Part 1: The U.S. Financial Crisis
Med Jones is the president of International Institute of Management - A U.S.
based strategy think tank. Jones is recognized as one of the few financial
experts who predicted the U.S. financial crisis. We
asked Jones several questions about the root causes of the crisis, the economic
outlook for 2009 and 2010 and how best to get out of the crisis.
CEO Q > How Did We Get
Med Jones > The U.S. economy got here due to
spending money we do not have and not producing enough to pay back the credit.
It’s like luxury-living on credit cards, at some point the lenders want their
money back. Not to forget that in a new open global economy, the U.S. does not
have a competitive monopoly on knowledge, technology, manufacturing, services or
marketing anymore. Therefore, the growth rate of U.S. production (cars, airplanes,
electronics, IT ...) is not keeping up with the growth rate of the debt. The
housing bubble, subprime mortgage defaults, and associated financial crisis are
all symptoms of the core problem of too much debt-based spending and
over-extended leverage (debt-based investing). We cannot sustain debt-driven
economic growth forever. Add to that a global speculative (derivative
instruments) trading, the mix becomes lethal.
CEO Q > Why Other Economic Experts Missed
Med Jones > Experts missed the crisis
because of the groupthink mindset, and the lack of information and
misinformation in the mainstream media. In such an environment, few have the
insight and the courage to tell it as it is, and risk being ridiculed by other
industry experts. It is not enough to know the facts, what is needed is the
ability to see the big global picture and understand the dynamic interplay of
key economic forces.
From a critical thinking perspective, there are two
main reasons that caused mainstream economists and financial media
to miss the financial crisis of 2008. The first is the NIH (Not
Invented Here) bias, which is an organizational phenomenon
manifested as an unwillingness to adopt an idea because it
originates from unknown outsiders. It is a form of social cognition
bias that leads to errors in group judgments such as missing on new
opportunities or risks. The second reason is a cognition bias known
as the Confirmation Bias which is the tendency to search for, filter
in, or interpret information in a way that confirms existing
preconceptions. The Confirmation Bias is recognized as an individual
cognition bias, but when met with (NIH) bias it appears to develop
into a social bias very similar to the Groupthink syndrome.
CEO Q >
What is the Best Strategy to Rescue the U.S. Economy?
Med Jones > The financial rescue plan or the
economic stimulus package in its current version will cost taxpayers more than
a trillion dollar over the next 2 years, and there is no guarantee that it will
achieve its stated goals. The plan will more likely soften the fall but it will not
correct the economy, it will only delay the correction, and therefore, the
real recovery too. The most cost effective and quickest method to stimulate the U.S.
economy is to support job creation through investing in the creation of U.S.
and innovation development. U.S. Census Bureau statistics show that 98 percent
of all U.S. firms have less than 100 employees. These 27 million small businesses create over 85 percent of all new jobs and employ over 56 percent of
all private sector workers. The main focus of development programs should be
innovation development, export and employment support through enterprise
This solution would be much less of a burden
to the taxpayers, it can be
implemented without too much new legislation, and would have a much faster
positive impact on the economy. It can be based on existing federal programs
designed to direct federal funds to small businesses. The medium Business
Reauthorization Act of 1997 stipulates that a minimum of 23 percent of all
federal prime and sub-contracts be awarded to small businesses.
Oversight is critical to the success of the implementation of
any rescue program. The effective and efficient program execution is necessary
to avoid waste, fraud, and the abuse of loopholes to divert these funds to
special interest groups.
objective of President-elect Obama is to lead the
economic recovery through the middle class, then the job
creation initiative through small business and
innovation development, would be hitting three birds
with one stone. The birds are sustainable job creation,
middle class support, and increasing U.S. businesses
competitiveness through innovation development.
would have a significant, and immediate positive impact on the national economy.
The European Commission has invested hundreds of billions of dollars in
innovation and enterprise creation since 2002. I personally was on the steering
board of 3 innovation EU research consortiums. I saw the impact
of these investments first-hand. The result of the EU innovation
and small enterprise creation initiatives is that they quantum-leaped U.S.
companies in Telecom, Aerospace, and several other industries. The Euro today is
almost 50% more valuable than the US dollar, compared to 2002.
CEO Q > When Do You Think
the Economy Will Recover?
Med Jones > The timing of the economic
recovery depends on several factors, the most important are the effectiveness of
the new economic policies in establishing trust in the U.S. economy (such as
reducing budget and trade deficits, etc.), and the performance of corporate
America (profits, job creation, etc.). The markets need at least 2 consecutive
quarters of business growth and profits, so that CEOs, investors and consumers
will establish the confidence to invest again and reverse the negative cycle.
