We Need the Right Kinds of Innovation

Innovation is the engine of the economy. However, we need the right kinds of innovation. One promising area is in mass transportation. Maybe, we should consider putting G.M. to work manufacturing light rail and high speed rail cars (systems).

The Failed Promise of Innovation in the U.S.

During the past decade, innovation has stumbled. And that may help explain America's economic woes

By Michael Mandel

"We live in an era of rapid innovation." I'm sure you've heard that phrase, or some variant, over and over again. The evidence appears to be all around us: Google (GOOG), Facebook, Twitter, smartphones, flat-screen televisions, the Internet itself.

But what if the conventional wisdom is wrong? What if outside of a few high-profile areas, the past decade has seen far too few commercial innovations that can transform lives and move the economy forward? What if, rather than being an era of rapid innovation, this has been an era of innovation interrupted? And if that's true, is there any reason to expect the next decade to be any better?

These are not comfortable questions in the U.S. Pride in America's innovative spirit is one of the few things that both Democrats and Republicans—from Bill Clinton to George W. Bush to Barack Obama—share.

But there's growing evidence that the innovation shortfall of the past decade is not only real but may also have contributed to today's financial crisis. Think back to 1998, the early days of the dot-com bubble. At the time, the news was filled with reports of startling breakthroughs in science and medicine, from new cancer treatments and gene therapies that promised to cure intractable diseases to high-speed satellite Internet, cars powered by fuel cells, micromachines on chips, and even cloning. These technologies seemed to be commercializing at "Internet speed," creating companies and drawing in enormous investments from profit-seeking venture capitalists—and ordinarily cautious corporate giants. Federal Reserve Chairman Alan Greenspan summed it up in a 2000 speech: "We appear to be in the midst of a period of rapid innovation that is bringing with it substantial and lasting benefits to our economy."

Where are the new products?

With the hindsight of a decade, one thing is abundantly clear: The commercial impact of most of those breakthroughs fell far short of expectations—not just in the U.S. but around the world. No gene therapy has yet been approved for sale in the U.S. Rural dwellers can get satellite Internet, but it's far slower, with longer lag times, than the ambitious satellite services that were being developed a decade ago. The economics of alternative energy haven't changed much. And while the biotech industry has continued to grow and produce important drugs—such as Avastin and Gleevec, which are used to fight cancer—the gains in health as a whole have been disappointing, given the enormous sums invested in research. As Gary P. Pisano, a Harvard Business School expert on the biotech business, observes: "It was a much harder road commercially than anyone believed."

If the reality of innovation was less than the perception, that helps explain why America's apparent boom was built on borrowing. The information technology revolution is worth cheering about, but it isn't sufficient by itself to sustain strong growth—especially since much of the actual production of tech gear shifted to Asia. With far fewer breakthrough products than expected, Americans had little new to sell to the rest of the world. Exports stagnated, stuck at around 11% of gross domestic product until 2006, while imports soared. That forced the U.S. to borrow trillions of dollars from overseas. The same surges of imports and borrowing also distorted economic statistics so that growth from 1998 to 2007, rather than averaging 2.7% per year, may have been closer to 2.3% per year. While Wall Street's mistakes may have triggered the financial crisis, the innovation shortfall helps explain why the collapse has been so broad. (To see a full explanation of the problems with the economic statistics, go to Growth: Why the Stats Are Misleading.)

But here's some optimism to temper the gloom: Many of the technological high hopes of 1998, it turns out, were simply delayed. Scientific progress continued, the technologies have matured, and more innovations are coming to market—everything from the first gout treatment in 40 years to cloud computing, the long-­ballyhooed phenomenon "information at your fingertips." The path has been long and winding, but if the rate of commercialization picks up, the current downturn may not be as protracted as expected.

To see both the reality of the innovation shortfall and its potentially happy ending, look at Organogenesis, a small company in Canton, Mass. Back in 1998, Organogenesis received approval from the Food & Drug Administration to sell the world's first living skin substitute. The product, Apligraf, was a thin, stretchy substance that could be grown in quantity and applied to speed the healing of diabetic leg ulcers and other wounds that had stayed open for years.

From a health perspective, the approval of Apligraf seemed to open up an entire world of "tissue engineering," growing all sorts of replacement body parts from living human cells. From an economic angle, the possibilities were equally appealing: Apligraf, approved in Canada and Switzerland, was being exported, creating skilled jobs in Massachusetts. This was the sort of high-tech product needed to drive the U.S. economy into the 21st century.

But there were several big problems, recalls Geoff MacKay, the company's current CEO, who repeatedly used the word "cautious" during our interview. For one, Apligraf cost more to make than the company could sell it for—never a good way to stay in business. In addition, Organogenesis couldn't figure out how to deliver Apligraf reliably, since it was shipping a product made out of living cells. "This is something no one had done before," says MacKay, who at the time was working for Novartis (NVS), then the marketing partner for Apligraf. "The way to commercialize this type of technology was more difficult than initially anticipated."

By 2002 the early enthusiasm for Apligraf had vanished, along with the money. Novartis pulled out, Organogenesis declared bankruptcy, and jobs were slashed. The company was not alone: The entire field of tissue engineering was languishing. Shortly after, MacKay took over at Organogenesis with a clear mandate to straighten out the company's manufacturing, logistics, and sales, and turn this tarnished product into a moneymaker.

And that's what he did. By bringing down costs, "we now have margins that are pharmaceutical-like," says MacKay. Sales of Apligraf are growing at more than 20% per year, the company is taking over two more buildings on the same street in Canton, and it has FDA approval to install high-reliability robots from Japan's Denso, the same supplier Toyota (TM) uses, he says. Employment is expected to climb from 350 jobs to about 600, the company is introducing products, and MacKay is talking about "cautious globalization." In other words, Organogenesis is fulfilling the promise of 1998—a decade later.

stumbling blocks

Now multiply that story a hundredfold and extend it to other areas. Consider, for example, micromachines—miniaturized gyroscopes, pumps, levers, or sensors on a silicon chip. Also known as MEMS (microelectromechanical systems), micromachines have been around in one form or another for years, most notably as the sensors that trigger airbags in cars.

In 1998, MEMS suddenly became the "next big thing." Engineers started to see how the devices could be useful in all sorts of ways that conventional semiconductors were not. For example, MEMS, in theory, could be used to make miniature sensors to monitor a hospital patient's blood at far less cost than conventional medical equipment. Venture capitalists threw billions into optical MEMS, miniaturized arrays of tiny mirrors designed to run fiber optic networks.

"In 1998 friends of mine started a MEMS company and asked me if I wanted to live the semiconductor revolution again," says Jeff Hilbert, now president and chief operating officer at MEMS outfit WiSpry in Irvine, Calif. "I naively thought it was a lot closer to being commercialized than it was." A whole array of challenges arose when it came time to move to mass production. "We didn't know what we didn't know," says Hilbert. WiSpry, which just closed a $20 million round of venture funding, is now about to start shipping MEMS chips that will go into cell phones, improving battery life and reducing dropped calls.

And then there is the biotech sector. The story driving the biotech boom was both scientifically sound and economically compelling: By understanding DNA and the human genome, researchers could develop effective drugs more quickly and easily. Pharmaceutical companies would no longer have to rely on serendipity to find a treatment for an illness. Instead, they could focus like lasers on the biological mechanisms that were broken or needed to be shored up. And the benefits of biotech were supposed to stretch into new sources of energy, increased agricultural production, and better ways to clean up environmental problems.

But fixing and improving the human body turned out to be far more complicated than expected. Even the sequencing of the human genome—an acclaimed scientific achievement—has not reduced the cost of developing profitable drugs. One indicator of the problem's scope: 2008 was the first year that the U.S. biotech industry collectively made a profit, according to a recent report by Ernst & Young—and that performance is not expected to be repeated in 2009.

red flags

There's no government-constructed "innovation index" that would allow us to conclude unambiguously that we've been experiencing an innovation shortfall. Still, plenty of clues point in that direction. Start with the stock market. If an innovation boom were truly happening, it would likely push up stock prices for companies in such leading-edge sectors as pharmaceuticals and information technology.

Instead, the stock index that tracks the pharmaceutical, biotech, and life sciences companies in the Standard & Poor's (MHP) 500-stock index dropped 32% from the end of 1998 to the end of 2007, after adjusting for inflation. The information technology index fell 29%. To pick out two major companies: The stock price of Merck declined 35% between the end of 1998 and the end of 2007, after adjusting for inflation, while the stock price of Cisco Systems (CSCO) was down 9%.

Consider another indicator of commercially important innovation: the trade balance in advanced technology products. The Census Bureau tracks imports and exports of goods in 10 high-tech areas, including life sciences, biotech, advanced materials, and aerospace. In 1998 the U.S. had a $30 billion trade surplus in these advanced technology products; by 2007 that had flipped to a $53 billion deficit. Surprisingly, the U.S. was running a trade deficit in life sciences, an area where it is supposed to be a leader.

A more indirect indication of the lack of innovation lies in the wages of college-educated workers. These are the people we would expect to prosper in growing, innovative industries that need smart, creative employees. But the numbers tell a different story. From 1998 to 2007, earnings for a U.S. worker with a bachelor's degree rose only 0.4%, adjusted for inflation. And young college graduates—who should be able to take advantage of opportunities in hot new industries—were hit by a 2.8% real decline in wages.

