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Wednesday, May 10, 2006

An Alternative State Of the Union Report

Originally Posted: January 22, 2006 -- 7:31 PM
Fool Boards Link: http://boards.fool.com/Message.asp?mid=23593419

After hearing the real SOTU, I'm still thinking this one was more on target.


====================

News wires are already speculating on themes likely to appear in the 2006 State of the Union speech on January 31. I'm willing to be pleasantly surprised by a speech that would even tackle one problem facing the United States with realistic analysis of the causes and possible solutions, but I'm not holding my breath.

Here's an alternative analysis of the state of our union. I've included references to economic information used in the narrative at the end for those that care to check my facts. For critics that say this amounts to naysaying and gloom with no suggestions for improvement, I'll post some proposals to address some of these issues in a few days.

OUR ECONOMY

The strength and margin of error for the health of our economy boils down to one number:

3,720,000.

That's the daily output of oil from Iran in barrels. (#1) Current world oil demand is about 80 million barrels per day (#2) while total world production capacity is about 84 million barrels per day. (#3) That means Iran's production roughly equals the total slack in the world market, meaning ANY interruption in that production will instantly melt down oil markets. Iran has publicly stated its intentions to continue nuclear weapons development as its president and other leaders continue making inflammatory speeches about the elimination of Israel. This has led the US and other countries to pursue discussion of possible sanctions against Iran which Iran could counter by cutting off oil to countries attempting to impose sanctions. Oil has already spiked back to $68/barrel on fear alone.

As the oil market tightens, there are at least four core weaknesses in the American economy that are all only one or two degrees of separation from a spike in oil prices. Keep in mind none of this speculation attempts to factor in the additional uncertainty from a political / military perspective if the Iran standoff escalates beyond the obvious supply / demand issue of crude oil.

Inflation and Interest Rates - A spike in oil prices to $75 to $80 per barrel will definitely spike prices for gasoline and home heating oil. Based on normal seasonal swings in prices, you can bet that if gas sits at $2.80-$3.00/gallon in March, it will hit $3.30-$3.60 a gallon during peak summer demand. Those giant gas-guzzling Hummers, Tahoes, Escalades and Excursions will be FLYING off the lots then, won't they? Any jump in oil prices deemed to be long term (lasting 12-24 months) will get baked into inflation expectations which will drive up short term interest rates, directly affecting credit card balances of American consumers, further contracting spending. I don't know enough about the oil markets to estimate exactly how volatile crude prices might be if Iran cuts production. I've heard some estimates of $100/barrel.

Airline Bankruptcies - A spike in oil prices will hit carriers HARD. Higher fares, fewer seats sold. Even Southwest, which has remained profitable for the past five years, will begin feeling the pinch (though I'm sure they'll remain profitable). Their fuel price hedge strategy that was launched a few years ago has provided them access to fuel at prices no other carrier can obtain simply because of their financial position at the time. However, the time horizon on those contracts only lasts so long and at this point, the greater uncertainty in world oil markets is likely already reflected in any incremental supply contracts Southwest can obtain, reducing this portion of their advantage in the coming years. If crude hits $85-100/barrel, you can bet another 20,000-30,000 airline employees will lose their jobs.

Auto Manufacturing - Ford just announced a restructuring plan that will close plants in Atlanta (Taurus), St. Louis (Explorer) and other locations, amounting to about 25% of their manufacturing capacity and 30,000 hourly and salaried jobs within four years. (#4) GM is already in major trouble and seems to have done even less than Ford to address the underlying management issues that have weakened the company. GM's dependency on cash flow from auto loans and morgages through GMAC and Ditech also increases its vulnerability to interest spikes as demand for these products will obviously decline with higher interest rates, curtailing GM' main cash lifeline. The only bright spot in domestic manufacturing is that Toyota continues to gain market share and seems bent on adding manufacturing capacity within the US.

