall below raw material costs on a permanent basis), and with VERY low sale volumes. Yes, 90% of the (state-owned) retailers and manufacturers went bankrupt and eventually disappeared.

(4) very low prices, and high sales volumes (read: large flea markets) for anything second-hand.

Another thing to note is that if wages fall dramatically, then it becomes profitable to establish production facilities in the US again. In November 2007 we took a vacation in Florida, and my first thought at the sight of the massive wall of dark, empty condo towers north of Miami was: "Five years from now, a smart entrepreneur will buy a few of them for a pittance, build a factory next door and a light rail line from the apartments to the factory (roads were never adjusted to the projected population density), and offer people a factory job + housing package, which the homeless crowds will gladly take. The catch is that the salary would be very small of course. Heck, probably the state will buy the condos or confiscate them from the banks for not paying taxes, and offer them at zero rent to entrepreneurs, just to generate jobs".

Thank you, A.C. for a multi-faceted commentary based on experience. We turn now to correspondent Freeacre for a report that shows it's not just small businesses being driven under by absurd government junk fees:

"I so needed to build an additional bathroom onto my home in Tahoe when I lived there. I could have created a small, but nice, little apartment that I could have rented out to help keep a roof over my head. I had a housemate who was a carpenter, who would have worked for rent. . . But Nooooo. In order to build a bathroom, it would have required $5,000 upfront just for the building permit!! Extortion!

Now we are in Oregon and fighting the county tooth and nail regarding these ridiculous $30-40,000 individual sewage treatment monstrosities that they want to require us to install. They will require a separate phone line, a $400 per year maintenance fee, and a license as a water treatment plant to put in - for a nitrogen reduction situation that is only projected by a flawed computer model to be a problem in 120 years! And, they don't even treat for real problems like chemical and pharmaceutical pollution.

The latest insult is that the money supposedly set aside to help poorer people put in these things is $65,000 light now because they gave it to a staff person to answer our e-mails. They blame it on us getting involved in the public process!

It's not just the small business owners, it's the citizenry as a whole that these parasites are sucking dry. We are in the process of organizing a local Grange that will have an on-site Farmers Market and Trading Post. We will trade and barter food, goods and services when the economic grid goes down, and they can kiss our collective butts. I can hardly wait for the county to have to lay off those SOBs. If they continue to insist that we put in a nitrogen reduction system, we'll just purchase a $1,000 composting toilet. They we can tell them to "eat dung and die." And, we can use the compost for the garden.

The government, the banks, and the investment class are all in the process of killing the geese that lay the golden eggs. Nothing will change until we get them off our backs.

For fun, Charles, I have sent the county your article just to mess with their heads. Ha!"

Thank you, Freeacre, for an eye-opening report. Here are a few other "hard times/debt-bubble implosion"-related titles to explore:

The Richest Man in Babylon
Only Yesterday: An Informal History of the 1920's
Since Yesterday: The 1930's in America, Sept. 3, 1929 to Sept. 3, 1939
Maxed Out: Hard Times, Easy Credit and the Era of Predatory Lenders
Collapse: How Societies Choose to Fail or Succeed

11 New excellent reader comments.

New Essay by Eric Andrews:
Life and Cash-flow Accounting
"There’s something tickling the back of my brain about the whole reporting of the economic crisis and the “solutions” offered. That’s not just mainstream commentators either; it’s equally visible among contrarians, deep thinkers, critics and so on, but it’s something I’d like to share with you today."

New Operation SERF installment. Operation SERF, Part 5
“Thanks for meeting with me, Colonel Barry,” Scott said to the officer seated across from him. The two men were alone in the Colonel’s office within the wire of Fort Knox. “I had hoped we might have the commanding general here for this meeting as well.”

Book Notes: My "little book of big ideas," Weblogs & New Media: Marketing in Crisis is now available on amazon.com for $10.99. New Kindle edition available for only $4. Weblogs & New Media: Marketing in Crisis (This version is downloaded electronically to Amazon's Kindle reader device.)


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Monday, December 29, 2008

Trends for 2009: The Death-Spiral of Local Government and Small Business

December 29, 2008

State and local governments are responding to shortfalls in tax revenues and spiraling pension costs by raising "fees" (a.k.a. taxes or junk fees) just as the backbone of the economy--small business--is struggling for survival. The more government employees demand "what was promised" in pensions, the more small businesses will fold, cutting government revenues in a death-spiral with only one end: state, county and city insolvency.

I am starting a new series today entitled "Trends for 2009" which will attempt to describe those trends which will be working beneath the MSM-induced "everything's gonna return to 2007 real soon" fantasy.

Let's start with the death-spiral of state and local governments raising taxes and fees to offset their collapsing tax revenues.

Contrary to the illusion created by glossy adverts and a corporate-owned MSM (mainstream media), huge global corporations are not the primary provider of jobs and taxes in the U.S.--that role is filled by small business, which also provides roughly 80% of the job creation and innovation in the economy.

The MSM tries to make a distinction between "marginal small businesses" and "small business," but all small enterprises are marginal in our high-overhead, high-tax, high-fixed cost economy. So guess what happens as revenues decline but fixed costs (rent, business license fees, utilities, health insurance, etc. etc.) stay high? Small businesses will close en masse.

Slump Batters Small Business, Threatening Owners' Dreams (WSJ)

Now put these two together: higher taxes/fees and small businesses on the precipice. Welcome to "death spiral 2009" in which public employee union demands for higher taxes to pay their bloated pension and healthcare benefits will kill off an ever-rising number of small businesses, further depressing tax revenues.

Note to politicos, government managers, public employees and their unions: we don't have to keep our door open. You seem to think we do, but we don't. When we can't pay ourselves and/or we get tired of the endless stress and grind of all your regulations and taxes and fees, then we'll close our doors and issue a big sigh of relief. We'll make do somehow without employees, storefronts, offices, permits, and all the other sources of income you, our governments' employees, depend on for your paychecks.

I have to chuckle (bitterly) when I hear some corporate or government manager complaining of stress. If you have a steady paycheck, you have never experienced full-court stress. (With the exception of emergency medical care staff and U.S. Armed Forces personnel in combat duty, of course; I mean "regular civilian employment.")

Small business owners have to wear more hats than any corporate manager or government employee, and they do so without pay as times get tough. Many tap their own credit cards to pay employees and fill orders for good customers. You want stress? Then do whatever job you do for a paycheck but imagine that you're doing so with only the hope of future paychecks--a hope that dwindles every week that the economy continues its free-fall.

This is why I have predicted that local and state governments are completely ill-prepared for the tidal wave of small business failures which are about to decimate their tax revenues. The average municipal manager is assuming everything will return to normal soon, as all those faceless small-business worker bees will persevere and keep paying their rent, taxes and fees regardless of the hardships, stress and rising debts.