The final clue: the agonizingly slow improvement in death rates by age, despite all the money thrown into health-care research. Yes, advances in health care can affect the quality of life, but one would expect any big innovation in medical care to result in a faster decline in the death rate as well.

The official death-rate stats offer a mixed but mostly disappointing picture of how medical innovation has progressed since 1998. On the plus side, Americans 65 and over saw a faster decline in their death rate compared with previous decades. The bad news: Most age groups under 65 saw a slower fall in the death rate. For example, for children ages 1 to 4, the death rate fell at a 2.3% annual pace between 1998 and 2006, compared with a 4% decline in the previous decade. And surprisingly, the death rate for people in the 45-to-54 age group was slightly higher in 2006 than in 1998.

Each of these statistics has shortcomings as an innovation indicator. The relatively small decline in the death rate for many age groups could reflect an increase in obesity-related diseases among the American population rather than a shortfall in health-care innovation. The import and export numbers leave out trade in services and innovative products produced by U.S. companies overseas. And drawing conclusions about innovation from movements in stock prices is a dicey business at best. But taken together, these statistics tell a story of weaker-than-expected innovation.

The final piece of evidence is the financial crisis itself. After the 2001 tech bust, trillions of dollars flowed into the U.S.—but most of it went into government bonds and housing rather than into innovative sectors of the economy. While subprime mortgages boomed, venture capital investments have more or less stagnated since 2001, with few tech startups going public. "The U.S. was awash in capital, much of it desperately seeking a good deal," says Robert D. Atkinson, president of the Information Technology & Innovation Foundation, a nonpartisan Washington think tank. "If this had truly been an innovative period, then a vast array of cutting-edge innovations and their commercialization would have demanded hundreds of billions of dollars of capital."

If the description of the last decade as an innovation shortfall turns out to be accurate, that could make a big difference in how we think about the U.S. economy. For one thing, it helps explain why the trade deficit skyrocketed. A high-wage country such as the U.S. either has to develop innovative products and services to compete with low-cost countries such as China or accept a lower standard of living. "The competitive advantage of the U.S. economy has to be leveraging our science capacity for economic growth," says Pisano of Harvard. Fewer innovative products mean a weaker trade performance.

An innovation shortfall might also have weakened the country's underlying productivity growth, which in turn influenced real wages and the ability of consumers to spend without borrowing. Certainly economists on both the left and the right believe innovation is an essential ingredient for growth. A December 2006 paper by the Brookings Institution, co-authored by Peter R. Orszag, now head of the Office of Management & Budget, observed: "Because the U.S. is at the frontier of modern technological and scientific advances, sustaining economic growth depends substantially on our ability to advance that frontier."

The flip side: A shortfall in innovation could undercut growth and incomes, especially over a decade-long period. True, the economic statistics appear to show decent productivity growth across this stretch. But since there is compelling evidence that the figures are overstated by the credit bubble and statistical problems, we can construct a plausible narrative for the financial bust that gives a starring role to innovation—or rather, to the lack of it. It goes something like this: In the late 1990s most economists and CEOs agreed that the U.S. was embarking on a once-in-a-century innovation wave—not just in info tech but also in biotech and many other technologies. Forecasters upped their long-run growth estimates for the U.S. economy. Consumers borrowed against their home equity, assuming their future incomes would rise. And foreign investors lent America money by buying up U.S. securities, assuming the country would come up with enough new products to pay off the accumulated trade deficit.

This underlying optimism about the economy's growth potential became an enabler for Wall Street's financial shenanigans and greed. In this narrative, investors and bankers could convince themselves that rising home prices were reasonable given the bright future, which was based in part on strong innovation. In the end, the credit market collapse in September 2008 reflected a downgrading of expectations about future growth, which put trillions of dollars of debt underwater.

beyond info tech

Many economists are skeptical about placing the blame on an innovation shortfall, preferring to focus on problems on Wall Street and in Washington. "I tend to see the direct causes in our regulatory system," says Paul Romer, an economist at Stanford University's Graduate School of Business renowned for his work on innovation. "The big task is to explain why risk was so badly mispriced, particularly the risk of a collapse of the housing bubble."

Whatever the ultimate cause of the downturn, a pickup in innovation would provide a welcome economic boost. In part, that could come from information technology, where the combination of Google, social networks, wireless technology, and the beginnings of cloud computing is substantially altering the way people live their lives.

Of course, no industrial revolution in the past has been based on a single technology. A combination of radio, television, flight, antibiotics, synthetic materials, and automobiles drove the productivity surge of the early and mid-20th century. The Industrial Revolution of the second half of the 19th century combined railroads, electricity, and the telegraph and telephone.

Similarly, for sustainable economic growth, the U.S. needs breakthrough innovations outside of core IT. Some technologies weren't ready for prime time 10 years ago but have matured. MacKay of Organogenesis says that after spending years cutting costs and increasing reliability, he is ready to "reinject innovation" back into the company. He is in the process of submitting new treatments for FDA approval, including a product made from living cells that helps stimulate the growth of gum tissue. "This is the type of manufacturing that won't be lost offshore," says MacKay.

MEMS, too, is maturing. Nintendo is about to release a new add-on for the Wii controller, containing an innovative MEMS gyroscope chip that makes it easier to sense a wider range of user movements. The chip is made by InvenSense, a Sunnyvale (Calif.) startup that was able to build on 10 years of industry false starts to produce something small enough and cheap enough to go into a mass consumer product. "If I had any idea how difficult it would be, I wouldn't have started the company," says CEO Steve Nasiri. He expects a fivefold increase in revenue this year, and he sees a competitive advantage for the U.S. "In MEMS technology, the U.S. is two to three years ahead of Europe and Japan," says Nasiri.

The imponderables are biotech and alternative energy. In biotech, the clinical-test pipelines are full of breakthrough treatments, any of which could turn out to be a blockbuster. But as we've seen far too many times, a drug can be promising up to the moment it is rejected by the FDA. Similarly, the potential for innovation in alternative energy is enormous, but it's hard to know which approach will pay off.

The professor, trader, and author Nassim Nicholas Taleb calls technological breakthroughs "positive Black Swans"—unexpected events with huge positive consequences that in retrospect look inevitable. Some, such as Google, come out of nowhere to dominate within a short time. Others take years to mature and are surprising only because people forgot they were there. We've learned over the past 10 years just how unpredictable technology can be. But right about now, the U.S. could use a few positive Black Swans.

Business Exchange: Read, save, and add content on BW's new Web 2.0 topic network

Puny Progress

A February 2009 report from the Information Technology & Innovation Foundation ranks 40 countries and regions on a range of innovation-based competitiveness metrics, including R&D investment, IT infrastructure, and science and technology researchers as a share of the workforce. The U.S. is No. 6 on the list, behind South Korea. The biggest gainer by the ITIF's metrics since 1999 was China. The country with the smallest advance? The U.S. /p>

To read the report, go to http://bx.businessweek.com/innovation-economics/reference/.

Mandel is chief economist for BusinessWeek.

Ouch!

Treasury Secretary Tim Geithner is in China today, doing whatever it takes–no matter how shameless and sordid– to make sure that the Chinese don’t pull out of American bonds, which are tanking in value thanks to Geithner’s multi-trillion-dollar gift to Wall Street. The Chinese are not happy, and since the Chinese loaned America all the money it’s now blowing, they call the shots.Treasury Secretary Tim Geithner is in China today, doing whatever it takes–no matter how shameless and sordid– to make sure that the Chinese don’t pull out of American bonds, which are tanking in value thanks to Geithner’s multi-trillion-dollar gift to Wall Street. The Chinese are not happy, and since the Chinese loaned America all the money it’s now blowing, they call the shots.

Lagging Recognition from Clusterfuck Nation

Here is an essay from James Kunstler, author of the Geography of Nowhere, a critical tome about suburbanization in the U.S. Kunstler's website is Clusterfuck Nation.

http://www.kunstler.com/



Enjoy


Through the tangle of green shoots and sprouting mustard seeds, a nervous view persists that the arc of events is taking us to places unimaginable। The collapse of General Motors and Chrysler signifies more than the collapse of US car manufacturing. It spells the end of the motoring era in America per se and the puerile fantasy of personal liberation that allowed it to become such a curse to us.

Of course, many Nobel prize-winning economists would argue that it has only been a blessing for us, but that only shows how the newspapers are committing suicide-by-irrelevance. And if other societies, such as China's late-entry industrial start-up, want to adopt a similar fantasy, they will only find themselves all the sooner in history's garage with a tailpipe in their mouths.

Here in the USA, we will mount the most strenuous campaign to keep the motoring system going -- in fact, we're already doing it -- but it will fail just as surely as two (so far) of the "big three" automakers have failed. It will fail because car-making is only one facet of a larger network of systems that is coming undone, namely a revolving debt cheap energy economy.

Americans will never again buy as many new cars as they were able to do before 2008 on the terms that were normal until then: installment loans. Our credit system is completely broken. It choked to death on securitized debt engineered by computer magic and business school hubris. That complex of frauds and swindles coincided with the background force of peak oil, which meant, among other things, that economic growth based on ever-increasing energy resources was over, and along with it ever-increasing credit. What it boils down to now is that we can't service our debt at any level, personal, corporate, or government -- and that translates into comprehensive societal bankruptcy.

