Early Indications - December 2008
December 2008 Early Indications: The Predictions Issue
Given a year in which oil prices inflicted broad economic pain -- then fell $100 a barrel, a Republican president nationalized key banks, and an African-American first-term U.S. Senator won the presidency, it's pretty tough to predict the encore. Volatility is obviously on everyone's mind, bad people from Wall Street to Mumbai are doing outrageously bad things, and the quality of news we receive about the state of the world is up for grabs. What framework can possibly explain what might happen next?
Despite arguing that interconnectedness of many factors matters a lot, I'm going to start by dividing the world into a domestic sphere (U.S., in this case) and a global sphere, then discuss the latter first.
Externalities of Globalization
An externality, in simplified form, is a spillover cost or benefit that accrues to someone outside an economic transaction. Pollution is a classic negative externality, but positive ones also exist, as when my health prospects improve in proportion to the percentage of the population that gets flu shots.
Two main points of view delineate the globalization debates. Thomas Friedman carries the flag for the "flat" (level playing field) school, while the "lumpy" camp, which asserts that places, notably cities, are far from being fungible, is associated with urban theorists like Richard Florida. Wherever one comes down on that spectrum, there's no denying that the world has changed dramatically in the past decade or two. Whether one looks at Russia, or Korea, or Iraq, or India, huge changes are afoot in communications, life style, crime and warfare, ethnic relations, and other important realms.
All that is known; what's the prediction? As we have seen with armed conflict, capital flows, disaster relief, and other phenomena, a globalized world creates a new category of issue that requires multi-lateral response well beyond the scope of traditional definitions of sovereignty. A few examples illustrate the issue:
-Efforts to address the effects of climate change are impossible to restrict by nation-state: it's not as though Canada, let's say, could bear responsibility for some number of square miles of the ozone layer or the Gulf Stream. Action and impact are impossible to connect in either time or space, except at a macro level, if then. As environmental concerns lead to the "internalization" of previously external phenomena (end of life disposal for goods with toxic components, cross-border pollution lawsuits, carbon taxes, and other arrangements), the need for both new definitions of sovereignty and new types of multi-lateral institutions will increase.
-Dealing with bad guys proves similarly problematic. The Somali pirates are a case in point: if some were to be caught, where might they be lawfully (and practically) imprisoned and tried? Guantanamo, for all its controversy, does serve a useful purpose, as the "not in my back yard" discussions related to its closure illustrate: at both the state and international level, there are few practical options for relocating the current detainees, many of whom are now men without a country. The international reaction to the Mumbai terror attacks supplies yet another example of the issues: much terror is now a global as well as a regional, tribal, and/or national question, yet we lack the institutions with which to prevent and fight these sorts of actions.
Furthermore, as the case of Mexico illustrates, the line between criminality and terrorism is extremely fuzzy. When narcotics gangs kill law enforcement and judicial officials, invade hospitals to kill survivors of prior attacks or threaten doctors, and shake down schoolteachers to surrender annual bonuses, they systematically undermine conventions of civil society. Conventional police forces are outgunned by such gangs, but as the Italian example shows, soldiers with adequate firepower, when mobilized to reassure tourists and citizens, lack training in even the basics of policing. Extend the conflict across borders, and the need for new kinds of multilateral action and coordination becomes an issue yet again.
Immigration -- whether in China, Greece, Norway, South Africa, or the U.S. -- provides another example of the need to address the externalities of globalization, as do several other new-era problems:
-Information flows matter in intellectual property, news media, or business transactions. These include offshore programming, contracts, or ingredient provenance as in the melamine matter.
-The governance and monitoring of global capital flows by nationally-delimited regulators have already been a topic of conversation at the G20 and G8 levels.
-Reporting standards for everything from land mines to life expectancy to laboratory results rarely coordinate or enable effective (and cost-effective) information across continents and often borders.
With so much room between the cracks of law, enforcement, and reporting, expect to see more global equivalents of dropped fly balls in 2009. (Speaking of sports metaphors, the internationalization of professional leagues including soccer, American football, and perhaps most successfully basketball bears watching.)
The Domestic Conundrum
As we noted in the October letter, many of the challenges facing U.S. public- and private-sector leaders, most notably President-elect Obama, are sticky and intertwined: it's hard to reduce the inventory of unsold houses with rising unemployment, no matter what the interest rates, but cheapening the dollar by lowering these rates causes problems of its own (a probable increase in oil prices for starters).
