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Saturday April 19th 2014

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From Wall Street Bird Nests to Main Street Growth Cycles

© Copyright 2009 by Thornton Parker

America’s economic health has been declining for decades.  Symptoms of the decline included the loss of jobs, which began in manufacturing and spread to other fields; the failure of middle class incomes to keep up with the highest brackets; increasing concentration of wealth among the richest few; and record levels of borrowing.  These and other symptoms were ignored as long as the financial system produced enough loans to keep the consumption side of the economy growing faster than the production side could support.  Then like the Roadrunner, it all went splat!

Most experts working on the stalled economy are from the financial services industry, or Wall Street for short, and see it as a financial problem that needs financial solutions.  As someone said, “To a hammer, all problems look like nails.”  But just thinking in financial terms led to the problem in the first place.  As nearly everyone concentrates on banking, credit, housing, and automobile problems, the more basic question of how to beef up the production side of the economy enough to support the consumption side is being ignored.  That is like trying to jump-start an engine without knowing why it stalled.

The dichotomy between Wall Street and Main Street is not just rhetorical or political; the streets represent very different aspects of the economy.  Workers and their families on Main Street need some of Wall Streets’ financial services to facilitate the money flows between the production and consumption sides.  But as Wall Street tried to grow beyond its supporting role, it saw itself as becoming a director of the economy and a free-standing industry on the production side that makes major contributions to the Gross Domestic Product.  Many of today’s troubles were caused by Wall Street’s attempt to live up to its exaggerated self-image and by its forcing Main Street companies to inflate their stock prices.

The economy cannot be made healthy again without our understanding what has  happened with stocks as well as credit, returning Wall Street to its supporting role, and rebuilding the production side.  Retirement plans run through the whole story.
Bird Nests

Before a product can be manufactured, someone must specify what it is to do.  Then engineers or industrial designers fill in the details of how it will work and how to make it.  Boomers’ retirement plans were not designed that way.  No one specified that their primary purpose was to pay dependable cash incomes to a large generation of retirees, or filled in the details of how to get the cash.

Instead, millions of retirement plans were assembled like bird nests with available bits from Wall Street and guided by instinct.  Stocks and stock mutual funds were dressed up as retirement investments and promoted to people who would never otherwise have gambled with them.  Wall Street made them more attractive (and lucrative for itself) by shifting emphasis from cash dividends to “total returns” which include price gains.  The shift was misleading, but it appealed to everyone’s instincts for rapid and measurable growth, and in good times gains appeared to swell nest eggs faster than dividends.  The shift hurt people who had already retired and needed cash incomes, but that had not been specified so the industry ignored it.

At the end of 2008, retirement plans of all types (including pension systems, defined contribution plans like 401(k)s, IRAs, and annuities) owned nearly two thirds of the domestically-owned stocks traded on U.S. markets.  Because the plans were never formally designed and stock prices have disappointed for a dozen years, attention is now turning to whether there will be any gains and if so, how to sell the stocks to convert gains into cash incomes.

The plans have two serious flaws.  The first is like the flaw that led to the housing bubble—assuming that prices always trend up.  But that assumption has been wrong for both stocks and houses.

The second flaw is that when boomers gradually shift from the buying half of the stocks-for-retirement cycle to selling half, the primary domestic buyers will have to be the same younger workers that some say will not be able to afford sustaining Social Security.  Like the Madoff scam, the stocks-for-retirement cycle fits the definition of a Ponzi scheme; a fraudulent investment plan designed to pay its early investors (boomers) with money that it takes in from later investors (younger workers).

Despite what some opponents of Social Security say, that program is not a Ponzi scheme because it was always intended to have workers help retirees, not to be an investment plan.  But boomers’ retirement plans and Social Security are joined at the hip because they will be driven by the same demographics and younger workers’ purchasing power.  If younger workers will be able to pay inflated prices for the boomers’ stocks, there will not be a Social Security problem.  Conversely, if younger workers can’t afford to sustain Social Security, then adequate gains from today’s stock prices are probably impossible.

The most rudimentary engineering design process would have spotted both flaws, but Wall Street cites no due diligence report, feasibility study, or system failure analysis that explains how the boomers’ stocks-for-retirement cycle can be expected to work as it has been promoted.  If such a document existed, it would be quoted like a mantra.

Few boomers have saved nearly enough to retire for long.  Many are deeply in debt and the first flaw in stock-based retirement plans was exposed when the housing, credit, and stock market bubbles burst and shrank millions of nest eggs.  Coming on top of these conditions, the second flaw will ensure that most boomers will have to work well into their later years.  Many of them know this, but millions of Main Street jobs will have to be created on the production side of the economy in order to accommodate them in addition to the younger people coming into the workforce and those who are unemployed because of the recession.