The efforts of our federal government to work around this now, to cover up the "non-performing" debt and to generate the new lending necessary to keep the old system going, is a tragic exercise in futility. I'm not saying this to be a "pessimistic" grandstanding doomer pain-in-the-ass, but because I would like to see my country make more intelligent choices that would permit us to continue being civilized, to move into the next phase of our history without a horrible self-destructive convulsion.

Another consequence of the debt problem is that we won't be able to maintain the network of gold-plated highways and lesser roads that was as necessary as the cars themselves to make the motoring system work. The trouble is you have to keep gold-plating it, year after year. Traffic engineers refer to this as "level-of-service." They've learned that if the level-of-service is less than immaculate, the highways quickly enter a spiral of disintegration. In fact, the American Society of Civil Engineers reported several years ago that the condition of many highway bridges and tunnels was at the "D-minus" level, so we had already fallen far behind on a highway system that had simply grown too large to fix even when we thought we were wealthy enough to keep up. Right now, we're pretending that the "stimulus" program will carry us over long enough to resume the old method of state-and-federal spending based largely on bonding (that is, debt).

The political dimension of the collapse of motoring is the least discussed part of problem: as fewer and fewer citizens find themselves able to buy and run cars, they will feel increasingly aggrieved at the system set up to make motoring virtually mandatory for all the chores of everyday life, and their resentments will rise against the elite that can still manage to enjoy it. Because our car-dependency is so extreme, the reaction of the dis-entitled classes is liable to be extreme and probably delusional to an extreme, too.

You can already see it being baked in the cake. Happy Motoring is so entangled in our national identity that the loss of it is bound to cause a national identity crisis. In places like the American south, the old Dixie states, motoring lifted more than half the population out of the dust, and became the basis of the New South economy. The sons and grandsons of starving sharecroppers became Chevy dealers and developers of suburban housing tracts, malls, and strip malls. They don't have any nostalgia for the historical reality of hookworm and 14-hour-days of serf labor in hundred-degree heat. Theirs is a nostalgia for the present, for air-conditioned comfort and convenience and the groaning all-you-can-eat Shoney's breakfast buffet off the freeway ramp. When it is withdrawn from them by the mandate of events, they will be furious.

Given the history of the region and the predilections of its dominant ethnic group, one might imagine that they will want to take out their gall and grievance on the half-African politician who presides over the situation. Among the ever-expanding classes dis-entitled from the so-called American Dream, the crisis is only marginally different in other regions of the nation. Mr. Obama faces a range of awful dilemmas, and it is painful to see them go unrecognized and unacknowledged by his White House. It's hard to imagine that the president and his elite advisors are blind to these equations, but as the weeks tick by they seem stuck in a box of limited perception.

We're in a strange hiatus for now. "Hope" levitates the legitimacy of the dollar, the stock markets, and the authority of leadership. In the background, implosion continues, debt goes unpaid, banks ignore bad loans to keep them off their books, jobs and incomes vanish, cars and other things go unsold, and a tragic wishfulness strains to sustain the unsustainable. Our expectations are inconsistent with what is happening to us.

It will be very painful for us to walk away from the car-centered life. Half the population faces the ugly obstacle of being hopelessly over-invested in a suburban house and all the life-ways associated with it. There will be no easy way out for them, whatever they chose to do politically, whatever noise they make, whomever they scapegoat, whatever fantasies they cultivate about what the world owes them, or who they think they are.

Mr. Obama should not waste another week pretending that we can keep this old system going. The public needs to know that we will be making our livings differently, inhabiting the landscape differently, and spending our days and nights differently -- even while we suffer our losses. The public needs to hear this from more figures than Mr. Obama, too, from leaders in the state capitals, and the agencies, and business and education and what remains of the clergy. But somebody has to set in motion the chain of recognition, or events will soon do it for us.

We Don't Need No Education

This article is from Reason. It reflects some of my thoughts about higher education in the U.S. I will write a more thorough essay in the future that explains the real reason for the infatuation with higher education in the U.S., and it does not have to do with money nor education itself...


Ask random members of the professoriate at my alma mater, the University of Massachusetts, Amherst, and many will confide that too many people—not too few, as recently suggested by President Barack Obama—are attending college these daysThis opinion is impolite and impolitic (perhaps, in the context of the American university, we should say "un-PC"). But years of furtive conversation with academics suggest it is commonly held. And one can see why. To the professor with expertise in Austro-Hungarian history, for instance, it is unclear why his survey course on the casus foederis of World War I is a necessary stop in a management-level job training program at Hertz.

This is not to say that some Americans should be discouraged from participating in a liberal arts education. As the social scientist Charles Murray writes in his book Real Education, "Saying 'too many people are going to college' is not the same as saying that the average student does not need to know about history, science, and great works of art, music, and literature. They do need to know—and to know more than they are currently learning. So let's teach it to them, but let's not wait for college to do it."

Take this bullet point, proudly included in a November 2008 press release from the Boston public school system: "Of the [Boston public school] graduates from the Class of 2000 who enrolled in college (1,904), 35.5 percent (675 students) earned a degree within seven years of high school graduation. An additional 14 percent (267 students) were still enrolled and working toward a degree." In a news conference celebrating these dismal numbers, Mayor Tom Menino called for a "100 percent increase" in the number of city students attending college, though offered no suggestions on how to ensure that those students actually graduate or are properly prepared to handle undergraduate studies. Besides, if 14 percent of those enrolled are still ambling towards a degree after eight years, is Menino convinced that the pursuit of a university education was the right decision for these students, rather than, say, vocational training?

Alas, these numbers are not uncommon. (They're often worse in other major American cities.) Citing a recent study by two education experts at Harvard University, former Secretary of Education Margret Spellings sighed, "The report shows that two-thirds of our nation's students leave high school unprepared to even apply to a four-year college." Nevertheless, a huge number of these students are matriculating to four-year universities, incurring mountains of debt, and never finishing their degrees.

The devalued undergraduate degree is one thing when the people doing the devaluing have privately financed their education. It is quite another when the federal government foots the bill. While America debates the merits of the Troubled Asset Relief Program, the nationalization of General Motors, and how to fix a broken health care system, the Obama administration has been quietly planning a massive expansion of the Pell Grant program, "making it an entitlement akin to Medicare and Social Security." Read that sentence again. As we spiral deeper into recession and debt, our dear leaders in Washington are considering the creation of a massive entitlement akin to the expensive, inefficient, and failing Medicare and Social Security programs.

According to a report in The Washington Post, Obama's proposals "could transform the financial aid landscape for millions of students while expanding federal authority to a degree that even Democrats concede is controversial." It is a plan that has met with outspoken—though likely toothless—resistance from Republicans. Rep. Paul D. Ryan (R-Wis.), the senior Republican on the House Budget Committee, suggested that the president reform existing entitlements before creating new ones. And, as noted in the Post, Obama is facing resistance from his own side of the aisle as well, with Sens. Ben Nelson (D-Neb.) and Tom Harkin (D-Iowa) expressing skepticism towards both the price tag and the necessity of such an expansion.

Beyond the massive cost of expanded Pell Grants, Ohio University economist Richard Vedder argues that, historically, "it is hard to demonstrate that enhanced federal assistance has either significantly expanded college participation or brought about much greater access to higher education by those who are financially disadvantaged." If the idea is expanded into an entitlement, Vedder sees rising demand for higher education leading to significantly higher costs. "When someone else is paying the bills, costs always rise."

With more than 40 percent of students who enter college dropping out before graduation, Vedder's suggestion that "a greater percentage of entering college students should be attending community colleges, moving up to four year universities only if they succeed well at the community college level," seems sound. But the idea pushed by President Obama that, regardless of a student's career aspirations, secondary education is a necessity in 21st century America, ensures that an undergraduate education will become a required (very expensive) extension of every high school diploma.

To the average high school senior, the American university has become an institution that one simply must slog through to reach a higher salary. As one college dropout recently told the Pittsburgh Post-Gazette, "I am determined to finish my degree. A high school job isn't cutting it these days." The former student, the reader is told, simply wants "to do something else with her life," though it is unclear just what that something else is. Perhaps she'll figure that out after getting the degree.
As Charles Murray observed in The Wall Street Journal, "Our obsession with the BA has created a two-tiered entry to adulthood, anointing some for admission to the club and labeling the rest as second-best." But not to worry. If Obama's plan for a secondary education entitlement is foisted upon us—the final cost of which remains anyone's guess—we might soon have a one-tiered system where everyone is second-best.

Keep the Heat on Obama as Well

Constructive criticism can be beneficial -- I know, how cliche. However, I do think the largely Republican criticism of the media "going easy" on President Obama is correct. Institutionally, the presidency is a precarious institution -- the abuse of the Commander in Chief power by just about every president is the most evident example of this. See the Prize Cases and ex parte Milligan (1865) for President Lincoln's abuses and FDR's can be seen in the infamous Korematsu v. U.S. (1944) case. The potentially explosive problems that could occur through further abuse by the President should be the prime constitutional issue brought up in light of Supreme Court nominee Sonia Sotomayor. Wise Americans will pay attention to this issue(s) and NOT allow themselves to be distracted by the nonsense social issues of abortion, gay marriage, illegal immigration, etc. that the Republicans will bring up.