However, we will not see the hugely inflated stocks and real estate prices
CEO Q > How is the Health
of the US Economy?
Med Jones > I do not
subscribe to gloom and doom scenarios. We have to do an unemotional assessment
of the health. The next 8 years will be the most critical in determining the
health of U.S. economy. A healthy economy has no or low debt, a
strong base of savers and investors financing GDP growth through investment
in production and exports. The government has a budget surplus and uses this
surplus to invest in the infrastructure, education and new innovations. The best
way to get the picture is to let the numbers speak for themselves.
The U.S. Economy in Numbers:
The size of the U.S. economy = $13 trillion. Commonly known as the Gross
(GDP) - The 2002-2006 growth has been mostly driven by debt spending, inflated real estate
prices and assets valuation
(mainly the housing and mortgage/financial bubble)
U.S. 2008 deficit is about 1 trillion
dollar = 8% of GDP.
U.S. National Debt (accumulated) is about $10.5 trillion. Actual numbers are much higher, since U.S. government accounting rules do not
meet private business accounting standards.
A large national debt is bad. Why? The Government has to
pay interest on the debt. As the debt and the interest
payment grow, eventually all the Government can afford to do is pay the interest
payments, with no money left over for other socioeconomic development
investments or even critical expenditures.
If uncontrolled, this could lead to states and national bankruptcy and major
related socioeconomic crises.
During the 2006 fiscal year, the U.S. Government spent $406 Billion of its
budget on interest payments to the holders of the national debt. Compare
that to Education at $61 Billion, and Department of Transportation at $56
Billion. When interest payments become larger than other
critical socioeconomic budgets, this calls for a major concern.
Consumers are the main engine of any economy, the less money the
consumer has to spend or invest, the less is the economic growth. By
the end of 2006, the U.S. consumer debt was about $11 trillion.
Foreign Debtors hold about 40% of the US National Debt
(Mainly China, EU, Japan and Oil producing countries). According to the Commerce Department, the United States paid more to its
foreign creditors than it took in from its overseas investments. The gap was
about $2.5 billion for the last quarter - the first time that has happened
in more than 90 years! (Are you noticing the negative trends in numbers?).
According to the Commerce Department, the personal savings rate for 2006
was a negative 1 percent; the worst in 73 years! This is the lowest level
since the Great Depression, which could be a problem for the millions of
retiring baby boomers and for the job market.
About 45% of American households live
“paycheck to paycheck”.
In 2007, the median annual income for
Americans aged 65 or older is less than $17,000.
The average American household has more than
$8,500 in credit card debt.
28 million households will need food stamps
U.S. (economic) health is bad, but it is not terminal. The new administration
can enact new policies to reverse the negative trend, but if it does not do that
soon, we will be in a critical state in the long term.
CEO Q > What About the
Real Estate Bubble and Subprime Mortgage Crisis?
Med Jones > The Real Estate Bubble and
Subprime mortgage are the epicenter of the current crisis. However, they are not
the root cause of the crisis. The crisis resulted from a national culture of
spending more than what the nation can produce. There are also other problems
following the subprime loans, including other risky loans and inflated assets
categories that we will experience in 2009. ARM and other variable loans are
expected to reset in 2009/2010, thus resulting in more foreclosures and loan
defaults. This will depress the Real Estate and financial markets even further.
Adding to this challenge, there are other issues related to the health of the U.S.
economy including the falling dollar value, budget and trade deficits, and
the diminishing position of the global competitiveness of U.S. industries and that is
the real American challenge for the next few decades.
CEO Q > What Do You
Think of the "Bad Bank"?
Med Jones > The Bad Bank is a Bad Idea.
It will sure help the banks, Wall Street, and the stock market. The market will
rally and it will help the credit flowing again. However, beware, it is a
psychological trick. The saying you could fool most of the people for
sometime is true here. But you have to remember, it is not a solution to the
crisis, it is only transfer of the toxic assets from the banks to the
government. In this game, the losers are the government and the tax payers. It is
likely that we have to pay the price later. Obama's Administration or the next
one will have to pay the heavy price for the worthless Bad Bank
assets, out of control budget deficits, and even a worse economy. On the other
hand, my preference would be for a state-owned “Good Bank”. A government-owned
bank that will provide liquidity to the market, distressed home owners, and
small businesses. The difficulty would be the bureaucracy and efficiency of
operating the good bank, but that can be achieved with
private-public partnerships with other healthy banks and investors. The bank can
be for profit and will help reduce budget deficit and finance growth and reduce
public and private investors win.