Creating those jobs will require record amounts of capital which Wall Street is not prepared to provide.  Its members claim that buying stocks with retirement savings makes capital available to companies so they can grow and create jobs, but the claim is false for several reasons.

Retirement plans primarily buy “used” stocks on public, on secondary markets.  The sellers are previous stockholders, not the companies that issued the stocks, so  companies get little of the money.  As retirement plan purchases helped drive stock prices up after 1981, companies bought back or otherwise eliminated more dollars worth of stock than they sold.  This is shown as the $737 billion negative net flow on the first line of the following table, which is based on data in the Federal Reserve Flow of Funds Accounts.

That leads to an important question; if stocks are good long term investments as Wall Street claims, who sells them, and why?  The table provides clues to revealing answers.

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Much buying and selling goes on within each group, but households are the primary net sellers.  Employer pension plans are also net sellers because many of them are being closed down.  The compounded growth rates of the sellers, which include portfolio gains but not dividends, show they made far more from stocks than the groups which were net buyers.  Pension plans acquired most of their stocks years ago and had much higher returns than life insurance companies that came to the game late and had serious losses.  Households were the clear winners, but where did they get their stocks and why were they so successful?

The answer is that some households are where corporate insiders live.  Insiders get large blocks of stock directly from companies at below-market prices and sometimes for free.  Lucky insiders create fortunes when the market sets the price of their shares; and when they sell, retirement plans are the primary buyers.

Bill Gates, said to be the richest person in the world, is the extreme example of this. He took 45% of the Microsoft stock before the company went public and has sold more than 2 billion  shares.  He still had 793 million shares in November 2008 after selling 146 million shares for nearly $4.4 billion during the previous 2 years.  Nearly all retirement plans own Microsoft and statistically, about a third of their shares were sold into the market by Gates himself.  He more than recovered his investment from his first sale and all subsequent receipts were profits.

Many companies issue stock to early insiders this way, and also by granting options that let insiders buy from the company at below-market prices.  At one time, there were an estimated 10,000 “Microsoft millionaires,” and as most them sold at least some of their stock, retirement plans were the primary buyers.

Few retirement plans can enjoy the growth rates that households receive because most of them buy stocks at market prices which are far above what insiders pay.  When retirement plans buy insiders’ stocks, they transfer middle class savings to the wealthiest people in the country and help to increase the wealth gap.  In addition, there has been a symbiosis of boomers’ retirement plans and insiders.  The plans wanted the insiders’ stocks and the insiders wanted the boomers’ money.  But when the plans gradually shift from buying to selling, the relationship will change and boomers will have to compete for younger workers’ savings with insiders who will still be selling.  That can lead to a sustained bear market.

Most economists and Wall Street types avoid questions about what can happen as boomers age.  They don’t mention “Demography and the Long-Run Predictability of the Stock Market” by John Geanakoplos of Yale, Michael J. P. Magill of the University of Southern California, and Martine Quinzii of the University of California, Davis.  That 2004 paper, said that stock prices can’t be related to generation ages because of general price level fluctuations.  But when stock prices are expressed as price-earnings ratios, the picture becomes clear.

The report said, “Since 1945 the price-earnings ratio has strikingly followed the cyclical pattern of the medium-young ratio in the population while the rate of return on equity has a significant relation with the changes in the medium-young ratio…”   The writers said in their conclusion, “…our model predicts a decline in the PE ratio in US equity market over the next twenty years…The only real prospect for offsetting the effect of a small generation of middle-aged agents buying the equity of a large retired generation, comes from an increased participation in the US security market by investors from the developing countries.”

The report did not discuss the implications of broad ownership of US companies by their foreign competitors or the role of insiders, and it was written before the credit bubble broke. It does, however, provide a strong reason to be concerned about the risk that boomers’ stock-based retirement plans will fail as pension plans are failing because stocks are not doing what promoters said they would do.

Retirement plan promoters also avoid mentioning that while the plans provide little money to companies to expand and create jobs, they can have just the opposite effect.  Pension and mutual fund managers, who are expected to make their portfolios grow, pass the pressure for growth on to companies.  Companies respond by cutting costs, downsizing, merging, eliminating domestic jobs, shortening their time horizons, promoting globalization, going global themselves, and taking other actions intended to inflate stock prices.

Wall Street is a major promoter of globalization because it can profit in many ways now that money is easy to move around the world.  As it expanded into other countries, it both forced and helped U.S. manufacturing companies move their operations to areas with lower labor costs.  It developed its own self-reinforcing growth cycle in which sales of stocks and mutual funds led to more pressure on companies to abandon communities and move to other countries; which created more opportunities for its foreign offices to provide capital-raising and other services; which increased its profits and encouraged it to promote more globalization.  As the industry’s growth cycle expanded, U.S. job losses spread to administrative, professional, and managerial fields.