Nobody can operate their business for long when they're losing money. I would guess that over half of small businesses in the U.S. are already marginalized in terms of survivability, and very little separates those from their "if we can just get through 2009 we'll make it" brethren who still have a bit of cushion.

As noted here before, an entrepreneur always has an alternative "Plan B" livelihood : whatever one used to do in a formal, high-cost way, then do it informally from home. Do it for barter, do it for cash; pay no office or warehouse rent, have no employees, pay no business taxes, and whatever net income is left, it will be so low that the income taxes will be negligible.

If the politicos and government employees think they're in trouble now, wait until the end of 2009. When the streets are lined with closed storefronts, the chain stores and malls have been shuttered, and the auto dealerships are weed-filled empty lots, then go ask the survivors to pay more taxes and fees.

Oh, and here's where some state/local tax revenues are going (link courtesy of Cheryl A.): Double-Dipping Government Employees in Florida.

Sadly, there won't be many left to hear your pleading for more tax revenue. But go ahead and raise taxes and fees anyway, and drive the survivors under. Then the last businesses you can try to load up with higher costs will be Wal-Mart and Safeway and the local branch of Citicorp/WAMU/BofA/Countrywide/Morgan/Chase or whatever it will be called.

You can try raising property taxes, but as homeowner net worth and equity continues sliding, you may find some resistance to higher property taxes. You can start charging $10 to use the county park, and guess what, you'll find nobody needs to go there now. You can charge $10 a month to use the library, and guess what, you will either face a citizen insurrection or few will enter what was once considered a sacrosanct civil institution--the public library.

Or you can take stock and realise that government is an enterprise, too; it too needs to live within its means--especially as those means diminish along with the economy which supports you. Unlike the Federal government, you can't print money to pay yourselves or fund your pensions. You might want to focus on helping the goose which lays the eggs--small business--survive rather than devote all your energy to strangling it with higher taxes and fees.

You can either keep the libraries open, or you can fund your pensions. But you won't be able to do both.

The more taxes and fees are raised, the less tax revenue will be collected as the pool of small-business survivors melts under the strain. It's called a death-spiral, and we will all have ringside seats as 2009 unfolds its dark wings.

Lest you think this is just some outlier attitude, please read this commentary from an astute reader. This was written in response to my essayProductive and Unproductive Capital (December 27, 2008), but it resonates with the death-spiral I describe today:

"I compare today to say America in 1832 to 1942, what we did, what we believed, how we lived with mostly independent agrarian life, no distances, no transit, only walking to the homecoming game with your pal and your gal at the school 3 miles away. I keep saying, "does that sound so bad?" Is it so terrible to work where you live, in small, modest shop of our own making small, modest profits?

Your last post was insightful in this, which has a near-absolute effect on people who control and deploy capital. If there's all risk and no return, why deploy it? This single change could probably do more than any other. I am one of those capable of deploying capital, but all my life I haven't even once: the legal maze is incredible, the taxes are near 100% of profits, and the risk is total loss of everything you own, and with liability and garnishing wages, everything you might ever own. This same math drove my father out of small business altogether, and that was the early 90s when the gov't (including Fed debt) was 1/4 of todays' size. Was it too small then?

For example, here in Rochester, NY, there are 12-BR Craftsman mansions, all woodwork, fireplaces, show homes, 20min from the city, already cut into 3 apts for, oh $220,000. That's like giving it away. Replacement cost would be in the millions. You know what? The return on that investment is zero; the rents + taxes + risk would take ALL the profits, every penny: to the state, the bank, and the insurance companies.

That's why the present owner is trying just to sell it at breakeven. He doesn't want it either.

That's what I'm talking about in deploying capital, although laundromats, farms, restaurants, are all the same math. You work entirely for the State. Any profits are more than overshadowed by the additional risk. So I do nothing; and neither does anybody else. Do we get anything for this cost and nuisance? No. At least 30 miles north, in Canada, they GET something for their equivalent taxload: universal health care, and a system that has no personal risk. The dole is easy to get on, and there's no real stigma or bother attached to it. In NY we don't even get good roads.

It's nonsense. Go back to how it was--let the roads go back to dirt for all I care, cancel health care and everything else--despite the promises we don't really get it anyway. Most people out here would agree with me.

If we steal from workers and savers to give to speculators and borrowers, then why should people work for themselves anymore? And I can attest that here in NY, they don't. The farms were economically firebombed years before the rest of the economy. There's now no work people wish to do--although astonishingly there's still a lingering work ethic. So we do nothing, and nothing gets done.

Money won't solve this problem. That's the real point. Only work in the real world will. To get that, we need to reverse the reward structure 180' and reward people who work instead of those who shuffle, actively prevent the work of others, or who speculate.

History shows that will happen and despite recent appearances, it seems this may even happen peacefully, if with great hardship. Time will tell but the American people seem to be avoiding that path by not getting riled even when VERY put upon. They seem to be content with simply playing out all the rope that the present system needs. When it is completely nonfunctional, it will more or less hang itself without our needing to get off the couch. That's unconscious, and it's giving great benefit to the people, but here in the country, people KNOW they're getting screwed into poverty every day--and I mean actual no-heat, lose-the-house poverty. It's not as they say in the suburbs: that people are fat and lazy and don't know. THey seem to know well enough here but still prefer to play out the rope. I think people are more or less terrified of the explosion that might occur if they allowed themselves to get angry and take action. History would show, I believe, that their common sense in this is correct.

I liked the reader who spoke of "living on the land"--he has the relaxed and patient method I wish I had, although he wasn't able to flesh out this important idea so thickly. Living in farm country, thick with turkey and deer I can agree--hunting in a Depression is a dangerous fantasy. It took from 1932 to 1990 for turkey to return here, and only when re-introduced. Deer were virtually wiped out until the late 50s. There are no fish now even in normal times. Imagining hunting might work is an excellent way to get killed. Far better to buy a few hundred in garden seeds and a shovel, something I intend to write on if I can clarify a plan before people are already inside the storm. But you just can't write a 100-word essay on growing food. It's like being a doctor or a mason, it takes decades to learn to do well, everything is a soft-case exceptions, and only experience can teach you.

It seems like that idea that non-edible savings itself is illusionary, and that money is useless compared to real work are ideas that need to be explored. I look forward to seeing what you discover."

Thank you, reader. Here are two ideas to start with: tax the heck out of unproductive capital and unearned income, not just to raise revenue but to drive that capital into productive uses, and lighten the tax burdens placed on small business. The more that survive, the more tax revenues you'll actually gather.