CEO Q > When Do You Think
the Recession Will End?
Med Jones > A modest and slow recovery can
start sometime in 2010. The recession will end with a period of stable (flat) economic
activities. The timing of the recovery is dependent on the effectiveness of Obama’s policies.
All economic predictions are subject to a set of key variables. The two most
important variables for the aforementioned timing are:
The competitiveness of the U.S. business environment
(investment attraction via lower taxes, improved confidence, lower cost of
doing business including healthcare, etc.) and;
The health of the U.S. innovation and entrepreneurship engine.
The only hope for reversing the negative cycle is in the creation and development of new
innovative and globally competitive
The first recovery from the great depression (post-war recovery) was driven
mainly by the new auto industry.
The second recovery from the 1980s crisis was led by the information and
communication technology (ICT) industry, this time it is the same. The U.S. needs to
invest in or develop a new industry that will lead the recovery by increasing
wealth and creating jobs. The timing of the recovery might be delayed if the
U.S. engages in another war or implement more flawed socioeconomic policies.
CEO Q > What Could Hinder the Recovery of The U.S. Economy?
Med Jones > There
are several possible scenarios. The complex government and banking
accounting rules hide the fact that the current investment
papers, including risky debt and derivatives are overvalued.
Credit ratings are not always trustworthy. This is very dangerous.
National and global investors will sooner or later catch up with the fact that
their investments are highly inflated and riskier than they thought. If reforms
are not taken, the result could be the serious erosion of investors’ confidence.
The confidence in the U.S. economic policies is the single most important factor
for recovery. The loss of confidence in the U.S. Economy could lead to the significant
loss of the dollar value and the migration of capital from the U.S. financial
markets to alternative
international investment destinations.
CEO Q > What is the Worst
Case Scenario and What are the Risks?
Med Jones > There are several risks including, but not limited to:
The devaluation of U.S. treasuries and other assets
New waves of home foreclosures from variable rate mortgage
loans that are set to reset in 2009 & 2010
New waves of major consumer and business bankruptcies
(especially for large industries) in 2009 and 2010
Double digits unemployment rate
Wrong economic policies (uncontrolled spending deficits and
higher tax policies)
Wrong foreign policies (increased instability and decreased
Geopolitical and security risks
The combination of some of the
counterproductive policies and bad news, can further damage the investors'
confidence, thus sending the economy in downward spiral and resulting in another
“great depression” period with ~ 25% unemployment rate. This would be the worst
case scenario. Fortunately, the new administration does
have the tools to mitigate those risks and it is not too late to implement the
new needed economic reforms.
CEO Q > What is the Best
Case Scenario and Positive Forces?
Med Jones >
The deregulation and
globalization of markets, capital and trade, information technology, better
management, lean inventory and production systems will all help in a faster
New (financial) market regulations such as increasing mandatory banking
reserves, increasing the power of the shareholders to manage executive
compensation, and regulating credit reporting agencies and the role of
speculative derivatives in major funds will improve
confidence in U.S. investments.
A lower dollar can help export increase, thus supporting foreign
capital spending and growth.
The lower mortgage rates will allow investors and
first-time home buyers to get into the market thus reducing the market inventory
and improving prices.
The proactive monetary and fiscal policies will help
absorb the shock and help ease the credit market crunch (assuming the bailout
plan is not abused by the banks to reduce their balance sheet losses and create
new asset bubble, rather
than loaning money to consumers and businesses).
In a global integrated economy, the global investors (including the Chinese, Japanese and the Gulf Arabs), all
want the U.S. to recover so that they can recover their investments. We can
expect to see a collaboration with various central banks and investors which
will help us overcome the crisis. It is unlikely to see these governments
taking hostile actions which would cause the collapse of the dollar or the financial system
in the US.
Recession lower demand will lower oil prices, giving U.S. businesses and consumers a
The government can invest in, and help develop new industries including
biotech, alternative fuel, and nanotechnology, thus creating new jobs which will
generate enough income to reduce the budget deficit.
CEO Q > When Do You
Predict The Next Boom?
Med Jones > There need to be at least 2
years of stability before the next economic boom can occur. The next boom cycle
is subject to the rise of new industries. That being said, strong innovative
research investments and tax policies will help accelerate this cycle. If a new
industry evolve, we can expect to see the beginning of a new boom cycle as early
as 2012 or 13, otherwise we could suffer another crisis by 2015 from the
CEO Q > How Will Obama’s
Economic Policies Impact the Economy and the Financial Markets?
