How the Great Recession Will Transform America

Warren Buffett bought a RR anticipating a major change in America driven by high energy costs. The article Warren Buffett vs the Soccer Moms lays out the thesis that "Buffett is betting on higher energy prices and a different transport focus." In effect, Warren is betting that the American Dream is over. Instead of living in a suburban McMansion with a green lawn, an SUV, and suburban schools, the middle class will be force to re-huddle in cities and rely on public transportation, with trains rather than trucks moving goods between city cores. 

I think America will be transformed by the Great Recession, but not in such a dispirited direction. 

Let's start with Warren's energy bet. The bet seems plausible, given fears of Peak Oil and Obama's intent to regulate and tax energy under Cap & Trade or similar schemes. The bet reminds me, however, of the bad policy and misleading extrapolation of the '70s: 

• Then, as now, we had a weak Dollar policy which led to rising commodity prices, especially oil. 
• Then, as we intend now, we regulated oil prices, which led to shortages. 
• Much doom & gloom was extrapolated from those bad policies, including the demise of the American Dream.

But the story ended the other way. For those too young to remember, in 1971 Nixon first took the Dollar off gold, leading to a terrible decade of inflation; and Nixon tried to stem inflation with ill-fated wage & price controls, which he had to soon remove, except inexplicably he kept them on for oil & gas. We had lines at gas stations, capped wells, and increased dependence on imported oil. When Reagan stopped the price controls, the shortages vanished, the lines disappeared, and perhaps most paradoxically for central planners, oil prices began a long slide lower, to $10/bbl in 1999. Even with Bush's weak Dollar policies, oil was still at $16/bbl in 2001, and was around $25/bbl after the quick Iraqi strike in 2003. Only when Greenspan's Indian Summer of monetary stimulus took hold in 2004 did oil began to rise, reaching $147 by July 2008. Near the peak policy makers once again wrung their hand over Peak Oil and extrapolated a dismal future of high energy for American soccer moms and their despised SUVs. 

Seems to me investors are once again are in grave danger of being driven down the wrong path. Policy changes create high prices and (potentially) shortages, and drive extrapolation of transformation from high energy costs; but those policies can and likely will be reversed if we have another decade like the '70s. Anyone investing in high energy in 1980 found their plans were busted by the continued drop in energy prices, and the gradual loss of government subsidies. Governments are always the last to react to a change in underlying conditions, and relying on them to hold dis-economical policies for long enough to get out is fraught with risk for investors.

Yet it is likely that America will be radically transformed by current economic conditions. The Great Recession is of a kind and scale seen three prior times in American history: 1929, 1873 and 1837. Each of those had a serious depression following a credit bubble, and led to rapid transformation of American business and power centers. You could see glimmers of the future change extant already, but the entrenched power centers were able to withstand the tide and hang on. The crash and subsequent depressions seemed to break open the constrained forces. Here are the prior three transformations:

1837: Andrew Jackson broke the Bank of the United States (the Fed of the day) and in doing so broke the power of Philadelphia bankers. The financial center shifted to NY, which has held it ever since; and the food processing center shifted from St. Louis to Chicago, where it has remained. 

1873: German reunification led to a global bubble and crash, and also came with a global shift from silver to gold, bringing about a grinding "long depression" of over 20 years. The mill towns of New England, which were the foundry to the Civil War, gave way rapidly to the new manufacturing powerhouses in the Midwest. Cities like Pittsburgh, Detroit and Cleveland became the foundry for the world. 

1929: A poorly-designed return to gold in 1925 by England led the Fed to loosen credit to bolster the Pound, and the Roaring '20s were off. Hoover's meddling after the crash exacerbated the problem, and a global banking crisis in 1931 led to the Great Depression. The US was dramatically transformed from agriculture (40% of employment before the crash) to manufacturing. After the recovery, power shifted from the Midwest, soon called the Rustbelt, to the suburban splendor of the Sunbelt. 

The impact and duration of these three depressions was charted back in 1943 and can be seen in this download  in comparison to other downturns.

If the pattern continues, I would expect a step function down in manufacturing, much like the vast shrinkage of agricultural jobs last time; and a shift away from the Sunbelt to a new power center. If we shrink in manufacturing jobs, what will the basis of production shift to? It won't be services, nor construction, nor 'green jobs' which tend to be temporary construction projects, not permanent new factors of production. (Spain provides a good case study in green jobs being a mirage for a new basis of production.) 

Instead, the US will drive for value in encapsulated intellectual property (IP), embodied in drugs, software, chips, web services (like Yahoo), data (like Google) and products (like the iPhone). We already see this happening in technology products, and now that the floodgates have opened will become the new factor of production across all industries. One of my favorite thinkers, Will McDonough, is the leading proponent of a "cradle to cradle" ecological architecture for technology. Among other achievements, he rebuilt the famed River Rouge plant of Ford, the very model of a modern major assembly line, into a sustainable model with pavers instead of asphalt, natural lighting, and grass on the roof. He is urging a technology cycle similar to a biological cycle, where manufactured products can reduce back into the ecosystem. An example is to redo plastics based on organic carbon, not petrochemicals. These plastics look and feel like petro-plastics, and yet dissolve when thrown away.The whole plastics industry can transform itself into a new range of products. With a little extension of thinking, this approach can go into architecture, autos, food processing and across many other industries. Rather than the lame green jobs of Obama, to build wind farms and similar, this is the real green revolution. 