10 New excellent reader comments.

New Essay by Eric Andrews:
Life and Cash-flow Accounting


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Saturday, December 27, 2008

Productive and Unproductive Capital
December 27, 2008

Putting capital at risk for a future return is the heart of Capitalism. But not all capital is productive. Encouraging productive capital and taxing unproductive capital is the difference between a financial recovery and a long Depression.

Let's take two wealthy capitalists. One has $10 million in tax-free municipal bonds which earn about $500,000 (5%) in low-risk, no-tax returns. The second one has $10 million sunk into a small business with a payroll of 25 employees and a brick-and-mortar office-warehouse. This "small business" generates millions in payroll and thus in payroll taxes, pays huge property taxes and sales taxes, and also generates tens of thousands of dollars in local government "junk fees" (business licenses, parking permits, fire inspection fees, etc. etc.)

The municipal bond investor is unaffected by the recession/depression until such time as one of the local governments which issued the bonds he owns goes bankrupt. He pays virtually no business or capital-related taxes.

Now let's consider a third capitalist who has $10 million in boutique hedge funds. Accounting legerdemain enables this capitalist to report much of his hedge-fund generated income as long-term capital gains, thus limiting his Federal taxes to 15%. He pays no business-related or payroll taxes, and doesn't even pay any FICA (Social Security) taxes on his income.

Many will note that the buyer of municipal bonds is providing capital which is spent repairing roads and schools, etc. and thus this money is productively invested. Others will claim the hedge funds might have provided capital to far-flung firms and thus "greased the wheels" of some distant productive enterprise.

Nice, but which capitalist is actually supporting his community with jobs and taxes? Only the small business owner. Those investing in Muni bonds and hedge funds may support their local community via consumption (eating out at restaurants, etc.) or they may not. They may be paying significant property taxes, or they may not.

The hedge fund investor certainly has placed his capital at risk (a fact now painfully visible to all), but the gains were entirely private when compared to the "real business" funded by the second capitalist who created 25 jobs, paid immense sums in Social Security and Medicare taxes (recall these are only paid on wages, not on rental or investment income), paid property taxes on his business facilities, etc.

Which capitalist do you want in your town? The wealthy investor who may or may not spend a dime locally, or the one who creates jobs and pays truckloads of taxes?

Which one pays the most Federal taxes? The "real business" owner, of course. Which one is most at risk? Some might claim the hedge fund investor, but the small business owner can also lose it all.

The real losers when the small business folds are the employees and the local community. They didn't just lose a frequent customer at a fancy restaurant, they lost livelihoods and hundreds of thousands in tax revenues and "junk fees" paid only by real businesses.

Which capitalist is most benefitted by the U.S. financial and tax system? The ones investing in paper assets, of course; their tax rates are the lowest, their risks are lowest and their flexibility is highest. Which is the most productive?

It can be argued that the original venture capitalists who invested in Apple Computer put their capital to extremely productive use. Fine, agreed. But how many hedge funds directly funded new enterprises via venture capital? Essentially zero. How much of the Muni bond investors' capital is actually at risk and funding new enterprises? Some new company may snare a local government contract to build a new school, but this sort of spending is not the same as backing Apple Computer's launch.

Clearly, both kinds of investment are necessary, venture capital and municipal spending raised from the sale of tax-free bonds; but where does small business, which generates 80% of the jobs in the U.S. economy, fit into this picture? Some small firms are funded by venture capital, and others get local government contracts; but what businesses receive long-term funding or contracts from hedge funds?

All of this is to say that invested capital is not taxed equally, nor does it generate equal tax revenues or jobs in the community. It seems rather obvious that the financial and tax structure of the U.S. punishes the most productive capital and rewards the least productive. As long as this is the case, then we can expect the real businesses which actually generate most of the jobs and taxes to wither and die under the immense burdens placed on them while capital will flow to the low-tax, low-productivity forms of rentier non-entrepreneural "capitalism" favored by the U.S. tax laws and financial system.

Who's paying for Medicare? Not the rentier capitalist; his income is untouched because it's not wages. Who's paying medical insurance for employees? Not the rentier capitalist; he doesn't need any employees to rake in a healthy low-risk, low-tax return.

"Get America working again." Nice, but with what money, when the advantages of low taxes accrue to rentier capital while entrepreneural capital pays full freight and faces staggering risks? How many will risk their $10 million in a real business with all its high risks, high taxes and high overhead costs? Why bother?

Honestly, it's much easier to sit at a desk at home and gather long-term capital gains (which may or may not be productively invested) or tax-free earnings than put up with the guff of real business. And if this is the case, then who's going to risk everything to hire people and "get America working again"?

This is why I predict 30 million formal jobs will be lost in this Depression; it's no longer worth it in terms of risk/return to start businesses when everyone is sucking real businesses dry and leaving rentier capital lightly taxed and lightly regulated.


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Friday, December 26, 2008

What's Up/Down with Oil?

Thank you, readers, for your many holiday greetings and comments. I am overwhelmed with family obligations for the next week and will do my best to reply in the first full week of January. Entries will be sporadic until then.

Even as oil relentlessly declines in price, the value of oil/gas companies has been rising for months. Why is that? Is the market discounting the continuing decline in oil? Or is that decline misleading/bogus? Whoever gets it right will profit.

One key tenet of oftwominds.com is that we as individuals have the opportunity to grow our capital/purchasing power with prudent investments, speculations and hedging. Even if someone only has a few hundred dollars in cash capital, that amount can be profitably put to use via options (puts or calls) which each control a hundred shares of the company's stock (futures contracts and other trading vehicles are also available to small speculators).

As always, please read the HUGE GIANT BIG FAT DISCLAIMER below before proceeding. This is a free website and it offers the opinions of an amateur chart-watcher (me), NOT investment advice.

Even as the ship of state and the global economy falter, some will retain more purchasing power than others. Why not make it "us" rather than "them" who grows our purchasing power?
Which brings us to oil and the rather striking divergence between the price of oil as a commodity (dropping) and the stocks of oil companies (rising). Either the people buying shares of oil companies are betting oil will soon stop declining and start rising, or they already know the price of oil is artificially low.

Let's look at two charts:
Please go to
www.oftwominds.com/blog.html to view the charts.

The charts are self-explanatory: even as oil continues declining, stocks like APC put in a bottom months ago and are forming very bullish divergences in MACD and a flag or pennant which looks rather likely to break out to the upside. (Disclosure: I made a little money trading APC and VLO calls in the past 2 months, and I just bought APC calls on 12/24/08. I also own APC and VLO in my paltry IRA account.)

I come now to one of the most important articles of 2008. First brought to my attention by frequent contributor U. Doran, the topic was addressed by my esteemed colleague Jesse at the Cafe Americain. The article explains why oil futures do not reflect global oil realities. Light sweet crude is priced upon delivery in Oklahoma, and as a result the price does not reflect the realities of demand elsewhere in the world or the availability of oil globally. The CFTC Is Failing to Regulate Commodity Market Ponzi Schemes.