Med Jones > Initially there will a positive
impact based on the goodwill from Obama’s positive campaign message and the
expertise of his team. However, to sustain the positive psychological momentum,
Obama needs to take some major socioeconomic and political reforms. The new
Administration has 6-9 months to establish trust in the U.S. economy (nationally
and globally). If the administration focuses too much on social welfare, they
will miss a huge opportunity for a quick recovery. The Financial and Auto
Industry bailouts in their current formats are bad ideas. They increase the
budget deficit, and delay the correction, thus prolonging the suffering. The
bailout plans reward bad management behavior and poor investment decisions. Not
to forget, there will be a lot of waste due to the lack of governance. There
will be abuse of funds by the financial industry and the executives of
bailed-out banks and financial institutions.
The stated goal is to reduce the intensity of the pain
of the fall, but in the process Obama can prolong the recession with the wrong
policies. In my
opinion, it is better to let the free markets correct themselves. This will
allow a faster recovery.
Short-term economic pain relief should not be at
the expense of long-term economic health. Pain-killers are not the solution. What the patient really needs is surgery
(or structural reforms). While some social and infrastructure
spending will be unavoidable, the best solution is to focus the investments on
new enterprise creation and innovative industries that can raise national income
and create jobs. New policies should focus on reducing taxes for new
industries in order to attract investments, thus reducing the budget deficit
while encouraging investments, growth and exports.
CEO Q > What Solutions
Would You Recommend?
Med Jones > The U.S. economic problems are
multidimensional, therefore the solution should address all the dimensions of
the problems, with careful balance between short-term and long-term impact.
Economists from different schools and political parties can argue for opposing
options. Each option has a benefit and a price to pay. In my opinion, there are
several ethical issues for raising taxes on hardworking citizens to pay for the
bailout of a group of investors, managers and companies who gambled with their
money and made bad decisions. The fallout from subsidizing bad behavior can be
serious, but ethics and politics are not the subject of this discussion.
It is not reasonable to try to avoid market correction.
Instead, the policies should focus on making the recovery faster,
to enhance the
competitiveness of US industries,
and to improve the business environment to
attract more investments.
In order to succeed, the solution should be pragmatic, not ideological. The
solution should not be led by either the liberal or the conservative
economic schools. It is not reasonable to try to avoid market correction.
Instead, the policies should focus on making the recovery faster, to enhance the
competitiveness of U.S. industries, and to improve the business environment to
attract more investments. The following is a partial list of strategies to establish trust and reverse the cycle:
Learn the lessons:
Keep state and federal spending in check
Regulate to protect investors and consumers, but avoid
overregulation or under-regulation
Let free markets correct themselves, while at the
same time have proactive and rapid response policies. The purpose of
intervention should not favor one company over the other or to control the markets. The goal
should be to
minimize speculation and market shocks, thus maintaining a healthy business
and investment environment which supports the global competitiveness of national
industries and businesses
Provide tax holidays for new industries
Create tax-free zones for exports and tourism
Lower interest rates and tax rates for smaller and new
businesses and foreign investments. This is important in order to attract
capital, start new companies and create new jobs
Investment and credit rating agencies should answer to investors, not
bankers, like the auditors they should have liabilities for bad performance
Increase FDIC cap from $100K to $300K, this will establish trust
in the banking systems
Raise banks’ mandatory reserves
Regulate to limit speculative-gambling investing,
mainly derivatives and high risk debt instruments
Reduce the cost of compliance and simplify Sarbanes-Oxley.
What is needed is accountability not bureaucracy.
Reduce government size and expenses drastically.
Change the income tax to flat sales tax or value added tax
(VAT). This will encourage investments and discourage consumerism
Change the way the government does business by creating
performance-based job functions linked to business metrics and socioeconomic scorecards
similar to the private sector with the focus on effectiveness, efficiency
Public performance reviews of Representatives and Senators.
Elections and re-elections should be tied to detailed states and national
metrics to minimize wasteful spending and the abuse of national resources by
special interest groups.
Instituting term limits on the Congress and Senate would
reduce the abuse of power and the long-term access of lobbyists to
Reduce healthcare system costs. The high costs of the
healthcare system come from 3 areas: labor, insurance and pharmaceuticals.
The best way to overcome them is (1) open immigration policies for doctors
and nurses to improve the healthcare labor supply/demand ratio, (2) limit
compensation caps on lawsuits (3) open the markets by importing medicine
from other countries (4) open interstate competition and regulate the Insurance
Reduce educational system costs and accreditation
bureaucracy, allowing the private sector and online programs to compete more effectively.
Keep but audit the Federal Reserve.