From Economic Weakness to Financial Crisis to Long-term Malaise:

Skirting the Edges of the Abyss

Industry

Business
Economy +
•Strategy
Geo-Politics •Operations

Business Cycles, the Financial Crisis and the Outlook:

Anticipating the Contours of the Next Decade “New Normal”
Llinlithgow Associates
contact@llinlithgow.com

March, 2010.
We’ve cycled thru a sequence of reactions, judgments and fears …
and there’s still a lot of confusion, uncertainty and doubts

Reading clockwise
from the upper left
1.An already weak and
slowing economy was
tipped over into near
collapse by the
breakdown of the
financial and credit
markets
2. Which resulted in
widespread panic – which
was not out of line with
possible realities. It was a
“near-run” thing
3. The collapse and
consequence was taken
as the “Death of
Capitalism” but that was
exaggerated
4. If anything we’ve
returned prematurely to
complacency with too
little attention on deep
risks
5. And are facing a great
deal of confusion and
puzzlement about what’s
next.

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 Understanding the Financial Crisis in the Economic Context:
Lots of Moving Parts, Pieces and Complications

1. Understanding the Business Cycle

2. Key Indicators (Employment, Retail
Sales, Housing and Investment)
3. Public Policy: the Stimulus and the
Strategic Challenges
4. Savings, Debt and Growth
5. Genesis of the Crisis
6. Trade, Exchange and the Dollar
7. Deficits, Public Debt, Financing and
Inflation
8. Strategic Outlook for the US
Economy
9. China and Geo-politics
10. Oil and Energy
11. Business Performance
12. Markets and Investment Strategy

The key is developing the right mental models to filter chaotic data into useful
information ….
… and use those filters to create a “dashboard” to monitor the state of the world
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
Two major sources of confusion – assuming a calm economy is
the normal state and being surprised by storms.
- and not appreciating the underlying patterns!

The Economy follows the same recurrent patterns, driven by the same forces and
governed by the same relationships but the actual behavior varies considerably.
The challenge is to understand the structure and relationships and monitor the
changes in the forces to anticipate what’s coming.
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 Economic Cycle
CREDIT 1. Any developed economy follows a
linked cycle where the core engine is the
Consumer Consumer driving the rest of the
Consumer Economy (65-70% in the US –
Confidence
Confidence
historically high).
Consumer 2. Businesses respond by producing what
Hiring
Spending they can sell now and, IF demand is
The Great growing hiring more workers and
investing in equipment and structures.
Economic 3. Part of their decision-making process is
Business Economy a multi-part “Credit” evaluation of
Investment Circle of Life outlooks, risks, financing and
expectations.
Business
4. Going round consumers perform a
Expectations similar evaluation based on jobs, wages,
expectations, uncertainties and
asset/wealth & financing value
CREDIT
• The last two bubbles were NOT based on
wage or job growth but were artificially
stimulated by leveraged asset-
Business Cycles: appreciation
1. As the Economy moves around the
Consumer-led Normal vs. Investment-driven Speculative cycle the result over time is a wave
pattern with repeating structures,
relationships, timings, etc. that depend
on how hard the “wind” is blowing
• A Normal cycle is led by Consumer
spending
Consumer-led • A Boom is driven by speculative
Investment-driven Investment (Tech, Real Estate)
Policy-managed • When excesses correct the impact can be
years on the bottom without public
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
spending
both are improbable
The economy has bottomed and is starting to “recover” but
employment lags and will lag for many reasons

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
Real economic data looks startlingly like the patterns we
showed …. Telling us a lot about the future
GDP and Consumption (yoy%) 1. GDP &
16.0%
Consumption have
14.0%
GDP followed the cycle
12.0%
PCE since 1950
10.0%