Here is the source document, via Reuters: NYMEX oil benchmark again in question.

I don't know the true state of oil supply and demand globally, but the stock market is indirectly suggesting that the NYMEX price of oil is not reflecting the reality of the global market. Why would oil stocks bottom in mid-October and start edging upward even as the price of oil plummeted? Why was there such a huge difference (contango) between the price of oil to be delivered at the close of the December contract and the price of the January contract?
Many citizens are questioning the numerous disconnects between the futures markets in precious metals and commodities and the realities of global supply and demand. As the saying goes: keep an eye on the referee. Maybe this match/game isn't quite as fair as it's advertised.

HUGE GIANT BIG FAT DISCLAIMER: Nothing on this site should be construed as investment advice or guidance. It is not intended as investment advice or guidance, nor is it offered as such. It is solely the opinion of the writer, who is NOT an investment counselor/professional. All the content of this website is solely an expression of his personal interests and is posted as free-of-charge opinion and commentary. If you seek investment advice, consult a registered, qualified investment counselor (As with any other professional service, confirm their track record and referrals).


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Wednesday, December 24, 2008

The Last (Consumerist) Christmas in America
December 24, 2008

Christmas Eve is an appropriate time to consider the possibility that 2008 will be the last consumerist-frenzy Christmas in America. Commentator Richard Metzger reports on what lies ahead.

As noted last week, I will be covering a number of critical topics entitled In conversation with Richard Metzger, as my discussions with Richard have ranged far and wide over the future of the U.S. economy and society.

Richard writes:
"When we first met up, there were so many topics we could have started with, but the most pressing one seemed to be, to both of us: 'What is "it" (Depression II) going to actually look like?' Or what will it look like in a year, then two, then five? What will be the visible and social manifestations of the crisis? Let's start with that here, shall we?

What strikes me at the moment, is just how poor the retail environment is. Well poor for the merchants, great for the consumers. Would they have slashed prices this deep, this early, unless sales were off on an absolutely monumental scale? My wife and I were walking around the mall the other day and the prices now are lower than they'd normally be at the end of February, when they REALLY want to get rid of stuff. As in 75% to 80% off.

There was a story on the radio about people haggling at Barneys in New York. Here in Los Angeles many of the chi-chi modern furniture stores and small clothing boutiques are closing or have closed already. Not to type out such a Grinchy prognosis, but here it comes anyway: I think it's obvious that as bad as this retail season has been --if 75% off isn't flat out DEFLATION, I don't know what is-- this will still be seen as the "last" great, old school American spend spend spend Christmas shopping orgy for some time to come.

Christmas 2008 will be the historical bookend of the consumer era. (Emphasis added: CHS) The last gasp. I don't see any possible chance of its return. This culture of spending, the conditions won't be there for it, nor the desire to consume like that again. I think it's simply been beaten out of us.

But, further to this point, with the tremendous implosion in the FIRE economy and the huge aggregate losses in the GDP from Wall Street, the banking sector and the real estate bubble (all essentially non-productive enterprises seen from hindsight. none likely to rebound for decades), when these losses get combined with a massive, massive slowdown in US consumer spending --which serves as a sort of gigantic furnace for much of world manufacturing and trade, of course-- we'll have an America where the GDP returns to the level of... what year?

You often read economists writing about real estate saying that housing prices might eventually return to pre-bubble levels by 2011, but what about the GDP? A lot of the Ponzi scheme profits of Wall Street and the hedge funds can now be seen to never have existed in the first place. There's been unprecedented wealth destruction in real estate. In practical terms for a reasonable guesstimate of the true United States Gross Domestic Product, might this mean a return to the GDP of, of say, pre-dotcom bubble America, taking the years 1994 to 1996 as an arbitrary yardstick?

Subtract the FIRE industries, throw in the consumer/debt shut down and how much THAT will subtract (I can't guess at that number) we are looking at one hell of a haircut for the GDP. It won't be anything like a 4% contraction-- already an epic nightmare-- it'll be an abrupt implosion of some high percentage of the GDP.

And when America's rapidly growing national debt is measured against a GDP that looks closer to 1996's tally than to 2006's, this is when the word DEFAULT will be on everybody's lips. It will begin to seem advantageous to repudiate the debt before there is no possibility of any sort of governmental spending beyond servicing it. What will that do to the currency, what will this do to world trade, etc.? So many more onion layers keep presenting themselves and it all looks doomed."

Excellent summary, Richard, thank you. The numbers being bandied about to quantify the wealth that's been lost/destroyed in the U.S. in the past year are truly staggering: $10 trillion seems to be a common number but I wonder if that is as underestimated as unemployment, etc.

The Fed is desperately attempting to re-inflate the debt bubble by lowering interest and mortgage rates and buying up all sorts of semi-toxic/impaired consumer debt. Well, mortgage applications have shot up, but it's basically existing homeowners rushing to refinance existing mortgages. Lower payments will free up some household spending, but what the Fed cannot do is make people borrow more money.

What the Fed dreads is the reality we all feel and see: fear of the future due to diminished wealth and shaky incomes. If your assets have been slashed, you feel poorer because you are poorer. Borrowing more at any interest rate will not make anyone feel wealthier.

People who fear their income may plummet due to layoffs or their hours being cut are not in the euphoric mood to borrow more.

People whose 401K and IRA retirement accounts have been decimated are not in the mood to borrow more; they're in the mood to save, not borrow. People whose homes are worth less than their mortgages--at least 20% of all mortgage holders, heading to 40%-50%-- are not in the mood to borrow more.

Thanks to the "head-fake" crash in oil prices, people have received a windfall "tax cut" which won't last. All the investment which should have been made in the global petroleum industry but was cancelled due to the drop in demand will have consequences. A few years from now, when demand exceeds the fast-dropping supply of oil, then the lines snaking around empty gas stations will remind aging Baby Boomers of the gas lines and shortages of 1973. But there will be one important difference: these gas lines will never go away.

Let's say we go ahead and drill the ANWR tract in Alaska. Whoopie, in about a decade we'll get at most 1.5 million barrels a day out of that field, or less than 10% of our daily consumption. In the ensuing ten years, global depletion will have hacked off 10+ MBD from global supply.

Simply put: no matter what technology is applied, depletion of the few supergiant fields which supply half the world's oil will decline faster than modest new supplies can come on line. Since our consumer economy and thus Christmas is fundamentally based on cheap, easily available fossil fuels, then the demise of cheap oil will mean the end of the free-wheeling consumerist frenzy.

This is the last Christmas in America because this is the last Christmas in America with cheap, abundant oil.