Most of Wall Street’s investors and clients are corporations, wealthy individuals, and managers of pension, mutual, and other investment funds.  Workers and communities on Main Street are not important, so they are ignored.  Wall Street bases its argument for globalization on the claim that everyone benefits when work is done at the most economical locations.  But no one explained how most American workers could maintain their jobs and incomes, and of course, they haven’t.  Even those who still have jobs face threats and competition from foreign workers who earn a fraction of what they do.

The drive to increase returns for retirement plan portfolios led to the loss of millions of jobs on the production side of the economy which spread from manufacturing to most types of work that can be automated or done for less in other countries.  The drive has been strengthened by pension plans trying to diversify their portfolios by putting money into private equity firms.  These are leveraged buy out operations that typically buy Main Street companies with large amounts of credit, drain the companies’ cash by paying large dividends, cut costs by eliminating jobs, and then sell the remains at a profit.  When a deal is successful, the winners include the equity firm managers, the pension plans, and other investors from Wall Street.  The company’s employees and its Main Street community are the losers.

In summary, although retirement plans are said to benefit people on Main Street, they are tools of and driven by Wall Street for its own benefit.  The plans have become engines for destroying the jobs of middle class workers and transferring their retirement savings to the very rich.  Wall Street profits from handling the plans’ stock and other transactions at the expense of the middle class as it has been shown to do with credit instruments.  Had Wall Street specified that the plans were to separate middle class workers on Main Street from their money, it could hardly have designed a more efficient process.

America’s Economic Problem
Much of today’s economic situation was caused by the Wall Street financial services industry which grew by:
•    Promoting retirement plans that contribute to the loss of middle class jobs, transfer savings from the middle class to the very rich, and are likely to fail;

•    Promoting globalization without regard to its effects on the production side of the economy;

•    Failing to promote investments that support the production side; and

•    Creating unmanageable and unsustainable credit schemes to support the consumption side.
The people who did this do not deserve to control the recovery.  Moreover, their discussions of ways to fix the economy are ignoring two major effects of over-borrowing.

First, people were encouraged to borrow ever more to pay for things they needed or were induced to want, and the growing consumption made the economy appear to be healthy.  But the appearance was deceptive.  Much of the borrowing was to compensate for stagnation or the loss of middle class incomes on Main Street which was caused by forcing companies to reduce labor costs and inflate stock prices.  But labor costs to some companies are customers’ purchasing power to others and credit was used to fill the gap.  The consumption side of the economy outgrew the production side until the credit schemes collapsed.  As a result, the production side of the economy has atrophied and will not be able to sustain the recent levels of consumption for years.

The second effect of over-borrowing was to distort America’s communities and industries.  There are more large homes and resort condos than there are families that can afford to buy them.  Many new houses cost more to heat, cool, and maintain than most young people coming into the home market will be able to afford, particularly if energy costs rise.  There is too much manufacturing capacity to produce SUVs, appliances, yachts, and expensive consumption items.  More people worked in the retail, finance, and real estate industries than will be needed for years.  Most discussions about restoring the economy and cleaning up the credit mess on Wall Street ignore the reality that America can’t go back to substituting credit for middle class incomes on Main Street.  That’s how we got into the mess, and trying to put things back as they were won’t solve the problem.

It will take years to correct the distorting effects of over-borrowing, and it will have to be done in the context of the world economy which was also distorted.  We are often reminded that the Great Depression was made worse by countries trying to protect their own workers, and America must honor the trade agreements it signed if it is to be respected by other nations.  So protectionism is not the solution.

The country’s task comes down to this:  It must create millions of dependable, middle class jobs for a larger and older workforce than it anticipated or ever had before, without taking the jobs from other countries, and that other countries can’t take from it.  To do this, the primary emphasis must be on the needs of people and sustainability, with finance playing an important supporting role but not the leading one.  With that specification, let’s start designing America’s Next Growth Cycle

America’s Next Growth Cycle
What Is a Growth Cycle?
The easiest way to explain the growth cycle concept is with the General Electric self-reinforcing cycle that ran for more than seventy years.  One side of the company made equipment to generate and distribute electricity.  The other side made everything it could sell that consumed electricity.  As consumption increased, electric utilities bought more generation and distribution equipment.  This led to more efficient utilities and economies of scale that lowered electricity costs and enabled new applications.  Growth by one side of the company led directly to growth on the other.  The flow of manufactured products created return flows of dollars to GE, which the company nurtured with its own credit operation, and there was an ever-growing flow of dollars from power consumers to the utilities.