8.0%
GDPTre nd
2. Both have turned
6.0%
up but are still very
4.0%
weak – a post WW2
2.0%
record
0.0% 3. Growth this
-2.0% decade was WEAK
-4.0% 4. The long-term
-6.0% trend slowed and
1950-I 1955-I 1960-I 1965-I 1970-I 1975-I 1980-I 1985-I 1990-I 1995-I 2000-I 2005-I
cliff-dove in the
GDP vs. Consumption vs Employment (yoy%)
Great Recession
12.0%
GDPx
10.0% PCE
1.GDP follows PCE
Em ploy but Employment
8.0%
follows GDP
6.0%
2. Employment has
4.0%
just turned up
2.0% 3. It also shows a
0.0% steady downtrend
-2.0%
since 1980.
-4.0%
4. Employment
growth was weaker
-6.0%
1980-I 1985-I 1990-I 1995-I 2000-I 2005-I each decade
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 In the short-run Retail Sales is a good high-frequency
indicator for the Consumer side of the economy
Retail Sales:(YoY%)
15.0%
1. Both real and
nominal sales
10.0% abruptly fell off a cliff
R2 = 85.6%
in late 08, been
5.0% marching long the
bottom but now show
0.0%
significant
improvement.
2. Real and nominal
-5.0%
Real Nominal sales, and x-Auto,
xAuto Trend
have all turned
-10.0%
slightly positive YoY!

-15.0%
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
1. Consumption tracks
LT Economic Outlook:
GDP, Consumption, Real
real Sales thruout the
10.0%
Real Sales
12.0% entire business cycle.
GDP
8.0%
Consump
10.0% 2. The drop in this
6.0%
8.0%
downturn was the worst
4.0% since 1960.
6.0%
2.0%
3. Despite the upturn the
4.0%
0.0% level remains very poor.
-2.0% 2.0%
4. Growth in Sales (&
-4.0%
0.0% Consumption) will
-6.0%
-2.0%
demand on Consumer
-8.0% demand – which
-4.0%
-10.0% depends on jobs and
-12.0% -6.0% wages.
1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 Capital goods orders are encouraging and a directional
change has now reached positive territory YoY…

Capital Goods Orders vs Economy 1.Durable goods orders

20% 9% and orders x-Aircraft
15% sharply improved and
7%
10% have turned strongly
5% 5% positive.
0%
3%
2. DG Orders and xAC
-5% are near 10% YoY.
1%
-10%
DGOrd
3. Much of the GDP
-15% exAC -1% surge was in
-20%
GDP
Inventory re-stocking
-3%
-25% which will fad beyond
-30% -5% Q2.
1993Q1 1995Q1 1997Q1 1999Q1 2001Q1 2003Q1 2005Q1 2007Q1 2009Q1

20.0% 10.0%
O rd e rs(x A C),Ca p e x , In d P ro d 1.Economic activity
15.0% (GDP) drives
10.0% 5.0% Industrial Production
drives orders drives
5.0%
capital spending in a
0.0% 0.0% typical cycle.
-5.0% 2. The order pickup is a
-10.0% -5.0%
sign of improving
capex potential.
-15.0%
xA C Or d s 3. BUT …. Capex lags
C ap e x
-20.0% -10.0% as much or more as
In d Pr o d
-25.0% Employment so
equipment and tech
-30.0% -15.0%
1993Q1 1995Q1 1997Q1 1999Q1 2001Q1 2003Q1 2005Q1 2007Q1 2009Q1
demands are limited.

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 Residential Investment (new homes) are a critical driver of growth ….
And remains in bad, though no longer abysmal, condition
GDP vs. Residential Investment (yoy%)
8.0% 15.0% 1.YoY Changes in RI
10.0% mirror and drive GDP
6.0%
growth – on a long
5.0%
4.0%
enough timeseries we
0.0% find that RI is a
2.0% -5.0%
leading indicator.
2. RI is also turning up
0.0% -10.0%
slightly on a YoY
-2.0%
-15.0% basis, after reaching a
GDPx
-20.0% terrible depth.
RI
-4.0%
-25.0%
3. At –12% it remains
abysmal however, and
-6.0% -30.0%
is likely to be weak in
1995-I 2000-I 2005-I
the future

Residential Investment (RI) vs. GDP, Gross Investment 1. RI has a steady-state

6.5% 40.0%
relationship around
6.0% 38.0% 5% of total GDP for
5.5%
36.0% years but was turned
34.0%
into a serious bubble
5.0% by financial
32.0%
4.5% engineering.
30.0%
4.0% 2. Relative to total
RIGDP%
RIInvest%
28.0% Investment it is
3.5%
26.0% turning up – more a
3.0%
24.0% measure of reduced
2.5%
Investment than
22.0%
health.
2.0% 20.0%
1995-I 2000-I 2005-I 3. But is essentially
bumping sideways
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
Housing has arrested its freefall but is a long way from healthy
… or even beginning to repair the sustained damage.