And this is but one example. Similar revolutions are occurring in pharma, biotech, entertainment, telecomm, lighting, marketing-media and other industries. 

What therefore changes is a drop in blue-collar manufacturing jobs and a rise in high-value-add knowledge jobs. While manufacturing flies overseas to China and India, we retain the marketing, design, control systems and materials science that goes into those products. It is no accident that the center of smartphones is now rising in Silicon Valley (Apple, Android, Palm), and the web world is also centered there (Google, Yahoo, Facebook, Twitter). This is but a sampler of what is likely to happen across the whole US. 

How will this change the power centers in the US? One of the most interesting thinkers of this potential transformation is Richard Florida. His view of the coming transformation is set forth in his books, and is most accessible in a recent Atlantic Magazine article. He is a proponent of the 'agglomeration effect' first popularized by a brilliant economist, Jane Jacobs. She is best known for saving Greenwich Village from a debilitating freeway through its heart, ending Robert Moses's remaking of NYC and starting the NIMBY movement to preserve the charming and inviting city centers of major US cities. I discovered her work in an Atlantic article that reprised her book, Cities and the Wealth of Nations. 

Simply put, "agglomeration" means a city-region becomes the center of a technology and holds it for a long time. Detroit for cars, Pittsburgh for steel, Chicago for food, NY for finance, LA for entertainment - these were the prime US examples. Today, we would say Silicon Valley for technology, Shenzen for contract manufacturing, Tokyo for cars, Milan for design, and London for finance. Birds of a feather flock to the center to be part of it. The efficiency and networking of being in the center lead it to get stronger. With globalization, the centers are no longer within protected boundaries. Where we had three car centers - in Stuttgart, Detroit and Tokyo - it appears the center is accreting to Tokyo. This also happens within a country, as the venerable Route 128 around Boston has given way to Silicon Valley. 

The implication of agglomeration is a shift from the Sunbelt to Knowledge Centers, denser areas in semi-urbanized settings such as Ann Arbor, Austin, Palo Alto and Cambridge. This is not the RR dream of Buffett, back to the urban core; but neither is it the continuation of suburban sprawl and transplant factories in far away cities. 

This change has already started. The great migration to the sunbelt seems to have ended. This chart from the WSJ (which is interactive if you click here) shows census data on how migration has begun shifting. A video discussion of this is below.

This transformation-by-innovation will not happen quickly. In another inestimable article, Houses of the Future, The Atlantic provides a model of how this will come about. The article looks the burgeoning housing innovation in New Orleans, post Katrina. First, the government had to get out of the way. After a failed stimulus and political squabbling between FEMA and local authorities, grandiose schemes with no follow-through gave way to bottoms-up innovation. A number of competing visions are emerging throughout the city, from Will McDonough's zero-energy green homes to much simpler "Caribbean" homes linked to the lifestyle of the locals. The key message seems to be for the government to back off gold-plated regulations and attempts to "help" and let innovation thrive. 

Similarly, after yet another Stimulus bill and continued attempts to impose costly regulations across our economy (healthcare, energy, autos, etc.), we should see these efforts peter out due to their own failure, to political squabbling and to lack of follow-through. At this point (2014? 2017?) the ground will have been prepared for innovation from the private economy to emerge. 

For investors, the key is to invest in the leaders of the new knowledge industries. For society, the key is to promote the rise of knowledge industries. Until then, we will have to suffer through a self-destructive decade of high taxes, hostility to small business and venture capital, false promotion of ebbing unions, and malinvestment in the wrong priorities. Caveat investor. 

Comments

[twitter.com/DrBubb]

I like you optimism, and I truly want to believe it.

Before we can have a positive outcome such as you have described, we need to "get real" first, and recognize the problems we have. The leadership we have in Washington has been captured by Wall Street and their role seems to be to keep us sedated while Wall Street louts the wealth of the country.

Facing reality means seeing the problems clearly:

+ A second leg down in US house prices lies dead ahead, with even larger fall is possible in the UK
+ Commerical property is headed towards a debacle in both the US & the UK
+ A second banking crisis seems inevitable (as the above problems manifest themselves)
+ Sovereign and US state credit ratings have come into question, and defaults are likely in 2010
+ Days of low inflation from the first downturn are ending (as low inflation from early 2009 gets lost in history)
+ Rates are bound to go higher, as savings rich countries attempt to flee the increasing credit problems
+ Iceland, and its stagflation are a model for the future in many countries, including the US & the UK
+ Weaker currencies are not really a cure, since they will bring much cost-push inflation in food & energy
+ The longer term cure only begins after we face reality, make writedowns, and restructure the economy
+ So-called stimulus programs merely add debt, and low-return investments to an economy which needs better

This outline comes from an article I wrote for Financial Sense, and it suggests some remedies:

+ New types of investment are required, western consumer economies must be restructured towards becoming producers again with more internal savings. That is a slow process, especially when limited capital is being steered towards wasteful areas, propping up old malinvestments in a an obsolete consumer-driven economy, rather than aiming to build a new and more efficient post-consumer economy with dramatically less reliance on expensive imported energy

+ As savings are rebuilt in Western countries, growth will be slower, and probably bring negative growth for many years.