GE is the only remaining member of the original Dow Jones Industrial Average.  Through its growth cycle, it made countless contributions to science, health, food, transportation, manufacturing, communications, education, and everyday living.  The cycle ran until institutional investors’ demands and the oil embargoes forced it to concentrate on increasing its stock price and reducing what came to be seen as wasting energy.  We will return to GE below.

A few other companies, including Westinghouse and RCA created growth cycles with strong positions in many interdependent industries.  As one part of these companies grew, it created demands or an environment for other parts to exploit.  Unlike today’s practice of requiring all units to meet company-wide profit standards, there was often deliberate cross-subsidization.  Individual technologies and products came and went, but the basic cycles allowed these companies to grow even when major product lines had problems or were discontinued.

Wall Street’s recent growth cycle has been mentioned, and growth cycles have played critical roles for countries.  For example, in describing the British Industrial Revolution, Paul Kennedy explained how the massive increase of productivity in the early 1800s, particularly in the textile industries, stimulated the demand for more machines.  This led to demands for more raw materials including cotton and iron, which in turn, created a need for more mining, shipping and communications.  And so the beat went on.

America’s Experience with Growth Cycles
America developed a powerful growth cycle during the 19th century.  It included a dominant mode of transportation (railroads); dominant fuels (wood and coal); dominant materials (wood and iron); and dominant goals (Westward expansion and development of Northern financial and manufacturing centers).

Two-way relationships evolved among all of the drivers.  Westward expansion, for example, required more wood and coal for fuel, more wood and iron for construction, more manufactured products, and of course, more rail capacity to move them.  The growing railroads then required more wood, coal, and iron for their expansion.  This cycle’s history is fascinating, as a few glimpses of the role of railroads will show:

•    Unlike Europe, where railroads were built to connect existing cities and towns, in the U.S., companies were given inducements to lay track across miles of unpopulated land.  The railroad companies knew the land would produce little revenue until it was settled, so they designed complete towns (even with standard street names) around the grain elevators which they spotted along rail lines across the prairie.  They even recruited immigrants from Europe to settle the towns and create neighboring farms.

•    The settlers produced grain and meat for the railroads to carry east and became markets for goods that only the railroads could bring to them.

•    As Chicago became the country’s largest rail hub, it also became the national catalog merchandising center.  Catalogs eventually included nearly everything a settler might want, including complete houses that were sent by rail as kits to be assembled locally.

•    Railroads became the country’s primary developers of managers.  Many of the leaders on both sides of the Civil War came up through the railroads, and even Lincoln had been a railroad lawyer.  Big enterprise management was almost synonymous with railroad management.

As with the GE strategy, this early U.S. growth cycle led to the development of countless new technologies and products that had unpredictable and largely forgotten interactions.  Two examples show how this worked.  First, telegraph systems grew in conjunction with the railroads by using railroad rights-of-way, aiding rail operations, and often being operated by station masters.

Second, time was important for train scheduling, so four standard time zones were established to replace the forty-nine different time schemes that had been used.  Before block signal systems were developed, time was used to control trains bound in opposite directions on single-line roads.  During 1853, after 65 accidents had killed 176 people by August 12, a serious wreck caused by a faulty watch led to a public outcry for safer operations.  That sparked a demand for more accurate clocks, reliable watches, and then for using the telegraph to synchronize them.  Major clock and watch industries in New England were a result.

The government helped start and nourish this cycle in many ways.  After the Louisiana Purchase, it granted land to promote westward migration and helped establish new states as the lands were settled.  It granted land to promote colleges.  It gave national charters to railroads, granted land to finance them, and used the Army to protect them.  It paid for the first test of long-distance telegraphy between Washington and Baltimore.  And it used tariffs to restrict imports from Europe to help Northern manufacturers.

The driving force, however, came from companies, investors, and thousands of individuals who could see what was happening and decide how to participate.  The obvious growth patterns of the cycle allowed them to plan and act with confidence.  In some respects, this period of expansion was not pretty by today’s standards, but it was so well understood that the term “manifest destiny” was coined in 1845 to explain and justify it.

The 19th century cycle gradually morphed into the 20th century cycle.  The new drivers included air and highway transportation (dominant modes); petroleum and electricity (dominant energies); steel, concrete, and aluminum (dominant materials); and suburban home building and the development of  Southern and Western manufacturing and finance centers (dominant goals).  GE’s cycle coincided with much of this cycle that ushered in industrial research and design, mass manufacturing and marketing of consumer products, and cascading technologies.  Millions of Americans who experienced part of this cycle think of it as “the good old days.”