1. New Home Sales

appear to be flattening
at a level at or below
the worst historical
one.
2. There is a worrisome
gap between New &
Existing Sales (existing
sales don’t contribute
to growth)
3. New Home Sales
dropped after the tax-
credit induced surge
1. The Inventory of New
Homes has improved
significantly but
remains at very high
levels (comparable to
previous peaks).
2. Housing prices are at
more reasonable
(affordable) levels but
DO NOT appear to
have reset to prior
lows – leaving
exposure.
3. THE goto source of
Housing is
CalculatedRisk.
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
Residential Housing is in a distressed state and continued
economic weakness is likely to worsen the stress …

1. Serious
delinquency rates
are soaring as
homeowners
exhaust their “wait-
it-out” alternatives.
2. The Market is
facing more ARM
resets in key
markets

1. Various forms of
“short-sales”,
including bank-owned
(REO) housing is at a
very high level and
rising
2. Continued
Employment
weakness will
maintain and increase
the pressures on
Housing; again,
especially in key
markets

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
The key to real growth, a healthy economy and future
prosperity is JOBS, period.
Priva te Job Cre a tion:1980-Now
150000
1.The US economy has
Public
140000 created ZERO private
Pr ivate jobs in over a decade,
130000
since 1999, over a
120000 decade!
110000 2. It is the worst post-
100000
war jobs performance
on record
90000

80000 Ne t P riva te Job cre a tion is ZERO since 1999! 1. Labor force growth
means we need about
70000
150K/month +/- to stay
60000 even.
1980Q1 1984Q1 1988Q1 1992Q1 1996Q1 2000Q1 2004Q1 2008Q1
2. Net New jobs is the
10000 1500 difference between
LT Em ploym e nt Tre nds new jobs and 150K.
1000
5000 3. A rolling total since
500 1980 shows extremely
poor performance
0 0
4. We entered the
-500 Recession in the hole.
-5000
-1000 5. We are now –14.1
million in the hole.
-10000 -1500
6. We estimate 46
AggNw Jobs -2000 million jobs would be
-15000 prosperity but
Ne tNe w Jobs
-2500
Ne w Job s anticipate getting 20
-20000 -3000 (BLS says 15!)
1980Q1 1984Q1 1988Q1 1992Q1 1996Q1 2000Q1 2004Q1 2008Q1

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
To understand the performance outlook follow clockwise around the economic
life cycle and read off the line…
Consumption vs GDP:1960-2009 Employment vs GDP: 1960-2009
10.0% 6.0%
y = 1.04x - 0.00 y = 0.63x - 0.00
8.0% R2 = 0.74 R2 = 0.62
4.0%

Output (yoy)
6.0%
2.0%
4.0%

2.0% 0.0%

0.0% -2.0%

-2.0%
-4.0%
-4.0%
Consumption (yoy)
-6.0%
-6.0%
-6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0%
-4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0%

Output vs Capex:1995-2009 Output vs Investment:1995-2009

20.0% 15.0%
y = 3.63x - 0.05 y = 3.67x - 0.07
15.0% 10.0%
R2 = 0.79 R2 = 0.91
10.0%
5.0%

Capex (yoy)

Investment (yoy)
5.0%
0.0%
0.0%
-5.0%
-5.0%
-10.0%
-10.0%
-15.0%
-15.0%
-20.0%
-20.0%
GDP (yoy) GDP (yoy)
-25.0%
-25.0%
-6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0%

Consumption growth of 2.5-3.0% implies GDP growth of 2.0-2.5%, the outlook for next year. 2.5% GDP growth
means Employment growth of <2.0%; really need 4% GDP growth. This is a weak and atypical recovery (typical
post-war recovers are 6% real growth) but means that Employment growth will be poor and Unemployment
stubbornly high. Especially given that long-term forecasts (OMB/CBO) call for growth in the 2.2-2.5% for the
decade. Investment (real estate and business) won’t pick up without strong growth, though residential tends to
lead a recovery it’s weakened and in repair mode for a long time. To see a surge in Investment spending would
require GDP growth north of 4%, or better. So not only Employment will be weak so will Investment and Capex
spending (implying weakness in the Tech and Equipment industries).
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
The single best indicator of demand is the change in real wages + employment
– and the critical question is whether the economy achieves takeoff velocity
where growth becomes self-sustaining…
7 .0 % 7 .0 % LT Cycle Drive rs: Consum ption, W a ge s, Em ploym e nt
C o n su m p tio n v s D e m a n d Consum p 12.0% 10.0%
W +E 6 .0 % GDP Co n W +E
6 .0 % 10.0% 8.0%
5 .0 %