Our Latin American neighbors copied the U.S. presidential system, and historically it has been a disaster. Scholars of Latin America like Arturo Valenzuela and Juan Linz have long called for its replacement with a parliamentary system. The head of government in a parliamentary system, usually called a Prime Minister, is generally chosen by the majority party. Political scientist Robert Dahl, in How Democratic is the American Constitution? points out the institutional flaws in the Presidency and makes a subtle argument that a parliamentary system would be better. So, regardless of your political party affiliation, it is wise to keep the heat on the president and not become infatuated. We've become a celebrity-novelty worshipping culture; let's wisen up a bit.

The Obama InfatuationRobert Samuelson

WASHINGTON -- The Obama infatuation is a great unreported story of our time. Has any recent president basked in so much favorable media coverage? Well, maybe John Kennedy for a moment; but no president since. On the whole, this is not healthy for America.

Our political system works best when a president faces checks on his power. But the main checks on Obama are modest. They come from congressional Democrats, who largely share his goals if not always his means. The leaderless and confused Republicans don't provide effective opposition. And the press -- on domestic, if not foreign, policy -- has so far largely abdicated its role as skeptical observer.

Obama has inspired a collective fawning. What started in the campaign (the chief victim was Hillary Clinton, not John McCain) has continued, as a study by the Pew Research Center's Project for Excellence in Journalism shows. It concludes: "President Barack Obama has enjoyed substantially more positive media coverage than either Bill Clinton or George W. Bush during their first months in the White House."

The study examined 1,261 stores by The Washington Post, The New York Times, ABC, CBS and NBC, Newsweek magazine and the "NewsHour" on PBS. Favorable stories (42 percent) were double the unfavorable (20 percent) , while the rest were "neutral" or "mixed." Obama's treatment contrasts sharply with coverage in the first two months of the presidencies of Bush (22 percent of stories favorable) and Clinton (27 percent).

Unlike Bush and Clinton, Obama received favorable coverage in both news columns and opinion pages. The nature of stories also changed. "Roughly twice as much of the coverage of Obama (44 percent) has concerned his personal and leadership qualities than was the case for Bush (22 percent) or Clinton (26 percent)," the report said. "Less of the coverage, meanwhile, has focused on his policy agenda."

When Pew broadened the analysis to 49 outlets -- cable channels, news Web sites, morning news shows, more newspapers and National Public Radio -- the results were similar, despite some outliers. No surprise: MSNBC was favorable, Fox was not. Another study, released by the Center for Media and Public Affairs at George Mason University, reached parallel conclusions.

The infatuation matters because Obama's ambitions are so grand. He wants to expand health care subsidies, tightly control energy use and overhaul immigration. He envisions the greatest growth of government since Lyndon Johnson. The Congressional Budget Office estimates federal spending in 2019 at nearly 25 percent of the economy (gross domestic product). That's well up from the 21 percent in 2008, and far above the post-World War II average; it would also occur before many baby boomers retire.

Are his proposals practical, even if desirable? Maybe they're neither? What might be unintended consequences? All "reforms" do not succeed; some cause more problems than they solve. Johnson's economic policies, inherited from Kennedy, proved disastrous; they led to the 1970s' "stagflation." The "war on poverty" failed. The press should not be hostile; but it ought to be skeptical.

Mostly, it isn't. The idea of a "critical" Obama story is a tactical conflict with congressional Democrats or criticism from an important constituency. Larger issues are minimized, despite ample grounds for skepticism.

Obama's rhetoric brims with inconsistencies. In the campaign, he claimed he would de-emphasize partisanship -- and also enact a highly-partisan agenda; both couldn't be true. He got a pass. Now, he claims he will control health care spending even though he proposes more government spending. He promotes "fiscal responsibility" when projections show huge and continuous budget deficits. Journalists seem to take his pronouncements at face value even when many are two-faced.

The cause of this acquiescence isn't clear. The press sometimes follows opinion polls; popular presidents get good coverage, and Obama is enormously popular. By Pew, his job performance rating is 63 percent. But because favorable coverage began in the campaign, this explanation is at best partial.

Perhaps the preoccupation with the present economic crisis has diverted attention from the long-term implications of other policies. But the deeper explanation may be as straightforward as this: most journalists like Obama; they admire his command of language; he's a relief after Bush; they agree with his agenda (so it never occurs to them to question basic premises); and they don't want to see the first African-American president fail.

Whatever, a great edifice of government may arise on the narrow foundation of Obama's personal popularity. Another Pew survey shows that since the election both self-identified Republicans and Democrats have declined. "Independents" have increased, and "there has been no consistent movement away from conservatism, nor a shift toward liberalism."

The press has become Obama's silent ally and seems in a state of denial. But the story goes untold: Unsurprisingly, the study of all the favorable coverage received little coverage.

Welcome to Imperium Americana

Imperium Americana is a blog dedicated to the study and discussion of the American Empire.

History has seen many empires. The United States, referred to colloquially as America, is an empire. Albeit, the United States is a unique empire; one that runs counter to the intuitive thought of empires as evil. That is, empires, such as the short lived Empire of Nazi Germany (1933-1945) that acquire territory for the sake of grandiosity.

Rather, the description of the United States as an empire is better fitted to the term hegemon; a term from the Greek which means leader (ἡγεμονία hēgemonía). Historically, and in light of this definition, the The United States is a de facto hegemon or world leader. The Realist scholar of International Relations John Mearsheimer calls the United States a Great Power. The United States became a hegemon as a result of its triumphal situation following the end of World War II. At the time, the United States emerged with only one Great Power rival, the Union of the Soviet Socialist Republics (USSR). And, indeed, the United States and the USSR engaged in what is today referred to as the Cold War for about 45 years. The USSR fractured in 1992 and Russia emerged as the only truly rival military great power to the United States although its relative military strength was not on a par with the former USSR.

For many, the dissolution of the USSR meant the "End of History", the triumph of capitalism and democracy. As political philosopher Francis Fukuyama put it, "There is nothing else ideologically; as all else [historically] has failed. " However, Fukuyama was wrong; the 1990s was soon marred by genocides in Southern Europe (Balkans) and African countries. The 1990s gave place to the term failed states: states like Somalia and Afghanistan where government control ceased to exist. In the midst of this, the United States actually increased its security presence, although it did not military intervene in all such conflicts. After the terrorist attacks of September 2001, the United States found itself a true global hegemon, with military bases in every corner of the globe including some in the countries that once were part of the USSR.

Now the United States finds itself an empire, albeit, a reluctant one. Some world leaders do not like to admit it, despite their emphasis on nationalism and soveriegnty, that they want the United States to retain its security presence. Political Scientist Michael Mandelbaum describes the United States as the World's Goliath -- a necessary empire least the historical antagonisms between countries be released anew. Ironically, on the other hand, world public opinion is generally against a United States presence in their countries. This is a particularly difficult dilemma for politicians in democratic countries. Terrorist acts carried out by radical Moslem militants are not the acts of states but groups which are generally well supported by public opinion. If you do not believe this, then reread the world's newspapers after September 11, 2001. Reflecting public opinion, but not the elites' opinion, these newspapers said: "We Feel for You but You had it Coming."

On the homefront, the American Empire is costly. The economic hegemony of the United States is in a perilous state; it has been in decline since the mid-1970s. The United States is not the physically productive economy that is was before the end of the Vietnam Conflict in 1975 and the Oil Shocks of 1973 and 1979 perpertrated by OPEC as deliberate acts of rebellion against the United States and Western Europe. Western Europe learned its lesson and revised accordingly. The United States did not despite the pleas of President James "Jimmy" Carter whom the next President Ronald Reagan ridiculed as a wimp. President Barack "Barry" Obama has learned his history lesson well from this -- do not emulate President Carter at all costs.

Since the mid-1970s, Americans' standards of living has fallen precipitously. Dual incomes are the norm not out of greed but out of necessity. Beginning with the election of President Reagan in 1980 the United States has become increasingly conservative; the better term is reactionary. Political scientist Theodore Lowi outlines this in The End of Liberalism: The Second Republic of the United States (1979) as well as historian Thomas Frank in What's the Matter with Kansas? How Conservatives Won the Heart of America (2004). You do not have to do much reading to know that physically productive industry in the United States has been in decline for some time now. The textile, steel and other similar industries were lost by the 1980s, and we are witnessing the end of the American automobile industry. As Frank illustrates the Republicans masterfully replaced reality, the decline of the U.S. physical economy, with nonsense social issues such as abortion, gay marriage, and zenophobia about illegal immigrants.

Why did we not see the severity of the decline? We did not see it because the productive physical economy was replaced by a pseudo economy built on personal services - tourism, fast food, etc.- and financial services. The other factor was an economy driven by suburban development. The creation of new homes and the moral promotion of home ownership by developers, interest groups, and the Republican Party. New homes need public services and conveniences and the developers were happy to provide. Sadly, this suburban development was done entirely in light of a continuing reliance on automobiles, which in turn was geopolitically predicated on the low price of oil. Continuous suburban development led to the illusion of growth, but most Americans were not getting wealthier.