And let's not forget that much of what is purchased in this frenzy is needless, superfluous crap. My wife saves the most egregiously gift-buying-frenzy advertising circulars, and one from Bed, Bath & Beyond caught my eye.

There is no difference between this "1001 Best Gifts" from BB&B and a parody of consumerist excess. Hmm, how about an "executive standing valet" rack of wood and plastic for $99.99.
To make this poor-quality contraption, a forest somewhere in a Third-World kleptocracy was cut down and precious, irreplaceable oil was burned shipping the lumber to China and from that factory to the U.S. across 6,000 miles of Pacific Ocean.

We know this spindly piece of garbage will break in a matter of days, weeks or maybe if the owner is especially careful, months; then the legs will break loose of the base, the towel bar will pull out, etc. and the "we cut down a priceless rain forest to make this" piece of human handiwork will be put on the curb where a diesel-buring garbage truck will haul it to the landfill.

The 16-bottle wine cellar/cooler from Cuisinart for $199.99 might come in handy storing something once it's unplugged--but a cardboard box will probably do just as well.
I for one will not mourn the last Christmas in America. Good riddance to the flaunting of borrowed money and the heedless, desperate purchase of valueless "goods" as gifts for an insolvent nation awash in too much of everything but common sense, accountability and healthy living.

Here is Part 4 of Chris Sullins' strategic action thriller, Operation SERF: Operation SERF, Part 4


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Tuesday, December 23, 2008

U.S. Schizophrenia on China
December 23, 2008

As the global depression takes its toll on all trading nations, a bizarre schizophrenia has developed in U.S. opinion on China: reports of civil unrest in China are accompanied by opinions that China is poised to reap historic gains from the financial turmoil of the West. Interestingly, the financial turmoil of the East is conveniently ignored or downplayed in these rose-tinted views.

After 8 years of what I have termed "Bogus Prosperity," the underlying structural flaws of both the U.S. and Chinese economies have been laid bare. In the U.S., the decline in real surplus/productivity has been masked by financial legerdemain and a system which favors leverage and asset-stripping over production.

In China, structural corruption/local-official looting, piracy, inconsistent environmental regulations and a focus on exports all are coming home to roost with a vengence. The two global "engines of growth" are dysfunctionally linked and thus falling apart simultaneously.

Yet even as the structural problems within China's political, economic and financial systems are being bared by mainstream media reports like these-- After 30 Years, Economic Perils on China’s Path (New York Times) and China Faces Unrest as Economy Falters (Wall Street Journal), other articles like U.S. Woes Open Door for China (Wall Street Journal) and The Great Crash, 2008: A Geopolitical Setback for the West Foreign Affairs) posit that China is well-protected from Western Depression:

"No country will benefit economically from the financial crisis over the coming year, but a few states -- most notably China -- will achieve a stronger relative global position. China is experiencing its own real estate slowdown, its export markets are weak, and its overall growth rate is set to slow. But the country is still relatively insulated from the global crisis. Its foreign exchange reserves are approaching $2 trillion, making it the world's strongest country in terms of liquidity. China's financial system is not exposed, and the country's growth, which is now driven by domestic activity, will continue at solid, if diminished, rates."

Unfortunately, all of the last line is simply incorrect. China's financial system has its own bubbles, malinvestment, legerdemain and hidden bad debt, and it is exposed to the Western malaise, even if indirectly. China's growth is not driven by its domestic demand except in the fantasies of the "China has decoupled from the West" Perma-Bulls; statistically, domestic consumption has actually shrunk as a percentage of Chinese GDP.

As I noted in A 1,000 Foot High Tsunami (October 21, 2008), Henry Paulson's essay in Foreign Affairs, The Right Way to Engage China, states China's domestic demand is only a third of the economy:

"One of the most notable indications of China's imbalanced growth is its large current account surplus, which last year amounted to over 11 percent of the country's GDP. This reflects the fact that China spends much less than it produces and earns and that it has a high rate of national saving. Chinese household consumption was only 35 percent of GDP in 2007, down from roughly 50 percent 30 years ago, when Beijing started market reforms. (Household consumption is roughly 70 percent of GDP in the United States and 60 percent in India.)

On the other hand, household savings are high, as individual Chinese try to compensate for the country's thin social safety net, limited options to finance major expenditures such as education, and few investment options other than bank deposits. Demographics will only exacerbate these trends: as China's population ages, the traditional source of support in retirement -- children -- will become increasingly scarce."

(If you'd like some context for China's long-term structural challenges, please read my 2005 report, China: An Interim Report: Its Economy, Ecology and Future .)

The schizophrenia between reports of China's "slowdown" and its supposed readiness to gain from global Depression has its roots in the U.S. mainstream media's basic ignorance of local government actions in China. It's not just the MSM which is clueless; even Chinese citizens without access to higher-ups in local government have no idea what's really going on.

The real action in China is always at the local government level. The structure of the Communist party and the central government lines of authority give the power for everyday management of the economy to local Party and government leaders. Everything from the central government is mostly ignored because there's no real authority to back it up except in cases where the entire nation is mobilized (the SARS scare, etc.)

What most Westerners don't understand is finance, economic development and local government are in constant, permanent collusion. Few Westerners understand that local governments borrow vast sums of money, too, to fund sports pavilions, etc. Few Westerners understand that local officials will essentially steal land from peasants and send locally hired and paid hooligans to beat up protesters while official police look the other way.

Few Westerners understand that loans are approved or arranged by local officials, who also grant the rights to foreign entities to build factories in local business parks. Few Westerners appreciate that the prime directive for local officials--and the source of their own wealth--is economic development, not strict accounting of funds or strict enforcement of nationally-issued environmental regulations.

Those directives are followed when reporters are around, i.e. for show, and then ignored the rest of the time. The Chinese government is essentially schizophrenic itself, with the central government claiming planning and regulatory control even as it cedes actual authority to local Party and government and makes economic growth the priority.

There is literally no advantage for local officials to take a hard line on accountability, anti-corruption and anti-piracy campaigns or strict environmental standards, while there are significant financial and official rewards to driving local growth--even at the expense of peasants, public safety (i.e. shoddy construction) and environmental damage.

Up to 40% of the Chinese GDP is direct foreign investment. As I quoted in Hot Air Dragon: Is China About to Pop? (July 20, 2006):

"Construction projects such as the forests of cranes on Changsha's horizon are just the most visible evidence of a nationwide investment binge that raised new spending on construction and factory equipment to $318 billion by the end of May, up 30 percent from the same period of 2005. Such investments are forecast to exceed $1.3 trillion this year, nearly half of China's GDP.