+ Those who are unprepared and unhedged are likely to suffer a huge loss in their wealth.

/see:
The "Y-shaped" downturn - A Greater Depression?
A more severe crisis is already "Baked in the Cake"
http://financialsense.com/fsu/editorials/hampton/2010/0210.html

[yelnick]

Dr Bubb, good start to the solution, how to get to the new economy post Depression. I have more to add to my piece, which I should do soon. I will include some of your ideas - if you have more or post another Y Shaped piece, please let me know. I think we lose assembly line (unskilled) manufacturing, but it has been leaving for years We replace it with a layer above where the real value is. But none of this is backed in; we need leadership and policies to help get us there, or we need the govt to get out of the way.

[twitter.com/DrBubb]

"I think we lose assembly line (unskilled) manufacturing, but it has been leaving for years We replace it with a layer above where the real value is. But none of this is backed in; we need leadership and policies to help get us there, or we need the govt to get out of the way."

I hope you are right - and you may be. But to have that "layer above", we will need access to materials and sub-assembly components. If the dollar is too weak, and we have stopped all mining in the US, it may be tough. Perhaps we should also focus on mining of certain strategic metals and base metals we need to run out own economy, as per the following comment which I originally posted elsewhere on your Blog:

DG's:
"I think that in the final analysis, oil prices caused the housing bubble to collapse by pushing the marginal subprime borrower into default, which goes to my point that oil is the single most important price in the economy. We can't inflate our way around that fact."

I Agree.
The subprime crisis was really an oil crisis. Stockton CA was "ground zero" in the crisis, with the city being 45 minutes drive from SF, 45 minutes from San Jose, and 45 minutes from Sacramento (have I got that right?) As oil shot thru $3 on its way to $4, peoole woke up and realised that they were not going to be able to afford to live there and drive 45 minutes each way to their jobs. The "cheap" homes they thought they had bought, were unaffordable. Those who planned to flip them, and make a profit they could use to buy somewhere closer saw it wasnt going to happen. So 1/3 of the buyers all defaulted at once, and the game was over.

Similar things happened in Phoenix and in ex-urban communities all over America. This end of the commuters suburban dream, was the final end of America's suburban project. But it will take a decade or so before everyone really understands that.

The suburban bust will reduce US oil consumption, as Chindia is growing theirs. And this little shift will turn into a much bigger shift as the dollar slides and really finishes off the suburbs.

Some think that a weaker dollar will be America's salvation. And, yes, that will bring back manufacturing in America. But at the same time, it will put up the dollar oil price - up to the moon. So as manufacturing comes back, ex-urban McMansion living will finally die. Very few will be able to afford the long commutes.

+++

I just had dinner here in Hong Kong, with a guy called Jack Lifton. He lives in Detroit and travels the word giving talks about Rare Earths, and how vital they will be in the future. The Japanese "get it", and are looking from sources of supply outside China. The US is only slowly waking up.

The high tech future that Duncan imagines relies on some vital inputs like that. Foreigners will not be keen to surrender vital metals and get paid in a sliding dollar. The US (and Canada too) need to realise that the global trade we have been seeing will be totally changed as the Dollar slides.

It will he a hard wake up call to take.

[yelnick]

Dr Bubb, I am overdue with part 2 of my discussion of how the US economy will be transformed. A lot is made of how the Agriculture Dept has more employees than we have farmers, but that is misleading at two levels: it leaves out migrant workers, and it overlooks where the money is made in foodstuffs: food processing, the layer above farming. The act of farming is highly automated (plus migrant pickers), and the value has shifted to a higher level. Productivity.

Similarly, the high tech future is one in which the layer above core manufacturing is where the value is. Assembly Line = Farming, Apple = Archers Daniel Midland. The middle class life that used to come for unskilled workers migrating to Detroit is gone, replaced by migrant college kids looking to work in "manufacturing processing."

Yes, certain rare earths are becoming more critical. I mention a couple over in my post on Investing in CleanTech, including Lithium for batteries and Thorium for clean nukes. There are many more, and a lot of them are not in the US. Fortunately for the West, a lot are in still-accessible places like Australia, which is not yet a suburb of Shanghai.

[DG]

Yelnick,

This guy seems to share some of your thoughts on oil and transport:

http://seekingalpha.com/article/195304-as-the-oil-age-ends-a-return-of-the-canal-and-rail-age

[yelnick]

DG, oh boy, fear that higher oil prices means we go to electric canal boats? Nuts.

[Irina]

Your stock market crash in 2011 video was spot on with a high of 1363 S P April 2011 and the next wave high of 1225(1218 August 31, 2011. Do you fololw the convergence of the moving averages(death cross)that appeared in August 2011? I'm sure more people would like to know more of your reasoning.