4 .0 % 8.0% 6.0%
5 .0 %
3 .0 % 6.0% 4.0%
4 .0 %
2 .0 % 4.0% 2.0%
1 .0 %
3 .0 % 2.0% 0.0%
0 .0 %
2 .0 % 0.0% -2.0%
- 1 .0 %

- 2 .0 % -2.0% -4.0%
1 .0 %
- 3 .0 % -4.0% -6.0%

0 .0 % - 4 .0 % -6.0% -8.0%
Jan -95 Jan -97 Jan -99 J a n -0 1 Ja n -03 Jan -05 J a n -0 7 Jan -09 1965Q1 1970Q1 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1

7 .0 % 4 .0 % 8.0% 10.0%
Fu tur e De m a nd C om p on e nts :9 5 -0 9 Future De m a nd: W a ge s+ Em ploym e nt
6 .0 % 3 .0 % 6.0% 8.0%

5 .0 %
2 .0 % 6.0%
4.0%
4 .0 %
1 .0 % 4.0%
3 .0 % 2.0%

2 .0 % 0 .0 % 2.0%
0.0%
1 .0 % - 1 .0 % 0.0%

0 .0 % -2.0%
- 2 .0 % -2.0%
- 1 .0 %
-4.0%
- 3 .0 % -4.0%
- 2 .0 % Wag e s Em ploy W+E(R)
W +E W ag e s Em p lo y
- 3 .0 % - 4 .0 % -6.0% -6.0%

- 4 .0 % - 5 .0 % -8.0% -8.0%
Jan -95Jan -96Jan -97 Jan -98Jan -99Jan -00Jan -01 Jan -02Jan -03Jan -04Jan -05 Jan -06Jan -07Jan -08Jan -09 1965Q1 1969Q1 1973Q1 1977Q1 1981Q1 1985Q1 1989Q1 1993Q1 1997Q1 2001Q1 2005Q1 2009Q1

1. Demand (= YoY change in wages + employment) drives Consumption. Employment dropped but real
wages went up as inflation fell due to falling oil prices. Now employment is flattening but labor market
pressures are causing wages to fall.
2. Continued weak labor markets will keep pressures on wages for the foreseeable future. The drop in
Demand (on the monthly and quarterly) charts is worrisome and should be watched closely.
3. Economic growth becomes self-sustaining when organic demand leads to higher Employment and the
increase causes Investment to accelerate growth. The outlook is problematic for the decade. As it was
for the last but
Strategy no longer
without disguised
execution by Execution
is fantasy. asset bubbles.
without Strategy is thrashing. And without a Management System
both are improbable
 Economic Indicator Cheatsheet
10.0% -4.0%
PCE GDP
9.0% EMP CPX
Tech Unem p -2.0%
8.0%
HANDY POCKET ECONOMIST

Indicators (yoy%)
7.0% 0.0%

Inverse Scale
6.0%
2.0%
5.0%
4.0%
4.0%
Key Indicator Growth Rates 3.0% 6.0%
Sales PCE GDP EMP Unemp CPX Tech 2.0%
8.0%
0.0% 2.0% 1.7% 1.0% 9.1% 1.1% 1.1% 1.0%
0.2% 2.1% 1.8% 1.0% 8.5% 1.5% 1.5% Retail Sales (yoy%)
0.0% 10.0%
0.4% 2.2% 1.9% 1.1% 8.0% 1.8% 1.9%

2%

4%

8%

6%

2%

8%

0%
0%

6%

0%

2%

4%

8%

0%

4%
6%

2%

4%
6%

8%

0%
0.

0.

0.

1.

2.

2.

3.

3.
0.

0.

1.

1.

1.

1.

2.

2.
2.

3.

3.

3.