Given the high stakes, and the relative freedom to address the issues (provided by the combination of a friendly but not veto-proof congress and the perception of a honeymoon period with the electorate), expect to see some combination of strong efforts that will have the effect of attacking boundaries between problems. Four key areas in particular are often attached:
Can a broadly inclusive appetite for change retie this massive knot into something more manageable? Demographics (see below) is driving unprecedented demand for care as the baby boom generation starts needing stroke care, diabetes treatment, heart surgery, and hip replacements in massive numbers: what will be the de facto or de jure rationing mechanisms? Managed care is historically credited with curbing cost increases but also blamed for unsustainably low morale among primary care providers -- and for today's thin pipeline of internists in medical schools. Defensive medicine, in part attributable to the American litigation climate, is estimated by the McKinsey Global Institute to cost $150-190 billion annually. Pharmaceutical pricing in the U.S. is 50% higher for equivalent molecules compared to other countries, but even concerted pressure on this sector cannot turn the tide without similarly dramatic changes in the status quo elsewhere. One number may be the scariest of all: 45 million Americans lack health insurance, and the number will rise given the trend in unemployment.
Big shifts are underway across groups defined by age, education, and sex. According to the Labor Department as reported in the Boston Globe (Dec 5), 1.1 million fewer men are working than were a year ago; 12,000 more women are now employed. Job losses in financial services and construction, for example, hit men hard, while health care, which is about 80% female, added 400,000 jobs. Intergenerational wealth transfer, often achieved via real estate, may in a rising number of cases be negative for the current generation of adult children. For a slightly younger cadre in their 20s, what Don Tapscott calls the Net Generation is integrating its experiences with technology into work, play, and social interaction -- and one study in the Archives of General Psychiatry controversially found roughly half of the college-age population to suffer from mental health disorders, some of which may relate to the dynamics of online interaction.
The biggest factor in demographics may be the collapse of many people's retirement assets. As one executive noted to me, people who retired two or three years ago made any number of assumptions that have been shattered, and jumping back into the labor market with old skills, contacts, and resumes is extremely tough in this economy. Even without the stock market drop, the shift in retirement funding from defined-benefit pensions (which aren't always defined or beneficial, as Motorola is proving right now) to defined-contribution proceeds always appeared to be a long-term gamble. A professionally managed pension plan costs 20% of salary to fund a full-salary pension. The fact that most 401(k) accounts, almost all run by amateurs, run less than 10% including employer match, should be cause for alarm even before adverse decisions and/or market performance exact their toll. It's not a 2009 prediction, but I believe a bail-out will eventually be required to address a massive shortfall between long lives and small retirement accounts.
Unlike health care reform, or bank bail-outs, or wars, demographic change typically takes decades to unfold.
Given high unemployment, what will be the source of customer demand to restart shuttered factories, reduce inventories, and stimulate hiring? The federal government, through a myriad of programs, is on pace to assume responsibility for a World War II-sized proportion -- of a much larger economy. On the private-sector side, growing verticals are hard to locate amidst broad and often deep layoff news. Just two chains of home improvement centers -- Home Depot and Lowe's -- together added over 250,000 jobs between 2000 and 2007 on the strength of the building and renovation boom, but it's hard to see a similarly promising retail (or other) sector on the horizon. Early retirement (see below) is less of an option than it might have been with less damage to retirement portfolios. Cashing out home equity fueled substantial spending earlier in the decade: according to a 2002 paper in the Federal Reserve Bulletin (Canner, Dynan, and Passmore 2002), over 50% of funds liquefied in 2001 refinancings went for home improvement and consumer expenditures. The numbers were staggering: according to a paper by researchers at the New York Federal Reserve Bank (McConnell, Peach, and Al-Haschim 2003), the annualized withdrawals of Q2 2003 amounted to $450 billion. Where can similar sums of cash originate in the near future?
-Soft asset markets
Lack of demand for consumer goods is echoed in equity, credit debt, and housing markets as all four suffer from imbalances between supply and demand, and/or uncertainty:
-How will bank balance sheets appear and be analyzed under a TARP model? How will investors react?
-Should people buy cars from a manufacturer in or near chapter 11? Should banks loan them money to do so?
-If an individual of Bernie Madoff's reputation can take down $50 billion, who else is hiding bad news?
-Should people try to improve or even maintain the value of their houses given a) the mortgage is upside-down and/or b) the number of repossessions in the neighborhood may make it impossible to sell my home?