Government help was critical to this cycle too.  In the aircraft industry, for example, federally funded aeronautical research after World War I produced new computation techniques for aluminum structures, retractable landing gears, variable-pitch propellers, and aerodynamic shapes such as engine cowlings.  The government subsidized air mail services to link cities in the four time zones, pioneered weather forecasting and air navigation systems, and the National Bureau of Standards became the nation’s timekeeper.  It also promoted development of hydroelectric power, which lowered the cost of aluminum.  These all came together in the 1930s and ’40s when the U.S. aircraft industry took the lead in transport aircraft and produced the planes that were vital to winning World War II.  The industry is still a global leader.

Japan’s Growth Cycle
After World War II, Americans helped the Japanese develop what they called their “virtuous cycle.”  With a resource- and fuel-poor island economy, they used export markets as their primary source of wealth.  They imported cheap materials but few expensive products and used as little fuel as possible.  They concentrated on knowledge-intensive industries to convert the fuel and materials into high-value-added exports.  They continuously improved the products, created new ones, and improved their manufacturing processes.

When competition eventually caused a product to mature and become a commodity, the Japanese exported the manufacturing processes to other countries that were closer to markets or had lower costs.  They replaced the exported manufacturing by upgrading their plants and work force to make new products that others could not yet make.  They helped the countries that imported the older processes earn enough to be customers for Japan’s newest products.  This self-reinforcing cycle depended on various forms of knowledge to stay ahead of international competitors in the ability to convert inexpensive materials into high-value-added products for world markets.  Unlike many U.S. companies that tried to protect their mature products, Japanese industrial groups treated their products as stepping stones to their next generation of products.  U.S. companies gradually adopted this strategy, led by the computer, communications, software, and entertainment industries.

For years, many U.S. economists and leaders did not believe the Japanese cycle could work.  Conventional economic theory held that over the long term, competition causes industries to work toward equilibrium.  At that point, companies and countries with the most favorable costs were supposed to become the leaders in each industry.  The theory did not recognize that companies and countries without cost advantages could deliberately prevent equilibrium by using knowledge and replacing products to stay ahead of competitors indefinitely.  To do that, however, they had to emphasize producing and exporting over consuming and importing, as Japan did to become the world’s second largest economy.  This was just the opposite of what the U.S. economy has done recently.

Principles of Growth Cycles
General principles of growth cycles can be applied by companies, industries, regions, nations, and perhaps the whole world.
•    A few dominant industries and goals become drivers by establishing long-term growth trends.

•    Growth by one dominant industry or toward a goal creates new opportunities for the others.

•    Sales of goods and services among the dominant industries are matched by financial counter-flows that keep the cycle running.

•    The cycle becomes a massive communications system with growth of the drivers becoming patterns that individuals, companies, and investors can understand and use to their advantage.

•    The cycle spawns countless new technologies, products, markets, companies, and secondary industries.
The dominant industries must be interdependent—not just complementary.  The classic coal and ice man had complimentary businesses, but each could function without the other.

No U.S. Growth Cycle Now
If a successor to the 20th century growth cycle is running today, few people see it.  Some industries and various types of services are interacting and growing rapidly.  But they are less powerful than the drivers of the national growth cycles that affected almost everyone.  Instead of creating advancement opportunities for millions of unskilled and semiskilled people in this country, they tend to provide domestic opportunities primarily for the skilled and those who can become skilled.  Outside of tight connections among a few industries such as the makers of computer chips, sensors, components, assemblies, and software, there are fewer interdependencies of the kinds that linked the drivers in earlier times.  America’s fastest growing industries make only marginal differences in the way the energy is produced and consumed, communities are organized, people and goods are moved, or scarce resources are used.

The U.S. Contraction Cycle
The situation is not stagnant, however, because a contraction cycle is running that has three drivers.  Two of them are obvious, but few people see the third.  The most obvious is the end of the credit driven consumption era.  Little need be said about that here, but it must be considered in developing strategies for the future.

The second driver is the declining role of government.  Regardless of how one feels about taxes, spending, and budgets, few Americans pause to recall how much the government has contributed to aspects of everyday life that they take for granted.  The role of government has contracted since Ronald Reagan said “government is the problem,” and the country is paying the price.

The financial services industry is the third and most powerful driver of contraction on the productive side of the economy.  This was discussed above, but another point needs to be made.

There are two types of investments, productive and parasitic.  Productive investments pay for buildings, research and development, tools, instruments, training, distribution facilities, transportation networks, energy systems, and all the knowledge and real world things that are needed to produce and deliver goods and services.  Productive investments are unique, they often require long term commitments and are not easy to buy and sell.  They are absolutely necessary for creating jobs on Main Street.  They involve serious risks and their success is tied to the success of specific companies.  Most productive investments are made by small companies and by public companies using cash they have borrowed or generated through operations.  Except for helping with public offerings, Wall Street largely shuns productive investments that involve stock.