To finance that spending, China's big commercial banks, their already fat cash balances swollen by government bailouts and recent multibillion-dollar initial public offerings, issued new loans worth $267.5 billion in the first half of this year. The worry is that too much of the money is going into redundant or ultimately unprofitable investments, risking a rebound in bad loans and possibly a financial crisis. With China now an engine in the global economy and international investors joining in on the Chinese investment binge, a hard landing could jolt world markets."

For more on China's dependence on foreign trade and manufacturing, please read The Myth Behind China's Miracle (Foreign Affairs) and PART 2: The US-China trade imbalance By Henry C K Liu (published in the Asia Times:

"These figures show that trade is now a precariously excessive portion of Chinese GDP. And without a trade surplus with the US, China would face a global trade deficit of about 6.25% of GDP, more than the United States' 5.7%. China's addiction to trade: With any addiction, initial euphoria soon turns to agony. Chinese per capita GDP was $1,231 for 2005, while the country's per capita foreign-trade volume was $1,000.

Take away foreign trade, and Chinese per capita GDP would be $231, or 63 cents a day. And that number is per capita GDP, not per capita income, which is usually lower."

None of this is new, but the schizophrenia remains: despite the "decoupling" cheerleaders' hopes, China remains heavily dependent on three pillars which are crumbling: exports, direct foreign investment and borrowed money to fuel China's real estate bubble.

Bottom line: China doesn't need any exposure to the U.S. financial system's collapse: it has its own popping bubbles--in real estate lending, in exports, in direct foreign investment--to deal with.

The schizophrenia in U.S. opinion on China is partly driven by powerful wishful thinking; many here hope that China will somehow dodge all its own problems and "save" the U.S. with its massive reserves of dollars and potentially massive domestic demand for U.S. goods and services. But wishful thinking is no substitute for an understanding of China's homegrown, internal structural flaws and contradictions.

Only those with insider knowledge of local government in China can really know what's going on. Everything else is either rumor or propaganda packaged for domestic and foreign consumption.

Thank you, Cheryl A., for suggesting this topic.

Here is Part 4 of Chris Sullins' strategic action thriller, Operation SERF:
Operation SERF, Part 4


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Monday, December 22, 2008

Infrastructure and War December 22, 2008

President-Elect Obama is proposing a massive infrastructure spending program which rightly worries many citizens concerned about boondoggles and "bridges to nowhere." While this concern is valid, we must accept that the basic infrastructure of the U.S. is in terrible shape and needs trillions of dollars in renovations/upgrades.

War has many unintended consequences--the nation launching a war does so in the firm conviction of easy victory and no damage to itself--and one is the destruction of infrastructure. In a strange irony, the losers of World War II, Germany and Japan, were so heavily bombed that they could rebuild their infrastructure after the war (with America's money and aid) to the latest standards.

Meanwhile the Western winners of the war (Britain the U.S.--the U.S.S.R. did suffer much damage from the Nazi invasion) were left with aging infrastructures largely intact. (Though the bombing of London did much damage to buildings, the Nazi air assault left the steel mills, railroads, etc. of England mostly intact.)

The after-effects of this are still playing out 60 years later. One of my friends toured a number of U.S. auto factories in the late 90s, and he was struck by the decrepit state of the factories themselves--never mind the high-tech robots inside, the buildings and plant pre-dated World War II.

Why does this matter? I once read that the auto factories in Japan are heated to about 60 degree F., while union agreements keep U.S. factories heated to 68 degrees or higher. Imagine heating a huge, drafty old bulding in one of the coldest climes in the U.S.

This differential in the age of infrastructure is one reason Japan uses far less energy per dollar of output (GDP) than the U.S.

The more you know about aging U.S. infrastructures like subways, water works and electrical transmission lines, the more amazed you are they function as well as they do. For a fascinating look beneath the streets, check out The Works: Anatomy of a City .

Here in California, water districts continue to fund billion-dollar improvements to the hundreds of miles of pipes serving the most basic need of urban dwellers--fresh water. Billions more have been spent strengthening public buildings against earthquakes. In eastern cities, water systems from the 19th century are showing their age, and everywhere in the nation the electrical transmission system is inadequate to the task of moving ever-increasing quantities of electrical power around the nation.

Solar power plants are built in the great deserts of the U.S. for obvious reasons (few clouds, almost no rain, steady sunlight, etc.), but transferring that power to cities requires a new power grid which will cost billions.

The difference between "pork spending" boondoggles like the Bridge to Nowhere and a much-needed water system or power grid is rather obvious. The way to prioritize infrastructure spending is common-sense: those systems which serve tens of millions should be fixed before systems which serve thousands, and those most likely to fail with life-threatening consequences (bridges, etc.) should be upgraded before systems which are not life-threatening.

Many commentators have noted that Japan spent lavishly on infrastructure projects in its attempt to "spend its way out of recession," with little results. But as visitors to Japan know, it is a small nation whose railways and other infrastructure were already superb before the 1991 recession even started. Thus Japan had little to repair and so the spendng was squandered on thousands of bridges and roads to nowhere in sparsely populated rural Japan.

The difference is: the U.S. desperately needs trillions in upgrades, renovations and repair to basic infrastructures like railways, electrical grids, energy-conservation in public buildings, etc.

We are uncompetitive partly because we squander tremendous quantities of energy compared to our advanced-economy competitors. A good $100 billion could probably be well-spent simply better insulating public buildings and facilities in the U.S. and switching over to low-wattage lighting--the easiest, most low-tech ways of reducing the load on our aging power grid and reducing the cost structure of our economy.

Should the Federal government be borrowing a trillion dollars to spend? No, it shouldn't. But since it's a fait accompli, then we as citizens need to demand that the money be prioritized and spent wisely on our real needs, not just in "make-work" pork boondoggles. The Devil is in the prioritizing, and we as a nation need to pressure those tasked with distributing that money to do so not as political rewards but as common-sense repairs to our aging, inadequate water, transport and power grid systems.

As to those who are convinced that all government spending is wasteful and corrupt--it need not be so. Here in my area, the water districts are public utilities, and by all accounts the tax money being spent to insure our water supply is well-managed and profitably spent. Government, like any enterprise, can be well-managed if managers are held accountable and the elected board can be jettisoned for incompetence.

Hint to voters: if you want to reward incompetence, keep electing incumbents and show zero interest in an audit and accounting of tax money being spent.

Here is Part 4 of Chris Sullins' strategic action thriller, Operation SERF: Operation SERF, Part 4

Thank you, Michael A. ($10) for your most welcome generous donation to this site. I am greatly honored by your support and readership.

Thank you, Stephen A. ($10) for your much-appreciated generous donation to this site. I am greatly honored by your support and readership.

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Two Commentaries

December 20, 2008

I continue to be delighted by the in-depth commentaries submitted by readers of this site. Here are two which comprehensively address the choices I addressed in "Triage." Such critiques help clarify my own thinking and point out what ideas I did a poor job of communicating.