-With 10 years or more of equity gains wiped out, can I ever plan to retire?
In addition to the four big issues noted above, a number of other questions loom large. With only minor comment, these include the following:
-50 years after the birth of the modern civil rights movement, the election of an African-American to the presidency will shift the terms of the affirmative action debate. At the same time, the status of gay and lesbian couples in the eyes of the state is being framed in terms of both civil rights and religious authority. What will the civil rights movement of 2012 look like?
-The non-profit sector, including private colleges and universities, charities, and religious organizations, has been hit hard by the downturn in financial markets. Given that the end of the calendar year is a traditionally active time for donations, the true impact will be much clearer in January. Schools in the St. Olaf, Colby, and Beloit mold are reporting double-digit drops in the application pool in a year with a huge graduating class of high school seniors. Lower demand poses another challenge apart from the diminished endowments, yet health care, heating, and other fixed costs continue to rise. How many non-profits will add to the unemployment rolls next year?
On the supply side, meanwhile, philanthropy is being reinvented by the Gateses, the Omidyar network, Google.org, Lance Armstrong, and other innovators such as the Multiple Myeloma Research Foundation (profiled in The New Yorker last January). These efforts, running counter to the traditions of the United Way and Rockefeller/Ford/Mellon foundations, bear watching. Can this semi-private sector outperform the NIH in finding a cancer cure, or the WHO in mass inoculations, or big pharma in breakthrough drug discovery?
-For all the concern with jobs lost to overseas locales with lower labor costs, automation (including on-line self-service) remains an important factor in the employment equation. Labor costs at the Big Three automakers, while under scrutiny, disproportionately reflect retiree health care and pension costs: even major wage concessions by active UAW workers would only save about $800 per car -- and would not turn an unsold pickup truck into a Honda Accord/Toyota Camry/VW Jetta competitor. What forces can reinvigorate American manufacturing?
-The timing told a powerful story: on the day that the Chicago Tribune broke the story of Governor Blagojevich's arrest, the paper's parent company declared bankruptcy. In a time and in a world with so much up for grabs and such a pressing need for informed citizenries, the demise of the daily newsprint-driven business model raises critically important questions about accountability, about investment, and about the role of advertising. Meanwhile, Jason Calacanis, a founding father of blogging, quit doing so in July, saying "Today the blogosphere is so charged, so polarized, and so filled with haters hating that it’s simply not worth it." If present-day blogging isn't capable of replacing formerly great newspapers, what comes next? My prediction, not an original one, is that some foundations or other not-for-profits will be organized to fund critical elements of an effective press, potentially including bureaus, archives, and editors.
Why is this time different?
In classes and seminars, I've been asked several times this fall whether this recession is like or unlike the tech slowdown of 2000. The short answer: it's very, very different.
1) More sectors are involved. While Cisco, Intel, et al felt real pain, homebuilding and commercial construction were booming, cheap gas allowed Detroit to sell lots of trucks and SUVs, and the sectors that rely on demand in those areas -- banking, chemicals, steel, for starters -- all could thrive. Job losses in one place -- bank consolidation, let's say -- were partially offset by growth in mortgage lending or real estate.
2) The baby boom generation is farther through the python, demographically speaking, and is about to start drawing down their retirement assets, such as they are. The pace of change in the workplace means that people in their 40s and 50s now being laid off have less chance of re-landing a similar job to the one they lost. Early retirement, geographic relocation, and extended unemployment are all unattractive options for people at this stage of the life cycle. People gearing toward retirement need "less house," making a large component of the population more likely real estate sellers (or downsizers) than upwardly mobile buyers.
3) Many individuals are hit with some combination of a "triple whammy" of equity loss, job loss, and house value loss. In 2001, unemployment hit certain cities hard, but home prices continued to appreciate and extreme liquidity made selling a property reasonably simple for those who wanted to do so. Job losses are far more broadly shared now, and the stock market as a whole fell far less in 2001 than we are witnessing today.
4) Foreign competition is more mature: India's and China's economies have grown significantly, removing a proportional slice of U.S.-based production capacity from the 2001 mix. IBM, for example, has added 70,000 jobs in India in this decade.
All told, it's perfectly likely that next year's big stories come from as-yet unexpected sectors -- natural disasters, say, or mass ethnic violence -- thus making 2009 a completely logical follow-on to one of the wildest years in recent memory.