Today, we face a dilemma unlike any we have encountered before in our history. How do we meet the demands of empire while taking care of our citizens at home? How do we maintain the empire and deal with a destructive budget deficit? Some say we should abandon our far flung military bases and retreat. Doing so, so says Mandelbaum and others, would create chaos by undermining the security ties provided by the presence of the United States. The leaders of most countries, despite their rhetoric, understand this. What is the connection of our security provision to global trade? How do we deal with an increasingly hostile public opinion of the United States in light of the need to maintain empire? Finally, the destruction of our productive physical economy has left the United States with one truly viable industry -- the military or war economy. Wars and more wars are needed to fuel this economy. This is not an exaggeration. President Eisenhower warned Americans about the need to mitigate a potentially dangerous "military industrial complex" in 1954.

Hyperinflation: A Primer

The following is a primer on hyperinflation taken from John Williams' Shadow Government Statistics: Analysis Behind and Beyond Government Economic Reporting

Hyperinflation Special Report Issue No. 41 April 2008

The U.S. economy is in an intensifying inflationary recession that eventually will evolve into a hyperinflationary great depression. Hyperinflation could be experienced as early as 2010, if not before, and likely no more than a decade down the road. The U.S. government and Federal Reserve already have committed the system to this course through the easy politics of a bottomless pocketbook, the servicing of big-moneyed special interests, and gross mismanagement.

The U.S. has no way of avoiding a financial Armageddon. Bankrupt sovereign states most commonly use the currency printing press as a solution to not having enough money to cover their obligations. The alternative would be for the U.S. to renege on its existing debt and obligations, a solution for modern sovereign states rarely seen outside of governments overthrown in revolution, and a solution with no happier ending than simply printing the needed money. With the creation of massive amounts of new fiat (not backed by gold) dollars will come the eventual complete collapse of the value of the U.S. dollar and related dollar-denominated paper assets.

What lies ahead will be extremely difficult and unhappy times for many. Ralph T. Foster, in his "Fiat Paper Money" (see recommended further reading at the end of this issue), closes his book’s preface with a particularly poignant quote from a 1993 interview of Friedrich Kessler, a law professor at Harvard and University of California Berkeley, who experienced the Weimar Republic hyperinflation:

"It was horrible. Horrible! Like lightning it struck. No one was prepared. You cannot imagine the rapidity with which the whole thing happened. The shelves in the grocery stores were empty. You could buy nothing with your paper money."

This Special Report updates and expands upon the three-part Hyperinflation Series that began with the December 2006 SGS Newsletter, exploring: (1) the causes and background of the evolving hyperinflation and great depression; (2) why circumstances will differ from the deflationary Great Depression of the 1930s; (3) implications for politics and the financial markets; (4) considerations for individuals and businesses.

The broad outlook has not changed during the last year. More generally, though, developments in the economy and the financial markets have been in line with projections and have tended to confirm the unfolding disaster. Specifically, the current inflationary recession has gained much broader recognition, while the still-unfolding banking solvency crisis has confirmed the Fed’s and the U.S. government’s willingness to spend whatever money they have to create in order to keep the financial system from imploding. While the dollar has taken a heavy hit — down roughly 20% against key currencies from last year — selling of the U.S. currency still has been far short of the outright dollar dumping that eventually will lead to flight to safety outside of the U.S. dollar. That event is important to the shorter-term timing of the pending hyperinflation.

Regular readers may recognize text from last year’s Series, as well as material from various SGS newsletters, but such is the nature of revisions to prior material. Points that may be repeated from earlier newsletters are done so in sequence to help build the arguments explaining the unfolding crisis. Great thanks are extended to the numerous subscribers who offered ideas, questions and materials that have been incorporated in this report.

Defining the Components of a Hyperinflationary Great Depression

Deflation, Inflation and Hyperinflation. Inflation generally is defined in terms of a rise in general prices due to an increase in the amount of money in circulation. The inflation/deflation issues defined and discussed here are as applied to goods and services, not to the pricing of financial assets.

In terms of hyperinflation, there have been a variety of definitions used over time. The circumstance envisioned ahead is not one of double- or triple- digit annual inflation, but more along the lines of seven- to 10-digit inflation seen in other circumstances during the last century. Under such circumstances, the currency in question becomes worthless, as seen in Germany (Weimar Republic) in the early 1920s, in Hungary after World War II and in the dismembered Yugoslavia of the early 1990s.

The historical culprit generally has been the use of fiat currencies — currencies with no asset backing such as gold — and the resulting massive printing of currency that the issuing authority needed to support its system, when it did not have the ability, otherwise, to raise enough money for its perceived needs, through taxes or other means.

Foster (see recommended further reading at the end of this issue) details the history of fiat paper currencies from 11th century Szechwan, China, to date, and their consistent collapses, time-after-time, due to what appears to be the inevitable, irresistible urge of issuing authorities to print too much of a good thing. The United States is no exception, already having obligated itself to liabilities well beyond its ability ever to pay off.

Here are the definitions:

Deflation. A decrease in the prices of goods and services, usually tied to a contraction of money in circulation.

Inflation. An increase in the prices of goods and services, usually tied to an increase of money in circulation.

Hyperinflation: Extreme inflation, minimally in excess of four-digit annual percent change, where the involved currency becomes worthless. A fairly crude definition of hyperinflation is a circumstance, where, due to extremely rapid price increases, the largest pre-hyperinflation bank note ($100 bill in the United States) becomes worth more as functional toilet paper/tissue than as currency.

As discussed in the section Historical U.S. Inflation: Why Hyperinflation Instead of Deflation, the domestic economy has been through periods of both major inflation and deflation, usually tied to wars and their aftermaths. Such, however, preceded the U.S. going off the gold standard in 1933. The era of the modern fiat dollar generally has been one of persistent and slowly debilitating inflation.

Recession, Depression and Great Depression. A couple of decades back, I tried to tie down the definitional differences between a recession, depression and a great depression with the Bureau of Economic Analysis (BEA), the National Bureau of Economic Research (NBER) and a number of private economists. I found that there was no consensus on the matter, so I set some definitions that the various parties (neither formally nor officially) thought were within reason.

If you look at the plot of the level of economic activity during a downturn, you will see something that looks like a bowl, with activity recessing on the downside and recovering on the upside. The term used to describe this bowl-shaped circumstance before World War II was "depression," while the downside portion of the cycle was called "recession." Before World War II, all downturns simply were referred to as depressions. In the wake of the Great Depression of the 1930s, however, a euphemism was sought for future economic contractions so as to avoid evoking memories of that earlier, financially painful time.

Accordingly, a post-World War II downturn was called "recession." Officially, the worst post-World War II recession was from November 1973 through March 1975, with a peak-to-trough contraction of 5%. Such followed the Vietnam War, Nixon’s floating of the U.S. dollar and the Oil Embargo. The double-dip recession in the early-1980s may have seen a combined contraction of roughly 6%. I contend that the current double-dip recession that began in late-2000 already is rivaling the 1980s double-dip as to depth. (See the Reporting/Market Focus of the October 2006 SGS for further detail.) Please note that the definition for "great depression" below has been revised to a contraction in excess of 25% (from 20% stated in the March 16, 2008 newsletter), in order to be consistent with the usage in last year’s Series.

Here are the definitions:

Recession:Two or more consecutive quarters of contracting real (inflation-adjusted) GDP, where the downturn is not triggered by an exogenous factor such as a truckers’ strike. The NBER, which is the official arbiter of when the United States economy is in recession, attempts to refine its timing calls, on a monthly basis, through the use of economic series such as payroll employment and industrial production, and it no longer relies on the two quarters of contracting GDP rule.

Depression:A recession, where the peak-to-trough contraction in real growth exceeds 10%.

Great Depression:A depression, where the peak-to-trough contraction in real growth exceeds 25%.

On the basis of the preceding, there has been the one Great Depression, in the 1930s. Most of the economic contractions before that would be classified as depressions. All business downturns since World War II — as officially reported — have been recessions. Using the somewhat broader "great depression" definition of a contraction in excess of 20% (instead of 25%), the depression of 1837 to 1843 would be considered "great," as technically would be the war-time production shut-down in 1945.

The current economic contraction is about halfway towards being classified as a "depression," based on my definitions and GDP accounting. As the Great War became World War I with the advent of World War II, so too may the Great Depression become Great Depression I, as the current crisis reaches its full, terrible potential. As with the two world wars, what may become known as Great Depression II had its roots in Great Depression I.

Current Environment

Before examining how the current circumstance can evolve from an inflationary recession to a hyperinflationary depression and then great depression, it is worth defining the nature of the current economic and inflation conditions in the United States, and likely near-term developments.

Based on the regular material discussed in the SGS Newsletter, the U.S. economy is in an inflationary recession as will be reported in official statistics. Real (inflation-adjusted) fourth-quarter 2007 GDP, in July’s benchmark revision, and/or first-quarter 2008 GDP should be in contraction, with most underlying economic series showing distressed levels of activity consistent with a recession. Annual CPI inflation is at 4.0% and headed higher. Oil prices remain over $100 per barrel, weakness in the dollar is just beginning to impact the CPI, and the inflationary effects of soaring broad money growth should start to surface around mid-year. Official CPI could be running in double-digits by year-end 2008.

Net of gimmicked methodologies that have reduced CPI inflation reporting and inflated GDP reporting, the U.S. economy has been in a recession since late-2006, entering the second down-leg of a multiple-dip economic contraction, where the first downleg was the recession of 2001 that really began back in late-1999. Annual CPI inflation currently is running around 11.6%, again, facing further upside pressures.