Parasitic investments just use money to make money by taking advantage of productive investments that others have already made.  They do not require long term commitments and are traded like commodities, often in bulk.  Wall Street promotes parasitic investments, and claims that their risks can be managed with modern portfolio theory and trading techniques,  Much of the trading, however, is simply gambling that shifts risks and profits from one party to another without creating any real world value.

Buying a company’s stock on secondary markets from former stockholders in transactions that bring no money to the company is a parasitic investment.  When stockholders prevent the company from using money it already has for productive investments that could have long term benefits, parasitic investing is harmful and the term is particularly appropriate.

A good example of using retirement savings for parasitic investing is a pension plan that puts money into a private equity firm; the firm borrows more money to buy a healthy company with a conservative balance sheet; it takes the company private and  pays out the cash that the company has saved as dividends; it eliminates components that are not growing rapidly and lays off company employees to cut costs; then it sells the company back to the public with too much debt to survive the recession.  Less obvious examples are the hundreds of companies that avoid having balance sheets that are conservative enough to attract private equity firms.  They have learned that in order to avoid being gobbled up, they mustn’t be too healthy!

One can argue that parasitic investments should not be treated as investments at all; that they should be discouraged as wastes of capital and other resources that the country can no longer afford.  It is clear that parasitic investing, often using retirement savings, is a driver of today’s contraction cycle.

The tension between productive and parasitic investing comes back to GE, whose growth cycle was ended by the former president, Jack Welch.  An outspoken advocate of enhancing “shareholder value,” (a euphemism for inflating stock prices), he closed or sold all product departments that were not the first, second, or perhaps third largest in their respective industries.  He concentration on cutting costs and eliminating employees in the surviving divisions and earned the nicknamed of “Neutron Jack” after the proposed bomb that was said to kill people with radiation but leave buildings standing.  He became a darling of Wall Street that applauded his approach and urged other companies to follow his example.

However, in March 2009, after GE had cut its dividend and was facing reduced credit ratings, he said in an interview with the Financial Times that managing companies primarily to increase shareholder value by concentrating on quarterly profits and share prices was “a dumb idea.” “The idea that shareholder value is a strategy is insane,” he added.  This was a direct rebuke to Wall Street and the pension and mutual funds, which as parasitic investors, had promoted the insanity since the early 1980s.

As President Obama says, “It is time for change!”
Starting America’s Next Growth Cycle
The next growth cycle can have two phases.  During the first or start-up phase, the concept would be explained; the industrial drivers and long term goals for the next cycle would be identified; and the incentives and rules of the game would be established.  The open and public process for doing this would take time and negotiation because of all the interests that would clamor to be among the drivers or resist being left out.  During the second or run phase, which would last for decades, individuals, businesses, and investors would make their own decisions on how best to participate.

The two-phase approach is like what the framers of the Constitution did by providing a broad framework to guide citizens toward meeting their needs while enjoying unprecedented freedom.  The framework has lasted for more than two centuries.

To show how the first phase of America’s Next Growth Cycle might take shape, the goal drivers could include:

•    Expanding America’s middle class by providing jobs that must be performed in this country for all who need them.

•    Reducing pollution, waste, and consumption of scarce resources.

•    Aligning financial economic, environmental, and social objectives.

•    Insuring effective competition in all industries.
Industrial drivers that are compatible with these goals could include:

•    Renewable energy and energy conservation:  Energy must be a driver of any national growth cycle.  Peak oil, global warming, problems with foreign sources, and environmental degradation all point to the need to do more with less fossil fuel.  Most of the jobs provided by this new driver could be done in this country.

•    Water conservation and desalinization:  Water is an absolute necessity which will become an increasingly scarce resource.  Many jobs provided by this driver will have to be domestic.

•    Community and transportation improvement:  Urban sprawl, traffic congestion, decaying infrastructure, airline security, and energy consumption all point to the need to rethink how people will live, work, and get around.  Much of this must be done in this country.

•    Improving American’s health:  Reducing health care costs by developing new ways to prevent illness, delaying the effects of aging, and applying new treatment methods can be an economically and morally sound driver with strong export potential.

•    Education:  People are enabled by what they know and limited by what they don’t know.  In order to maintain one of the world’s highest standards of living after the era of credit-based consumption, Americans will have to continuously improve their ability to think.

•    Productive investment:  In order to end the contracting cycle and make the other drivers work, the financial system must concentrate on productive investments, inhibit parasitic investments, and include firewalls or circuit breakers to isolate financial problems for correction before they threaten the whole system again.