Consumer Spending and Bankruptcy - Holiday sales for 2005 wound up fairly strong and consumer confidence levels returned to pre-Katrina levels. (#5) Economic analysis by Deloitte (#6) points out two problems with these numbers, however. First, consumer confidence rose in part due to gas prices returning to pre-Katrina levels (which could vanish with more turmoil in Iran). Second, consumers continue to fund their spending via equity loans against increasing home values, which poses its own long term economic problems (see below). While consumer confidence improved, December home starts dropped 8.9% while experts had been only expecting a 4.1% drop, much of that being normal winter seasonal reductions. (#7) A combination of spiking oil prices, wholesale job cuts at major corporations in the $40k-$75k income bracket, and rising interest rates could put a serious squeeze on many families with high credit card debt or little savings to ride out a few months of unemployment.


OUR NATIONAL SECURITY

We haven't captured Bin Laden, Iraq is years away from stability, we have an obligation to stay in Iraq to avoid a civil war ("we broke it, we bought it"), we continue to turn a blind eye to Pakistan's involvement in proliferation of nuclear technologies, our tactics in Iraq and elsewhere continue to alienate our allies, and the impact of China's growing economy on world energy demand and its impact on worldwide political balance has completely vanished off the radar.

Bin Laden - Our failure to capture Bin Laden continues to artificially inflate his stature in the minds of the next generation of "jihadist" teenagers who have been fooled into thinking the US is primarily responsible for their plight rather than their own failed governments. We said "dead or alive" and we look impotent for not making it happen.

Iraq - We've turned four "corners" in Iraq (toppling Saddam, capturing Saddam, interim government elections, and now permanent government elections) and find ourselves with no improvement in basic security for Iraq's citizens. Insurgents are killing 10-20 people per attack on a near daily basis, reconstruction efforts remain hampered by ongoing security limitations and direct sabotage and about $416,000,000 in borrowed dollars are leaving the Treasury daily to pay the bills (about $150B yearly). We cannot even secure a 10-mile stretch of road from the Green Zone to the airport.

We need a serious debate about the wisdom of staying in Iraq versus reducing our profile. I honestly don't know what the answer is but the current approach clearly isn't working and the lack of a constructive debate isn't helping to identify any other alternatives. My inclination is that we need to retain current troop levels, if not add to them to actually produce enough stablity to alter the psychology within the country so Iraqis begin investing in their own infrastructure and believing that the new parliament and courts have a chance of working. This is basically the "we broke it, we bought it" doctrine. However, it seems equally easy to argue that a foreign presence will inhibit a local sense of control / responsibility from developing within Iraq, producing dependency on the US by the "normal" Iraqis while strengthening the argument of the "jihadists" that we are there to take over.

Pakistan - We could very well be putting Pakistan on a path to revolution much like Iran circa 1979. The government is dependent upon our military support to impose enough control to retain power, which is alienating a substantial portion of the population. The government is notoriously corrupt and has done nothing to halt proliferation of nuclear technologies to other countries, despite being our "ally." (#8) Pakistan has not signed the Nuclear Test Ban Treaty or the Non-Proliferation Treaty. Our recent Predator missile attack on a village within Pakistan only increases the sense of disrespect Muslims within the country already think we exhibit towards them as Pakistanis and as Muslims.

ABC's Brian Ross appeared on Charlie Rose on 1/21/2006 and stated Pakistan's regular army is doing virtually nothing to help hunt down Bin Laden due to internal power balance issues. Instead, Musharraf has created a separate "private" force that is working with US elements to infiltrate local groups supporting the audio recording courier routes that might eventually unearth his location. A great deal of money is being funneled to people within this force, virtually assuring additional corruption. The fact that Musharref must go around his own military and police forces to assemble a "task force" to assist the hunt for Bin Laden speaks volumes about the underlying sentiments within Pakistan about Bin Laden versus the United States. Pakistan could pose major problems if democratic or military forces oust the current regime.

China - China's growing economy is creating huge increases in energy demand which alone has the potential to upset any sense of geo-political balance in the world. Growth of the Chinese economy can come with two alternate approaches, both of which can pose problems for the United States and the world economy. Since they have the population to do it, China can continue to feeding bodies to their economic engine, using obsolete technologies and absorbing more manufacturing and textile jobs from the rest of the world, furthering the pollution and health problems they already face. China could instead invest in more modern technologies, which would even further enlarge their energy demands, tightening world markets for oil even more.