The current outlook does not exclude further bounces and dips in economic activity. As was seen during the Great Depression, in severe contractions the economy can hit bottom and then bounce briefly until it falls again, finding a new bottom. As discussed in the Depression/Great Depression section, the current economic downturn reflects a structural shift, which increasingly has constrained consumer activity during the last several decades, and which cannot be turned quickly. The current downturn, by my numbers, already is halfway to qualifying as a depression. The evolving depression quickly will move to great depression status, when the hyperinflation hits, as such will be extremely disruptive to the conduct of normal commerce.

The efforts by the federal government and the Federal Reserve to prevent a systemic collapse as a result of the banking solvency crisis has started to spike broad money growth, as measured by the SGS-Ongoing M3 measure, which currently shows a record annual growth rate of 17.3%. While the Fed has not been formally creating new money — yet — by adding to reserves, it has had the effect of creating new money by re-liquefying otherwise illiquid banks, by lending liquid assets versus illiquid assets. As a result, a number of banks have been able to resume more normal functioning, lending money and creating new money supply. As the systemic bailout proceeds, formal money creation will follow and already may be starting to show up in official accounting.

In response to the rapidly deteriorating fundamentals underlying the value of the U.S. dollar, selling of the greenback has been intense, but contained, with brief periods of stability as seen at the moment. In the near future, dollar selling should build towards an extreme, with heavy foreign investment in the dollar fleeing the U.S. currency for safety elsewhere. With the domestic financial markets and U.S. Treasuries so heavily dependent on foreign capital for liquidity, the Federal Reserve — now touted as the formal financial market stabilizer — will be forced increasingly to monetize federal debt. That process will build over time, given the federal government’s effective bankruptcy, as discussed in the section U.S. Government Cannot Cover Existing Obligations. Therein lies the ultimate basis for the pending hyperinflation.

Again, the current circumstance will evolve into a hyperinflationary depression, then great depression. Although such is not likely much before 2010, or after 2018, that financial end game for the current markets will tend to come sooner rather than later and will break with surprising speed when it hits. As discussed later, this likely will not be a deflationary environment as seen during the Great Depression.

What lies ahead for the current year will be severe enough and financially painful enough to affect the outcome of the 2008 presidential election. Historically, the concerns of the electorate have been dominated by pocketbook issues. Prior to gimmicked methodologies making the reporting of disposable personal income largely meaningless, that measure was an excellent predictor of presidential elections.

In every presidential race since 1908, in which consistent, real (inflation-adjusted) annual disposable income growth was above 3.3%, the incumbent party holding the White House won every time. When income growth was below 3.3%, the incumbent party lost every time. Again, with redefinitions to the national income accounts in the last two decades, a consistent measure of disposable income as reported by the government has disappeared. Yet, even with official reporting, the current annual growth in real disposable income is at 2.2%, well below the traditional 3.3% limit.

Accordingly, odds are quite high that the numbers for 2008 will favor an incumbent party loss, i.e. a victory for the Democrats. Where I always endeavor to keep my political persuasions separate from my analyses, for purposes of full disclosure, my background is as a conservative Republican with a libertarian bent.

What follows or coincides politically with a hyperinflationary depression offers a wide variety of possibilities, but the political status quo likely would not continue. Times would be financially painful enough to encourage the development of a third party that could move the Republicans or Democrats to third-party status in the 2010 mid-term or 2012 presidential elections.

Historical U.S. Inflation: Why Hyperinflation Instead of Deflation

Fire and Ice

Some say the world will end in fire,
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.

– Robert Frost

As to the fate of the developing U.S. great depression, it will encompass the fire of a hyperinflation, instead of the ice of deflation seen in the major U.S. depressions prior to World War II. What promises hyperinflation this time is the lack monetary discipline formerly imposed on the system by the gold standard, and a Federal Reserve dedicated to preventing a collapse in the money supply and the implosion of the still, extremely over-leveraged domestic financial system.

The accompanying two graphs measure the level of consumer prices since 1665 in the American Colonies and later the United States. The first graph shows what appears to be a fairly stable level of prices up to the founding of the Federal Reserve in 1913 (began activity in 1914) and Franklin Roosevelt’s abandoning of the gold standard in 1933. Then, inflation takes off in a manner not seen in the prior 250 years, and at an exponential rate when viewed using the SGS-Alternate Measure of Consumer Prices in the last several decades. The price levels shown prior to 1913 were constructed by Robert Sahr of Oregon State University. Price levels since 1913 either are Bureau of Labor Statistics (BLS) or SGS based, as indicated.

The magnitude of the increase in price levels in the last 50 years or so, however, visually masks in the first graph the inflation volatility of the earlier years. That volatility becomes evident in the second graph, with inflation history shown only through 1960.

What is shown in the second graph is that up through the Great Depression, regular periods of inflation — usually seen around wars — have been offset by periods of deflation. Particular inflation spikes can be seen at the time of the American Revolution, the War of 1812, the Civil War, World War I and World War II.

The inflation peaks and the ensuing post-war depressions and deflationary periods tied to the War of 1812, the Civil War and World War I show close to 60-year cycles, which is part of the reason some economists and analysts have been expecting a deflationary depression in the current period. There is some reason behind 30- and 60-year financial and business cycles, as the average difference in generations in the U.S. is 30 years, going back to the 1600s. Accordingly, it seems to take two generations to forget and repeat the mistakes of one’s grandparents. Similar reasoning accounts for other cycles that tend to run in multiples of 30 years.

Aside from minor average annual price level declines in 1944 and 1955, the United States has not seen a deflationary period in consumer prices since before World War II. The reason for this is the same as to why there has not been a formal depression since before World War II: the abandonment of the gold standard and recognition by the Federal Reserve of the impact of monetary policy — free of gold-standard system restraints — on the economy.

The gold standard was a system that automatically imposed and maintained monetary discipline. Excesses in one period would be followed by a flight of gold from the system and a resulting contraction in the money supply, economic activity and prices.

Faced with the Great Depression, and unable to stimulate the economy, partially due to the monetary discipline imposed by the gold standard, Franklin Roosevelt used those issues as an excuse to abandon gold and to adopt close to a fully fiat currency under the auspices of what I call the debt standard, where the government effectively could print and spend whatever money it wanted to.

Roosevelt’s actions were against the backdrop of the banking system being in a state of collapse. The Fed stood by twiddling its thumbs as banks failed and the money supply imploded. A depression collapsed into the Great Depression, with intensified price deflation. Importantly, a sharp decline in broad money supply is a prerequisite to goods and services price deflation. Messrs Greenspan and Bernanke are students of the Great Depression period. As did Mr. Greenspan before him, "Helicopter Ben" has vowed not to allow a repeat of the 1930s money supply collapse.

Federal Reserve Chairman Ben Bernanke picked up his various helicopter nicknames and references as the result of a November 21, 2002 speech he gave as a Fed Governor to the National Economists Club entitled "Deflation: Making Sure ‘It’ Doesn’t Happen Here." The phrase that the now-Fed Chairman Bernanke likely wishes he had not used was a reference to "Milton Friedman’s famous ‘helicopter drop’ of money."

Attempting to counter concerns of another Great Depression-style deflation, Bernanke explained in his remarks: "I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States …" As a quick point of clarification, Mr. Bernanke’s actions to address the current banking system’s solvency issues are still in the preventative phase. The money supply is not in collapse, and the Fed has not started dropping cash from helicopters, yet, but the choppers are in the air and remain at the ready.

As expounded upon by Mr. Bernanke, "Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero."

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation." The full text of then-Fed Governor Bernanke’s remarks can be found at: http://federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm.

Where Franklin Roosevelt abandoned the gold standard and its financial discipline for the debt standard, eleven successive administrations have pushed the debt standard to the limits of its viability, as seen now in the ongoing threat of possible systemic collapse. The effect of these policies has been a slow-motion destruction of the U.S. dollar’s purchasing power, as seen in the accompanying table, since the gold standard was abandoned in 1933.

Loss of U.S. Dollar Purchasing Power through March 2008                    —-Since January of —-Versus:             1914       1933      1970

Swiss franc        -80.4%     -80.4%    -76.5%CPI-U              -95.1%     -94.0%    -82.3%Gold               -97.9%     -97.9%    -93.4%SGS-Alternate CPI  -98.2%     -97.8%    -93.6%

Note: Gold and Swiss franc values were held constant by the gold standard versus coins in 1914 and 1933.Sources: Shadow Government Statistics, Federal Reserve,

As discussed in the next section, the limits to the unlimited abuse of the debt standard are particularly evident in the GAAP-based financial statements of the U.S. government, which show the actual federal deficit at $4.0-plus trillion for 2007, alone, with total federal obligations standing at $62.6 trillion. With no ability to honor these obligations, the government effectively is bankrupt.

At such debt levels, the markets soon will recoil from lending Uncle Sam whatever he needs. Major buyers of U.S. Treasuries from outside the United States, including a number of central banks, already are balking. These investors have funded nearly all net U.S. Treasury debt issuance of the last five years, putting to use the excess dollars flushed into the global markets by the United States’ excessive and ever-expanding trade deficit. This practice, however, generated liquidity for the U.S. markets that has helped to depress long-term Treasury yields as well as to boost equity prices, in general.