President Obama has already identified some of these drivers.  Some critics say his program is overly ambitious and will lead to mountains of federal debt.  They would rather see him concentrate on restoring the economy by fixing the financial situation, but they are missing two big points.  First, the credit-driven consumption economy failed because it was not sustainable.  The economy cannot become healthy until the production side has been rebuilt and is able to support the consumption side with far less borrowing.  We can’t go back to the past.

The second point the critics are missing is that the new drivers are not budget sinks; they are growth industries that include countless opportunities for individuals, businesses, and investors to create wealth.  As the drivers take hold and interact, they can lead to an era of prosperity that can last for decades.  Consider a just few of the possible interactions among the drivers:

•    New forms of energy and energy conservation will be critical to improving communities and developing better forms of transportation.  It is impossible to foresee the opportunities that these industrial drivers will produce, but one can imagine using computer and communications technologies to create local employment centers where people could work for distant companies with minimal commuting.  Built somewhat on the old computer service center model, they could provide child care and other benefits for the workers and data security for the companies.  The workers might even change employers without changing their workplace or communing habits.  The American company Cisco is already helping the Dutch city of Amsterdam set up a center like this.

•    Many people who will have to work into their later years will need good health, more accessible work places, and better transportation for the handicapped.  This, of course, ties health care into the two drivers discussed in the previous point, and may reinforce the need for local work centers.

•    All of the drivers will create new educational requirements which will translate into markets for educational institutions and jobs for their graduates.

Why a New Growth Cycle is Necessary
After the Cold War, the collapse of Communism was cited by some as proof that economic planning does not work.  According to that view, the most that countries can do is provide the conditions necessary for free markets to unfold.  But they ignored what the U.S. government has done in the past and what Japan did after World War II.

Many who took that hands-off view, also glossed over three fundamental weaknesses in the “science” of economics.  First, the farther into the future one tries to look, the less conventional economics can help.  Few economists, for example, have been willing to predict what can happen when baby boomers gradually shift from buying stocks to selling them.  This shift involves up to a third of the country’s adults and may already have started.  Stretch time periods out to twenty-five or fifty years and conventional economic thinking is even more limited.  Yet these are minimal time periods for designing retirement plans, analyzing environmental sustainability, or making major public utility and energy investments.

Economics tries to compensate for its forecasting limitations by expressing future values in terms of current prices.  This practice, called discounting, is based on compound interest and is particularly hostile to actions that would benefit the distant future.  When rates of return are inflated, as they were ten years ago by stock market expectations, or before that when interest rates were raised in order to control inflation, it is hard to justify any investment that is intended to produce its greatest value twenty-five years or more in the future.  But that is nonsense.  As even Alan Greenspan has said, on a national basis, and ignoring international payments, net interest costs are zero—costs to one are income to another.

The second limitation is that economics is based on transactions—the types of activities that feed into a company Profit and Loss Statement or a government budget.  There is, however, no national equivalent of a company Balance Sheet, and changes in the values of public assets are shrugged off as externalities or intangibles.  But many national assets, like seafood-producing capacity, clean water, topsoil, general levels of health, and social stability are essences of economic health and environmental sustainability.  Their value to future generations cannot be projected by discounting.

Finally, conventional economic principles stress efficiency through cost cutting and specialization.  These principles have led to social and environmental exploitation in many parts of the world and the declining middle class here.  Self-sufficiency is the opposite of specialization, and while not consistent with most conventional economic thought, it can be a key to social and environmental sustainability.  Similarly, cost cutting leads to treating employee salaries and wages as costs to be reduced, when from a national point of view, they are outputs to be increased.  Growth cycles have major economic benefits, but they can be much more than economic tools when used to promote the goals of social and environmental sustainability.

There is no Growth Cycles for Dummies, at least not yet.  Each cycle that does not start by itself, must be based on what is possible and ways must be found to start it.  Here are five examples of unconventional approaches that could be used.

1.    Contests.  One of the most effective but least-used ways to promote something is to sponsor contests with significant prizes for the winners.  Many advances in aviation were stimulated this way.  Except for the costs of promotion, the sponsor pays nothing until the objective is achieved.  All participants hone their skills, and the winners often build on their success.  Contests can be for specific accomplishments, such as the $25,000 price (offered in 1919 by a New York hotel owner) that Charles Lindbergh won for making the first nonstop flight from New York to Paris.  They can also be used to solicit ideas as companies use suggestion systems.  Contests can be used to advance thinking about practical sustainability and the next growth cycle.

2.    Performance-based contracts.  Some of the work to be done will require large projects which can be divided into segments.  When this is possible, proposals can be solicited with the understanding that two or more participants will be selected and each will receive only part of the total project.  For example, a project could be divided into thirds, each participant would receive a third, and the final third would be awarded on the basis of their performance.  In some cases, it may be desirable to continue competition between performers for the life of the project.  This approach provides a continuing opportunity to ensure that performance meets the intended criteria, reduces the risks of depending on a single contractor, and reduces the likelihood of delays due to award protests.  The Air Force would probably have its new tankers by now if it had split the project instead of insisting on only one supplier in a competition that neither bidder thought it could afford to lose.  The technique can be used for more than just procurement—operating licenses and even company charters can be awarded this way.