Reader comments illuminated the weakness of my coverage this week of certain key ideas. Let me try again on these:

1. The U.S. no longer creates enough surplus to fund its expenses/lifestyle. We as a nation have "made up the difference" between the surplus we generate as a nation (as priced in gold) and what we spend by unsustainable borrowing, leverage and speculation.

Think of national surplus income as a well. Ours has run dry for the past 8 years, so we borrowed water from others' wells (i.e. from their surplus), dumped the water in our well and then pulled up buckets of water proclaiming, "See? We still have plenty of water."

This trickery masked the reality that our well has run dry. Borrowing (whether via printing and selling bonds or creating money via leverage), leverage and speculative churning is not surplus--it's essentially stealing from future generations to pay our entitlements and other spending today. I find that unconscionable. There is no way to pay more wages (nationally), more entitlements or more of anything when we have no surplus. We need to produce a surplus before we can spend it.

2. Risk cannot be made to vanish--it can only be offset at great expense or hidden. Our entire system is based on the false idea that risk can be mitigated to near-zero. This is an illusion which has cost us dearly. Risk is now becoming visible in parts of our economy which felt "safe" (i.e. auto manufacturers, government employees, finance industry, etc.) Any solution which doesn't recognize real risk is doomed to fail as it is based on illusion not reality.

3. Regarding Has Capitalism Failed? December 19, 2008): I was trying to say that "real" capitalism will require the destruction of most stakeholder's capital in healthcare, autos, banking, etc., and since those stakeholders can buy political influence then they will "buy" government bailouts which are de facto nationalization to save their capital at taxpayer's expense. That isn't capitalism, yet for ideological reasons the reality of de facto nationalization is being cloaked with an illusion of "private enterprise" to hide the fact that what's being saved is private stakeholders' wealth and income.

The only thing "private" is the capital and incomes being "saved" by the taxpayer bailouts. The actual enterprise is essentially nationalized in everything but name.

OK, here are the two reader commentaries.

James D.

The triage article was great ( First Step: Triage December 16, 2008). Unfortunately, like you said, the chances of these things happening on a national scale are zero. I am emailing you about two topics: first, how to prepare, and second, what to do about energy.
On the first topic, we need to think through how to position ourselves to survive, thrive, and grow. To do this, we have to observe the Great Depression, Japan, and Argentina. In the short term, I see us completing this rally with perhaps a blow off to 1000 on the S&P after an auto bail out. Then we will retest 750 during 4th qtr. earnings. Following that, we will get a major rally. Up to now, the Fed has pumped a lot of money into banking, but it hasn't gotten out into the economy. That WILL change.

Obama is going to go on a trillion dollar spending spree. Banks will borrow from the Fed using the discount window at 0.5%, and buy long term government debt to provide the funding. Long term treasuries are going to continue to rally for quite some time. Since the government will be spending money, the money will end up in the markets. So I expect to see a big Obama rally in Feb./March. I won't be going long, but I will probably play it with gold. I might go long a few select shares, maybe oil services and maybe solar. Don't know yet. How long this keeps us afloat, it is too early to tell. But eventually it will fail. This final failure is the big one. You have to be ready for it, but you may have a year or two, so there is some time.

What smart people need to do is move to small rural towns where everyone knows everyone. Also, there are additional benefits. For example, I can put grass fed, chemcial free, free-range beef, butchered and wrapped, into my freezer at $2.15 per pound. I can get fresh free range eggs for cheaper than the store, and tons of farmer's market vegetables. I can also grow/raise my own (haven't done enough of that) by being in a rural community. Also, folks around here still look down on entitlements and tend to want to solve their problems instead of asking for a handout. Of course crime is very low and you can carry your gun without anyone even noticing.

The next thing people need to do is develop a black market skill that creates economic surplus. I told my fresh-out-of-college brother-in-law the following: Throw out the paper money for a moment and look at reality. In a few years either a lot of entitlement people and retirees will have to live in single wide trailers and eat rice and beans, or we have to become slaves. By slaves, I mean we will have to pay insanely high taxes and fees, endure rationing of medical care, and live under wage and price controls governing what we can charge. The retirees outnumber us, so get ready. Imagine if you can repair air conditioners. I assure you wage and price controls go out the window on a 100F day, and you will get paid in cash. This is coming, don't doubt it.

The next thing is building up a stock of precious metals. The government is going to print. It is already printing, and once the Obama plan is launched, prices of commodities will go back up. Gold will rise once more. I like having junk silver on hand, and gold over in BullionVault.

In summary for Item 1, we need to predict what will happen based on history. History tells us the Newer Deal is coming. This means a dead cat bounce, maybe up to two years, ending in a further drop, maybe S&P at 400. Unfortunately it also means World War III. But think about the implications of the Newer Deal and prepare for it. In fact, if you play it right, you can profit from it. Just don't swallow the B.S. and keep your eyes open.

A quick aside on medical, I pay cash and don't have insurance. I ALWAYS get a 25% discount, and sometimes up to 35%. Doctors love cash paying customers. This has included surgery and hospital bills. In the five years I have been without insurance, I believe I have saved over $30K to $50K in premiums on a family plan ($900/mo). It adds up quickly.

On the second topic we have energy. First, ditch wind power and ethanol. Wind power is a loser because it would require a huge investment in a new grid. Even with a new grid, the transmission losses from say North Dakota to Chicago would be enormous. But forget about that, we aren't going to get a new grid, so wind won't fly (pun intended). On ethanol, it is a net energy negative, so the depression will quickly disabuse us of that idea. The ethanol subsidies will get chopped or inflated away. So now the truth about energy. First, the main crisis we are facing are the looming Global Warming regulations. I don't believe in man-made global warming.

If you look at Hansen's predictions, he had three curves, with the "A" curve being the worst case, and the "C" curve being the best case. Our temperature rise has been below the "C" curve. This is a major red flag for me. But whatever you believe, companies are unwilling to invest big due to future restrictions. In fact we have plenty of coal to keep us going. We also have coal-to-liquids technology that will produce diesel and jet fuel. In fact, this technology is currently being used in Kansas to produce fertilizer and has been used overseas for decades for diesel and jet fuel. We also have had incredible success with 3-D seismic and horizontal drilling. These two technologies have given us the chance to greatly extend our oil reserves including going into "dead" fields and producing again. And then we have the massive oil fields sitting in Alaska. Put it all together and there is no need for a crisis.

In reality, the biggest crisis we have is political. Two very important sources for oil are Venezuela and Mexico. Venezuela is busy destroying their oil industry under Chavez. In Mexico, they have three elephant fields in the Gulf, however Pemex doesn't have the ability to develop them, and U.S. companies are not allowed in. Even with these problems, coal and technology in oil drilling will keep us going for twenty years more.