Although the U.S, government faces ultimate insolvency, it has the same way out taken by most countries faced with bankruptcy. It can print whatever money it needs to create, in order to meet its obligations. The effect of such action is a runaway inflation — a hyperinflation — with a resulting, effective full debasement of the U.S. dollar, the world’s reserve currency. The magnitude of the loss of the U.S. dollar’s purchasing power in the last 75 years now has the potential of being replicated within a few days or weeks.

In the present environment, the chances for the collapse in money supply needed to generate a consumer price deflation are nil. First, the discipline of the gold standard that helped trigger historical deflations is gone. Second, both from the standpoint of the government’s fiscal irresponsibility and from the Fed’s standpoint of providing the financial system with whatever liquidity is needed to keep it afloat, the U.S. central bank already is pushing broad money growth to new extremes, not containing it.

Shown in the next four graphs are powerful fundamentals that either drive U.S. inflation or reflect market expectations of the longer-term domestic inflation outlook. Oil prices are near historic highs, the dollar is near historic lows, and money growth is at an all-time. The near-term outlook for all three series is for new record levels and for extremely strong upside pressure on U.S. inflation. Accordingly, gold prices should continue moving higher, setting new historic highs.

U.S. Government Cannot Cover Existing Obligations

The U.S. Treasury publishes annual financial statements of the United States Government, prepared using generally accepted accounting principles (GAAP), audited by the General Accountability Office (GAO) and signed off on by Treasury Secretary Paulson.

The statements show that the federal government’s annual fiscal deficit, far from being officially in the low hundreds of billions of dollar — although 2008 numbers rapidly are moving towards the $500 billion mark — is careening wildly out of control, averaging $4.6 trillion dollars per year for the six years through 2007. The difference is in accounting for the net present value, and year-to-year changes in same, for unfunded Social Security and Medicare liabilities.

The government’s finances not only are out of control, but the actual deficit is not containable. Put into perspective, if the government were to raise taxes so as to seize 100% of all wages, salaries and corporate profits, it still would be showing an annual deficit using GAAP accounting on a consistent basis. In like manner, given current revenues, if it stopped spending every penny (including defense and homeland security) other than for Social Security and Medicare obligations, the government still would be showing an annual deficit.

The results summarized in the following table show the various deficit/debt/obligation measures. The official GAAP-based deficit, including the annual change in the net present value of unfunded liabilities for Social Security and Medicare is estimated at more than $4.0 trillion in 2007 versus $4.6 trillion in 2006. The 2007 estimate is based on a consistent year-to-year accounting basis.

Further, contrary to the suggestion of Treasury Secretary Paulson — aside from a weakening economic outlook discussed in the next section — if the annual deficit is beyond containment through standard fiscal actions, then the United States has no way to grow out of this shortfall.

U.S. Government - Alternate Fiscal Deficit and Debt                    Reported by U.S. Treasury       Dollars are either billions or trillions, as indicated.        Sources: U.S. Treasury, Shadow Government Statistics.                                                               Total        Formal      GAAP      GAAP       GAAP                 Federal        Cash-      Ex-SS    With SS     Federal     Gross     Obilga-Fiscal  Based       Etc.      Etc.     Negative    Federal    tions(2)Year   Deficit    Deficit   Deficit    Net Worth     Debt      (GAAP)(1)    ($Bil)     ($Bil)    ($Tril)    ($Tril)     ($Tril)    ($Tril)—–  ——     ——     ——     ——      ——     ——2007   $162.8     $275.5      $4.0(3)   $57.1       $9.0       $62.62006    248.2      449.5       4.6       53.1        8.5        58.22005    318.5      760.2       3.5       48.5        7.9        53.32004    412.3      615.6      11.0(4)    45.0        7.4        49.52003    374.8      667.6       3.0       34.0        6.8        39.12002    157.8      364.5       1.5       31.0        6.2        35.4(1) Fiscal year ended September 30th. (2) Revised to include grossfederal debt, not just "public" debt. (3) On a consistent reportingbasis, net of one-time changes in actuarial assumptions andaccounting, SGS estimates that the GAAP-based deficit for 2007 topped $4 trillion, instead of the gimmicked $1.2 trillion. (4) SGS estimates $3.4 trillion, excluding one-time unfunded setupcosts of the Medicare Prescription Drug, Improvement, andModernization Act of 2003 (enacted December 2003). Link to the 2007 statements: http://fms.treas.gov/fr/07frusg/07frusg.pdf

The GAAP-accounting is what a U.S. corporation would have to show. The Administration’s rationale as to why Social Security and Medicare should remain off balance sheet runs along the lines that the government always has the option of changing the Social Security and Medicare programs. That said, there clearly is no one in political Washington willing to go public with the concept of eliminating or substantially cutting those programs. Such includes the prospective presidential candidates.

Consider that given the current financial condition of the government, various politicians are pushing ever further for expensive cradle-to-grave programs for the electorate, ranging from national health insurance to bailouts of mortgaged homeowners at risk of foreclosure. With no full funding available for any new programs, the government again is showing its willingness to spend whatever money it has to create. The intent going forward is inflation — hyperinflation. This circumstance has evolved with the full knowledge of political Washington and the Federal Reserve.

As shown in the above graph, U.S. federal obligations are so huge versus the national GDP that the country’s finances look more like those of a banana republic than the world’s premiere financial power and home to the world’s primary reserve currency, the U.S. dollar.

If not for the special position the United States holds in the world, its debt — U.S. Treasuries — likely would be rated as below investment grade, instead of triple-A. Moody’s has even hinted at a longer-term downgrade on Treasury securities. While a three-month Treasury bill should be safe, I would not want to bet on receiving full value on a 10-year Treasury note or 30-year Treasury bond.

Yet, as shown in the following two graphs, most U.S. Treasury issuance has been purchased by investors outside the United States. Not only have these investors been taking a hit in terms of the value of the U.S. dollar, but also they face meaningful default/devaluation risk in the future. It is only a matter of time before this accommodation of foreign investors shifts to flight to safety outside the greenback, and therein will develop the early pressures for the Fed to start becoming the lender of last resort to the federal government.

Depression/Great Depression

The U.S. economy is in a deepening structural change that has resulted from U.S. trade policies that have driven the U.S. manufacturing base offshore. As a result, a large number of related, high paying jobs have been lost to U.S. workers.

As shown in the accompanying graphs, as the U.S. trade deficit has risen to the highest level for any country in history, U.S. average weekly earnings, adjusted for inflation, have fallen. Even using official CPI for deflation, current real earnings are below their peak back in the 1970s. Adjusted for the SGS-Alternate CPI measure, real earnings have been falling since the early 1980s. Also shown are real median incomes for U.S. males versus females, showing declines in recent years, per official government data.

The effect of this structural change has been that most consumers have been unable to sustain adequate income growth beyond the rate of inflation, unable to maintain their standard of living. The only way that personal consumption — the dominant component of GDP — can grow in such a circumstance is for the consumer to take on new debt or to liquidate savings. Both those factors are short-lived and have reached untenable extremes. Debt expansion and savings liquidation both were encouraged by the investment bubbles created by Alan Greenspan; he knew that economic growth could not be had otherwise. Part of what is happening today is payback for those policies.

This circumstance places both the federal government and the Federal Reserve in untenable positions, where they cannot easily or rapidly address the underlying problems, even if standard economic stimuli were available. From the standpoint of the federal government, traditional fiscal stimulus in the form of tax cuts or increased federal spending have reached their practical limits, with the actual annual budget deficit running out of control at $4.0-plus trillion per year.

From the Fed’s standpoint, it can neither stimulate the economy nor contain inflation. Lowering rates has done little to stimulate the structurally-impaired economy, and raising rates may become necessary in defense of the dollar. Similarly, raising rates will do little to contain a non-demand driven inflation, such as seen in the current circumstance that is so heavily affected by high oil prices.

By the time hyperinflation kicks in, the economy already should be in depression, and the hyperinflation quickly should pull the economy into a great depression. Uncontained inflation is likely to bring normal commercial activity to a halt. Such is consistent with the final graph in this group, which shows household income dispersion at historic highs.

The greater the variance in income, the more negative are the longer term economic implications. A person earning $100,000,000 per year is not going to buy that many more automobiles that someone earning $100,000 per year. The stronger the middle class is, generally the stronger the economy will be. Extremes in income variance usually are followed by financial panics and economic depressions. U.S. Income variance today is higher than it was coming into 1929, and it is nearly double that of any other "advanced" economy.

Hyperinflationary Great Depression

In the United States, the printing presses have not been revved up heavily, yet, but the commitments are in place, as seen in the annual GAAP-based deficit running on average more $4.0 trillion per year. That amount is far beyond the ability of the government to tax or the political willingness of the government to cut entitlement spending. While the inevitable inflationary collapse, based solely on these funding needs, could be pushed well into the next decade, actions already taken likely have set the stage for a much earlier crisis.

The current systemic bailout being worked at all costs by the Federal Reserve and the U.S. government, as well as earlier efforts by the Fed to buy time, have made the circumstance worse. Pushing recent Treasury funding needs on foreign investors — stuck with excess dollars from the ever-expanding U.S. trade deficit — has created a huge dollar overhang in the markets that already has started to crumble. The more the crisis has been pushed into the future, the greater the potential for pending calamity has become.