3.    Performance-based financial instruments.  There are many opportunities to develop new investment instruments and institutions to promote sustainability.  For example, returns to investors could be based on more than just interest rates, dividends, and stock prices.  If an objective is to increase the number of workers and their compensation, returns to investors could include royalties based on payrolls.  Investors’ returns would grow as employment grows, thus investors and workers would have complementary rather than competing interests.  This is consistent with the growth cycle principle of promoting interactive growth relationships.

4.    The fourth class of leadership.  Democracies have three traditional ways to get things done: using financial inducements including expenditures and taxes; using legal requirements, restraints, and enforcement; and performing functions directly.  All these methods have been used to the point where they are being resisted.  They are necessary for a growth cycle but the task is too complex to rely on them alone.  A fourth class of leadership must be developed that helps all parties make their own best decisions in ways that are consistent with the underlying goals.  The types of help could include:

•    Knowledge, such as the Department of Agriculture provides to farmers in conjunction with states and land grant universities.

•    Government and industrial research funding to fill gaps in environmental, economic, and social knowledge in addition to the technical and life science fields that are now funded.

•    Incentives to use mediation to prevent problems before they arise, instead of costly, after-the-fact legal remedies.

•    Product liability provisions for all types of products (including financial products) that encourage the use of new ideas but if necessary, fix responsibility and concentrate on what a company does after it learns that it may have a problem.
Countless other arrangements and incentives can be developed as the growth cycle concept spreads and becomes a positive-sum strategy.

5.    Publicity.  To be successful, a new growth cycle must be as obvious as westward expansion and suburban home building.  Most people, companies, and investors must understand it in order to make long term commitments.  This means that the goals and workings of the cycle must be publicized as the GE cycle was taught to its managers and trainees.  The Japanese even used comic books to inform the public about the cycle they were building.

Conclusion
Unless this paper is seriously wrong, the economy cannot be fixed by trying to go back to excess borrowing.  Recovery depends on making billions of dollars of productive investments to rebuild the production side by creating millions of Main Street jobs.  In order to do this:

•    Wall Street will have to shift from promoting parasitic investing for its own benefit to productive investing for the country’s benefit.

•    Retirement savings will have to be invested to provide future income flows, not increased stock prices that may never be realized.

•    Public companies will have to treat employee compensation as an output to be increased, not a cost to be reduced.

•    Financial “products” will have to be designed like other products, to perform as intended for their useful lives, and include intended-life warranties.

•    If small companies are expected to continue to be the country’s primary job creators, ways must be found to channel retirement and other savings to them.

These changes are possible.  At least one company is developing a royalty-based financing technique that provides small companies with a sum of money in exchange for royalty payments based on the company’s total sales for an agreed period of time.  If the recipient is successful, the royalty payments increase.  Both parties write off the sum at the end of the period so there is no repayment requirement or liability on the recipient’s books.

Those who argue that these changes are too big, and that the cost will put too much of a burden on future generations are selling America short.  The best way to understand what the country can do under government leadership is to look at what it did do in World War II.

The government took over the economy.  It created millions of jobs in uniform and war industries.  It controlled wages, prices, and allocations of food, fuels, materials, and manufacturing facilities.  It pioneered countless new technologies ranging from atomic energy to infection control.  It build the largest army, navy, merchant marine, and air force in history; helped England survive; and led the Allied forces to defeat Germany, Japan, and Italy—all in about six years.  Then it returned the economy to private control; started the GI Bill and the Interstate Highway System; helped rebuild Europe and Japan; did what it had to do as the Cold War began; and started to reduce the debt.  It applied the motto of the Navy’s construction battalions, “The difficult we do immediately—the impossible takes a little longer.”

Compared to this record, fixing the economy hardly qualifies as “difficult”. Those who oppose paying the costs of fixing it ignore the costs of the damage that has already been done.  If the critics are to be taken seriously, instead of just talking about government debt burdens, they must say what they think will be left to future generations if America does not rebuild the production side of its economy, restore the middle class, allow boomers who can’t retire to earn adequate incomes, and build safety factors into the financial system to prevent today’s mess from recurring.  To be credible, their proposals must be different from the policies and actions that led to the mess.


Thornton Parker is the author of What If Boomers Can’t Retire? How to Build Real Security, Not Phantom Wealth (Berrett-Kohler 2001).  He can be reached at [email protected]

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