The bigger problem with China is the attempt they are making to modernize their economy while maintaining an oppressive government. Russia has already proven this is a virtually impossible feat. This is good for America and good for worldwide democracy but with instability comes great short term uncertainty. Our government has not communicated any coherent policies for our relationship with China that reflect an understanding of the opportunity (if China goes in the right direction) or the short term risks as modernization unleashes other political forces that China may be less able to control.

Oh, by the way, if China's economy continues to grow at the 2004 rate of 8.3 percent, that 3,720,000 million barrels of margin in the world oil markets will disappear entirely, further stressing the world economy for all the reasons cited in the previous section.


OUR INDIVIDUAL ECONOMIC SECURITY

Long term economic trends at the micro (individual) level are not headed in desirable directions, either. At a time when macroeconomic problems subject more short term volatility and risk to individual Americans, the ability of Americans to look out for their own long term economic security is being weakened in three key areas.

Pensions - Most people entering the workforce in the last 5 to 10 years already know they're on their own regarding retirement savings. IBM announced they will eliminate all contributions to existing employee pension plans by 2008 and no new employees will be offered ANY pension. The real problem is that employees close to retirement and existing retirees are also finding their pensions at risk. The Pension Benefit Guaranty Corporation (PBGC), the equivalent of the FDIC for private pension plans, is already $22.8 BILLION in the red on its budget. It recently issued a report indicating 9.4 percent of current corporate pension plans have already been "frozen" as of 2003. (#9) Their report caveats the raw numbers by stating that the number of large company (5000+ employees) frozen is relatively small and affects a small percentage of the participants, but the trend for new or mid-career workers is clearly not good.

Pensions for public employees might be in even greater danger. The city of San Diego is teetering on the edge of bankruptcy because of past failures to properly account for the cost of employee pensions, putting the city $1.37 billion in the red. (#10) At one level, the "why" of how cities like San Diego or states like Illinois GOT into these positions is not the most important "macro" issue. Employees expecting benefits from corporate pensions that go broke or drastically curtail benefits will either spend less, reducing consumer spending, or stay in the workforce longer, depressing wages and salaries due to normal supply and demand dynamics. City, county and state governments scrambling to catch up to pension funding obligations will be forced to adopt some combination of spending cuts, job cuts, tax increases or bond issues with higher interest rates to compensate bondholders for greater risk.

One item to watch for regarding company cutbacks on pensions. After a company announces a freeze or elimination of a pension plan, it may actually get a jump in its stock price as the market adjusts the company's valuation upward as the uncertainty about future pension payment cash flows is eliminated. Investors need to be very careful they do not mistake this one-time "dead cat bounce" for an actual improvement in the company's performance. You can bet the executives will grant themselves huge bonuses for the one-time spike that has nothing to do with the company's ongoing performance.

Home Equity Spending - According to Money magazine (#11), Americans tapped into $300 BILLION in home equity in each of the past few years to fund spending on iPods, plasma TVs, gas guzzling cars, or more practical things like college tuition or home improvements. To the extent this money is spent on "throwaway" assets like consumer electronics that have a 2-5 year lifespan, Americans are basically destroying that equity. In the past, Americans treated their home like a 30 year savings account and used the increase in equity as part of their retirement savings plan. When the kids leave, the parents can sell the house, buy a smaller home, and put the rest in the bank to help fund retirement for another 10-20 years. Instead of $200,000 to $300,000 of equity in their home, many Americans are going to reach age 60, find they cannot afford the property taxes on their McMansion yet get nothing out of the sale to buy a smaller home or live on in retirement. The only lever government has to discourage this involves eliminating the mortgage interest deduction, which has ZERO chance of ever getting passed. This issue boils down to Americans waking up and managing their own finances better, or praying that $3000 plasma TV still works in 2025.