4.
0.6% 2.3% 2.0% 1.1% 7.4% 2.2% 2.3%
NOTE: yoy% tells you w hat the average annual NOTE: Unem ploym ent is inverted, so it
0.8% 2.4% 2.1% 1.2% 6.8% 2.5% 2.7% grow th rate relationship is; e.g. 2% Sales => 3% PCE. doesn't drop until sales grow th is > 3+%.
1.0% 2.5% 2.2% 1.3% 6.2% 2.9% 3.1%
1.2% 2.6% 2.3% 1.3% 5.6% 3.2% 3.5% All the Business Cycle Models and Data were
1.4% 2.7% 2.4% 1.4% 5.1% 3.6% 4.0%
1.6% 2.8% 2.5% 1.5% 4.5% 3.9% 4.4%
used to create a printable pocket guide to the
1.8% 2.8% 2.6% 1.5% 3.9% 4.3% 4.8% Economy and Forecasting
2.0% 2.9% 2.7% 1.6% 3.3% 4.6% 5.2%
2.2% 3.0% 2.8% 1.6% 2.8% 5.0% 5.6% • the Cycle is Consumption  GDP  Employment 
2.4% 3.1% 2.9% 1.7% 2.2% 5.4% 6.0% Investment  Consumption
2.6% 3.2% 3.0% 1.8% 1.6% 5.7% 6.4%
2.8% 3.3% 3.0% 1.8% 1.0% 6.1% 6.8%
• We started with Retail Sales as a high-frequency
3.0% 3.4% 3.1% 1.9% 0.5% 6.4% 7.2% monthly indicator to judge the state of the economy
3.2% 3.5% 3.2% 1.9% -0.1% 6.8% 7.7% and guestimate futures with …
3.4% 3.6% 3.3% 2.0% -0.7% 7.1% 8.1%
3.6% 3.7% 3.4% 2.1% -1.3% 7.5% 8.5%
• So some key relationships to pay attention to …
3.8% 3.8% 3.5% 2.1% -1.8% 7.8% 8.9% • 2.0% YoY Sales growth  2.7% GDP but 3.3%
4.0% 3.9% 3.6% 2.2% -2.4% 8.2% 9.3% Unemployment!
PCE=.47*Sales+
Economic .02
Indicator Cheatsheet • -4.0%
Unemployment doesn’t come down until you get 3.3%+ GDP
PCE
GGDP
DP=1.04*PCE-.004 growth… and not seriously until it approaches 4.0%
EMP CPX
Tech EMP=.63*G
Unemp DP-.001 • -2.0%
The L.T. outlook is for 2.5% GDP growth!!!
UnEmp=.19-5.89*GDP • 0.0%
Capex and Tech spending is asymmetric, I.e. the line is very
steep so slight positive growth gets a good bump … but
erse Scale

CPX=3.63*GDP-.05 nothing like expectations!!

2.0%
Tech=4.21*GDP-.06
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
4.0%
both are improbable
Even though the structures and patterns are the same sometimes
the FORCES are beyond expectations … in 2008 a rising storm
turned into a Tsunami when the credit markets broke

Even so there were plenty of warnings both about the structural risks on
structured, synthetic debt AND the metastasizing weaknesses in the Credit
Markets …. But nobody believed the warnings or prepared to meet them. Call it
complacent “business-as-usual” syndrome.
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
We got within 24 hrs. of a credit market collapse that would
have made the Great Depression like a cakewalk

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
The current state results from the links between the US and World
economies, credit and equity markets and Housing
The LUV Outlook & Risks
1.The US Economy will have weak
growth (U) and poor job creation
2. while Europe is facing a slower
and weaker outlook (L) and
3. the developing countries are
likely to be more V-shaped with
4. some major structural challenges
– China in particular
• China needs 6% growth for labor
breakeven and is
• facing the structural change in an
export-led economy
5. US Housing remains weak
6. Credit markets are self-repairing
but credit isn’t flowing because of
bank balance sheet damage, lower
demand and economic risks
• Small businesses are vulnerable
• Consumer demand is constrained
7. We think equity markets are over-
valued on a $ carry trade and are
exposed
• PE Ratios are abnormally high
• Economic growth will NOT be as
good as priced
• Earnings outlooks optimistic
• Likely priced beyond perfection

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
We need to look at some dry but real numbers to understand the contagion and
consequences:
[10Yr Treasuries (TNX), 3Mo (IRX), LIBOR (London Inter-bank Rate), TED (LIBOR-IRX)]