The future will be in thin film solar. 20 years from now you will buy solar cell film from Walmart for $20. Thin film solar is the solution because we can use the existing grid. It will be ubiquitous. It will be on the roof of you car and on the roof of your house. Your house will back feed the grid during the day after topping off your batteries. And that grid might be generating hydrogen from salt water which will be used in fuel cells. I think we will also need a lot more nuclear for base load, and some coal to liquids for air travel. So what can we do and where to invest?

1. We need nuclear, so that means we have to get Yucca mountain up and running. Before people freak out about nuclear waste, let me ask you a question. Would you rather hold radioactive material with a 1 week half life or 1 million year half life? Yep, the one week half life material is used to xray pipe welds, and will fry you. Nuke waste you could probably eat. That's an exaggeration, but it is safe. Something that takes millions of years to decay is not putting out a lot of radiation. Putting it a mile under the ground in Yucca is completely safe. We need to end the silliness and get more nuclear plants up and running.

2. On global warming, we need the truth. The Hansen predictions have turned out to be 100% dead wrong. If you monitor climateaudit.com, you will see that global warming is full of fraud. Maybe man-made global warming is true, maybe it is not. The objective answer at this point is that we don't know. I think we can wait twenty years for the development of solar. By that time we will be running out of oil anyway.

3. For investing, thin film solar is the way to go. Who to invest in? I don't know, but stay current on the developments.

4. Battery technology is also something to invest in. Learn about that.

5. Hydrogen fuel cells which run on hydrogen generated from the sea will probably play a part. Transporting the hydrogen will be a challenge unless we use existing natural gas pipelines. Maybe wind power can play a role on the coasts as part of hydrogen plants. I still don't think wind power will be a big player sans subsidies.

6. We need ANWR and other domestic oil deposits. We have to face reality. Alternative energy is at least 20 years away. That is the hard truth. We are going to need oil until we develop alternative energy, and that means ANWR.

7. Support legislation that allows you to "spin your meter backwards" and get paid for it. That is probably the best way that you can support the development of solar as an individual.

Kyle L.

There are at least three things I find wrong with your assumptions:

1) City/State Salaries: I find you naturally assume that city employees are overpaid instead of assuming private sector employees are underpaid. Instead of destroying well paid positions I suggest you advocate improving the pay in the private sector. Start with increasing minimum wage, which I find deplorable down there in the US. There are other levers to increase private sector pay. I deal with this below.

2) You said: "For instance, the 100,000-page tax codes could be tossed out and a 5-page FAIR (consumption-based) tax system put in place." Consumption-based tax is regressive. The problem is the massive assets accumulated by 1% of the population and denied to the rest of us. Our society must find a way to extract that wealth so it can be put to use. Consumption based tax will never do this; the wealthy have no hope of spending it all. Furthermore, all these assets are loaned out with interest: increasing the concentration of wealth.

I do not advocate taxing assets, but I also believe that there should be no pay for no work. This means capital gains should be taxed at 100% of income tax rate, and inheritance taxes should be taxed even higher. Capital gains are already offset by losses; so risk is already accounted for. The children of the rich should not be granted free money: they should work for it like everyone else.

3) "Take responsibility for your own healthcare" I disagree, and the reason is because of a bigger picture:

We, are "too efficient", and we two options for our society: Work less or have more.

Working less will never fly: Some people derive great pleasure from working hard, and at same time, will enjoy belittling those that work less. I see this in what you say about city/state workers. There is not enough work for everyone: The hard workers, who have "taken work" from others, will blame those that can not get a job. Unless there is a new level of compassion in our society for those that actually take the freedom our efficiency has granted us, we will never go down this path.

Our only real option is to have more, and generate enough employment for all. We must do this while at the same time living within our limited natural environment. To me, it seems we must change our attitudes away from having more *things*(which consume natural resources) to having more *services* (which consume human resources). Here are some things our consumer culture should be directed toward consuming:

A) Heathcare (but not drugs) B) Food Services
C) Body Care services

Healthcare: Cuba's heath care system is better than the US. Sure, Cuba can't cure exotic cancers, but the US can't cure simple sicknesses in the poor's infants. Government run and government funded heath care systems work very well and make a stronger economy generally: Both by increasing employment, and reducing individuals' risk:reward ratios. Efficiency is had by reducing paperwork and removing profit from the system costs: which are significant. The corporate propaganda machine has you believing that drug and diagnosis costs are going up, but they are not:

1) Drug costs are high in the US because there is no body with significant purchasing power: Government healthcare can negotiate country-wide discounts on drugs, AND have the power of withdrawing patent protection if negotiations are not done in good faith. This is done in Canada, and is why are drug costs are lower.

2) Increase in drug effectiveness, especially over the last five years, is due to the REMOVAL of bad drugs from the system. The New England Journal of Medicine found that even though each individual medical trial may be properly run, and the conclusions correct, the body of trials was badly corrupted. The corporations were canceling trials that did not produce proper results. Only the trials showing a new drug in a positive light was released for publication. Now the NEJM demands all trials be pre-registered if they are to ever be published:

( content.nejm.org). You can see its effect as dangerous drugs are being taken off the market, and simple drugs like aspirin, are shown to be just as effective.

3) Diagnosis is overdone: If doctors were not incentivized to request more diagnostic tests, they would not. The clear majority of medical problems do not require expensive diagnostics to determine treatment.

4) A robust heathcare system that services the whole population, and not just the rich, will employ more people.

Food: First, I agree: "... completely ditch the standard American diet of junk food, prepared food and high-salt, high-fat, high-sugar 'food.'". But I disagree that making your own meals is not the solution. Food can employ more people by increasing regulation and promoting eating out.

1) We want to regulate restaurants to make nutritious food, which means more regulation toward organic and proven-safe additives.

2) Illegalize the flavour industry: The flavour industry is required to make mass-market food palatable. Most natural food can not handle the packaging and freezing process: illegalize the modified vegetable oils, and other unnatural construction materials, and hopefully this industry dies.

3) Demonize the mass market food, and promote food that requires a high amount of preparation: The food must be served to your table. The food must be cut for you (like in China and Japan). The food must be better than the swill you make at home. More work put into the food, the more people are employed.

Body Care: I do not have much to say. May people consider this a luxury, so should be easy to promote in the consumer culture. It also employs many people, and seems to consume little natural resources for the number it employs.

Thank you, James and Kyle, for taking the time to present a wide range of thoughtful ideas/solutions.


Thank you, Gregory D. ($100) for your astonishingly generous donation to this site. I am greatly honored by your support and readership.

Thank you, Tom I. ($25) for your much-appreciated generous donation to this site. I am greatly honored by your support and readership.

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