Health Care - The new Medicare drug plan already seems doomed to be a major public policy failure. The plan eliminated the government's ability to leverage buying power to REDUCE prices paid to drug companies (producing a windfall for the drug companies). It has added confusion and inefficiency for patients trying to obtain prescriptions under the plan. After overcoming tedious and confusing enrollment procedures, many participants have discovered the plan they selected is failing to cover key drugs, even if they attempted to confirm coverage of the drugs prior to enrollment. Confusion within insurance companies about reimbursement procedures is causing denials of claims for prescriptions that in fact should be covered, leaving the patient to decide between doing without or paying for the subscription out of pocket while the dust settles.

Both current employees and retirees are finding companies cutting back or eliminating coverage of health insurance. For retirees left to find their own coverage, this imposes an unexpected, unbudgeted expense in a situation where pre-existing conditions may make it astronomically expensive or impossible to find replacement coverage. When a relatively common hospital procedure can cost $10,000, loss of coverage can wipe out most Americans' savings in a heartbeat.

Bush is expected to propose changes to Health care Savings accounts that would allow taxpayers to contribute larger amounts per year on a tax free basis. This does nothing to address the root causes of spiraling health care and provides no value for lower income workers who already don't make enough to contribute to 401ks, much less another savings plan limited to healthcare expenses with few allowances for any other emergency withdrawals.


OUR DEMOCRACY - Wow. Where to begin? President Bush has admitted to authorizing wiretaps without a court approved warrant when nothing prevents him from getting the warrants in a timely manner, states he plans on continuing to do so as he sees fit. California Republican Congressman Randy Cunningham is convicted of accepting $2.4 million in bribes from defense contractors. Ohio's Republican Governor Taft pled guilty to criminal charges in a scandal involving another Republican operative responsible for managing $50 million of state money who invested it in "rare coins", losing up to $12 million, while also funneling funds to campaigns for Bush and Schwarzenegger. Lobbyist Jack Abramoff has pled guilty and is cooperating with federal authorities regarding widespread corruption in both Florida and the US Congress. Republicans padded their congressional majority via unconstitutional redistricting in Texas aided by a Republican Speaker of the House and illegal lobbying at the state and federal level. (#12).

The problems facing the United States are enough of a challenge in their own right. We are now stuck with attempting to solve them with:

  • government agencies that are distorting / withholding information owed to the public about matters of public policy

  • government officials who have been outright purchased by special interests

  • election processes that have produced material questions of fraud in pivotal states in two consecutive Presidential elections in favor of the same candidate


It is tough to rev up the engine of reform after special interests and outright corrupt players have added sand to the crankcase. As I've stated before, American voters need an urgent refresher in basic civics to take back the controls of the country.


WTH

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#1) Iran Oil Production: http://www.globalsecurity.org/military/world/iran/oil.htm
#2) World Oil Demand: http://www.eia.doe.gov/mer/pdf/pages/sec11_6.pdf
#3) World Oil Production: http://www.eia.doe.gov/emeu/ipsr/t14.xls
#4) Ford Job Cuts: http://abcnews.go.com/Business/story?id=1526646&CMP=OTC-RSSFeeds0312&ad=true
#5) Consumer Confidence: http://www.usatoday.com/money/economy/confidence/2005-12-28-confidence_x.htm
#6) 2005 Holiday Spending: http://www.deloitte.com/dtt/research/0,1015,sid%253D15288%2526cid%253D105163,00.html
#7) Housting Starts Drop 8.9%: http://www.newsday.com/business/ny-bztopstk4593975jan20,0,5188808.story?coll=ny-business-headlines
#8) Pakistan's Nuclear Programs: http://www.fas.org/nuke/guide/pakistan/nuke/
#9) PBGC Analysis of Pensions: http://www.pbgc.gov/media/news-archive/2005/pr06-12.html
#10) San Diego Pensions: http://biz.yahoo.com/ap/060106/san_diego_finances.html?.v=4
#11) Home Equity Spending: http://money.cnn.com/2005/04/07/news/economy/debt_consumers/
#12) Government Corruption: http://uspolitics.about.com/b/a/207475.htm