Milton Friedman and Anna Jacobson Schwartz noted in their classic A Monetary History of the United States that the early stages of the Weimar Republic hyperinflation were accompanied by a huge influx of foreign capital, much as had happened during the U.S. Civil War. The speculative influx of capital into the U.S. at the time of the Civil War inflation helped to stabilize the system, as the recent foreign capital influx to the United States has helped stabilize the equity and credit markets of recent years. Following the Civil War, however, the underlying economy had significant untapped potential and was able to generate strong, real economic activity that covered the spending excesses of the war.

Post-World War I Germany was a different matter, where the country was financially and economically depleted as a penalty for losing the war. Here, after initial benefit, the influx of foreign capital helped to destabilize the system. "As the mark depreciated, foreigners at first were persuaded that it would subsequently appreciate and so bought a large volume of mark assets …" Such boosted the foreign exchange value of the German mark and the value of German assets. "As the German inflation went on, expectations were reversed, the inflow of capital was replaced by an outflow, and the mark depreciated more rapidly … (Friedman p. 76)."

The Weimar circumstance is closer to the current U.S. circumstance, although, in certain aspects, the current situation is worse. Unlike the untapped economic potential of the United States 140 years ago, today’s U.S. economy is languishing in the structural problems of the loss of its manufacturing base and a shift of domestic wealth offshore.

In the early 1920s, foreign investors were not propping up the world’s reserve currency in an effort to prevent a global financial collapse, knowing in advance that they were doomed to take a large hit on their investments in Germany. In today’s environment, both central bank and major private investors know that the dollar is going to be a losing proposition. They either expect and/or hope that they can get out of the dollar in time to lock in their profits, or, primarily in the case of the central banks, that they can forestall the ultimate global economic crisis.

It is this environment that leaves the U.S. dollar open to potentially such a rapid and massive decline, and dumping of U.S. Treasuries, that the Federal Reserve would be forced to monetize significant sums of Treasury debt, triggering the early phases of a monetary inflation. In this environment annual multi-trillion dollar deficits rapidly would feed into a vicious, self-feeding cycle of currency debasement and hyperinflation.

Lack of Physical Cash. The United States in a hyperinflation would experience the quick disappearance of cash as we know it. Shy of the rapid introduction of a new currency and/or the highly problematic adaptation of the current electronic commerce system to new pricing realities, a barter system is the most likely circumstance to evolve for regular commerce. Such would make much of the current electronic commerce system useless and add to what would become an ongoing economic implosion.

Some years back, I happened to be in San Francisco, having dinner with a former regional Federal Reserve Bank president and the chief economist for a large Midwestern bank. Market rumors that day had been that there was a run on a major bank in the City by the Bay. So I queried the regional Fed president as to what would be happening if the rumors were true.

He had had some personal experience with a run on banks in his region and explained how the Fed had a special team designed to handle such a crisis. The biggest problem he had had was getting adequate cash to the troubled banks to cover depositors, having to fly cash in by helicopters to meet the local cash flow needs.

The troubled bank in San Francisco, however, was much larger than the example cited, and the former Fed bank president speculated that there was not enough cash in the vaults of the regional Federal Reserve Bank, let alone the entire Federal Reserve System, to cover a true run on deposits at the major bank.

Therein lies an early problem for a system headed into hyperinflation: adequate currency. Where the Fed may hold roughly $210 billion in currency (sharply increased in the last year) outside of $50 billion in commercial bank vault cash, the bulk of roughly $780 billion in currency outside the banks is not in the United States. Back in 2000, the Fed estimated that 50% to 70% of U.S. dollar cash was outside the system. That number probably is higher today, with perhaps as little as $200 billion in physical cash in circulation in the United States, or roughly 1.5% of M3.

The rest of the dollars are used elsewhere in the world as a store of wealth, or as an alternate currency free of the woes of unstable domestic financial conditions. In Zimbabwe, for example, where something akin to hyperinflation is underway, U.S. dollars are used to maintain some semblance of economic activity, where wages and salaries seriously lag inflation, and goods often are available only on the black market.

Given the extremely rapid debasement of the larger denomination notes, with limited physical cash in the system, existing currency would disappear quickly as a hyperinflation broke.

For the system to continuing functioning in anything close to a normal manner, the government would have to produce rapidly an extraordinary amount of new cash, and electronic commerce would have to be able to adjust to rapidly changing prices.

In terms of cash, new bills of much higher denominations would be needed, but production lead time is a problem. Conspiracy theories of recent years have suggested the U.S. Government already has printed a new currency of red-colored bills, intended for some dual internal and external U.S. dollar system. If such indeed were the case, then there might be a store of "new dollars" that could be released at a 1-to-1,000,000 ratio, or whatever ratio was needed to make the new currency meaningful, but such would not resolve any long-term problems, unless it were part of an overall restructuring of the domestic and global financial and currency systems.

From a practical standpoint, however, currency would disappear, at least for a period of time in the early period of a hyperinflation.

Where the vast bulk of today’s money is not physical, but electronic, however, chances of the system adapting here are virtually nil. Think of the time, work and effort that went into preparing computer systems for Y2K, or even problems with the recent early shift to daylight savings time. Systems would have to be adjusted for variable, rather than fixed pricing, credit card lines would need to be expanded daily, the number of digits used in tallying dollar-denominated transactions would need to be expanded sharply.

While I have been advised that a number of businesses have accounting software that can handle any number of digits, I also noted on a recent cross-country trip that a large number of gas stations have older pumps that cannot register more than two digits’ worth of dollars in their totals or more than $9.99 per gallon of gas.

From a practical standpoint, the electronic quasi-cashless society of today also would shut down early in a hyperinflation. Unfortunately, this circumstance rapidly would exacerbate an ongoing economic collapse.

Barter System. With standard currency and electronic payment systems non-functional, commerce quickly would devolve into black markets for goods and services and a barter system.

Unlike Zimbabwe, the United States does not have widely available, for circulation, a back-up reserve currency for use in place of a highly-inflated domestic currency. The alternative here is in the traditional monetary precious metals. Gold and silver both are likely to retain real value and would be exchangeable for goods and services. Silver would help provide smaller change for less costly transactions.

Other items that would be highly barterable would include bottles of a good scotch or wine, or canned goods, for example. Similar items that have a long shelf life can be stocked in advance of the problem, and otherwise would be consumable if the terrible inflation never came. Separately, individuals, such as doctors and carpenters, who provide broadly useable services, would have a service to barter.

A note of caution was raised once by one of my old economics professors, who had spent part of his childhood living in a barter economy. He told a story of how his father had traded a shirt for a can of sardines. The father decided to open the can and eat the sardines, but he found the sardines had gone bad. Nonetheless, the canned sardines had taken on a monetary value.

Reserves of the Necessities of Life. Howard J. Ruff, who has been writing about these problems and issues since Nixon closed the Gold window, rightly argues that it will take some time for a barter system to be established, and suggests that individuals should build up a six-month store of goods to cover themselves and their families in the difficult times. Mr. Ruff covers this and many other excellent fundamentals in his new book How to Prosper During the Coming Bad Years in the 21st Century (see recommended further reading at the end of this report).

Financial Hedges. During these times, safety and liquidity remain key concerns for investments, as investors look to preserve their assets and wealth through what are going to be close to the most difficult of times.

In such a circumstance, gold and silver would be primary hedging tools that would retain real value and also be portable in the event of possible civil turmoil. Also, at some point, the failure of the world’s primary reserve currency will lead to the structuring of a new global currency system. I would not be surprised to find gold as part of the new system, structured in there in an effort to sell the system to the public.

Real estate also would provide a basic hedge, but it lacks the portability and liquidity of gold. Having some funds invested offshore — outside of the U.S. dollar — would be a plus in circumstances where the government might impose currency or capital controls.

While equities do provide something of an inflation hedge — revenues and profits get expressed in current dollars — they also reflect underlying economic and political fundamentals. I still look for U.S. stocks to take an ultimate 90% hit, peak-to-trough, net of inflation, during this period. Where all stocks are tied to a certain extent to the broad market — to the way investors are valuing equities — such a large hit on the broad market will tend to have a dampening effect on nearly all equity prices, irrespective of the quality of a given company or a given industry.

Other Issues. A hyperinflationary depression would be extremely disruptive to the lives, businesses and economic welfare of most individuals. Such severe economic pain could lead to extreme political change and/or civil unrest. What has been discussed here still has not been a comprehensive overview of all possible issues, but rather at least has raised some questions and touched upon some likely consequences. No one can figure out better than you the peculiarities of this circumstance and how you and/or your business might be affected. Using common sense is about the best advice I can give.

These matters will continue to be expanded upon over time in future SGSs, as circumstances and subscriber reactions continue dictate. As always, please feel free to offer your comments or raise your questions by e-mail to johnwilliams@shadowstats.com.

Recommended Further Reading

Two particularly valuable books, mentioned elsewhere in the text, are recommended to subscribers:

How to Prosper During the Coming Bad Years in the 21st Century
by Howard J. Ruff
www.rufftimes.com

Fiat Paper Money, The History and Evolution of Our Currency
by Ralph T. Foster
2189 Bancroft Way, Berkeley, CA 94704
Telephone: (510) 845-3015, E-mail: tfdf@pacbell.net