Zooming into 07-10 TED was very elevated – meaning

From 01-04 rates declined with economic weakness
banks weren’t willing to lend to each other
but s.t. rates climbed rapidly from 04-07. L.T. DID NOT!
At the height of the crisis there was a tremendous
Beginning in mid-07 both slowed as the economy did,
spike meaning banks were betting on each other to
s.t. more rapidly driving up the Yield Curve (TNX:INX).
default and go BK!!
LIBOR followed a similar pattern
The spread has come down enormously so credit
During the Crisis rates dropped to near zero.
markets are trusted and working again
The Yield Curve spike was a measure of how broken
Rates are still low – because of policy s.t. and
the credit markets were.
weakness
Strategy without execution is fantasy. Execution without Strategy + policy l.t.
is thrashing. And without a Management System
both are improbable
Credit and financing is the economy’s circulatory and respiratory
system – without things STOP

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 THE fundamental structural change between 1980 and now was the creation, growth,
exponentiation and metastasis of structured, synthetic financial products ….
… A General Purpose Technology mal-adapted, unlike say steam engines or fractional h.p.
electrical motors.

SSD’s changed the business model from loan to invest to originate to sell …changing
literally millenia of incentives from borrower quality to ability to pump volume to the
next sucker in line. A GPT turned into a financial contagion

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 Rocks, Ponds, Ripples: Welcome to FinEngr World
Initial Originator Bank(s) Ibank CDO1… Hedge Investors
LINKS Asset MBS/CDO N
(Loan) CDO/CLO
Boulders Big Rocks Asset Classes
Sub-prime

Alt-As

“Normal”

Commercial
Paper
CDO

CDO(N)

Bonds

Equities

Currencies

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
Our “Self-Arrest” was due to Fed policy where massive liquidity was injected
directly (thru “Quantitative Easing”) by expansion of the Fed’s Balance Sheet
… yet it HAS NOT resulted in a surge in Money

Normally the Fed injects money by buying Treasuries

This time it purchase Financial Debt Directly
• Direct purchase of credit securities
• Huge direct loans to Financial institutions
• All of which is winding down
And Agency (FNM/FRE) securities
• Agency mortgage funding is 80% of Housing Finance –
the only thing keeping the wheels on!
The huge surge in the Monetary Base was offset by a
surge in Excess Reserves … and the speed of
circulation has dropped enormously.
• Thereby constraining credit significantly
• But Banks have not re-built their balance sheets
• Written down toxic assets still on the books
• Or reduced under-water mortgages
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 The Finance Industry is still facing huge short-term problems.

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Credit P and L Balance Sheet

Tightening Losses Losses
3
5 4 1. Residual toxic assets are waiting to be
fairly valued and will drag earnings and
Cyclic Downsizing & capital requirements
Downturn Cost Reduction2. Meanwhile bad debt on the consumer,
business, real estate and commercial real
estate will continue to be severe problems
6 for the next several years
t
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……. 3. Balance sheet repair, which should have

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been done along with write-downs this

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Consumer BizzLoans
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Financing 4. Supporting the historic levels of

BONUSES
5. And calling into question both the
Business Models and Management
Systems of the Financials
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
Between the crisis, lingering impacts on Banks and continued economic
weakness (lowering demand) credit has contracted more severely than in any
post-WW2 period
1. Consumer loans have had a very
sharp YoY decline, more severe in
% and absolute terms than
anytime since 1980
2. Business loans have been even
more badly hit and, almost
literally, have fallen off a cliff.
Given their role in job creation
credit availability for SMB’s is a
major strategic problem.
3. Taking all bank credit together
from loans to credit cards, et.al.
the decline has, again, been
literally abysmal.
4. Given a weak economy these
pressures will continue
5. Given fragile bank balance sheets
and future bad credit problems
repair does NOT seem likely over
the next few years.
6. In the long-run the real key
question is how will Consumers
and Businesses react to the
lessons of the crisis. If there is a
permanent shift in credit demand,
as there should be, we are facing
major structural changes in the
credit and financial markets.

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
Finance is essential to L.T. growth by providing efficient and effective sourcing
and allocation of capital – has it served that purpose in the last 20-30 years?

65.0%
Fin Prof its 1. Over the last 60 years Wages, the
Fina nce Profits vs the Re st (% GDP) Non-F Profits ultimately measure of prosperity
Wages and driver of sustainable
60.0%
economic growth have declined
as a share of GDP.
55.0%
2. Corporate profits for traditional
industries have maintained a
50.0% significant share but, beginning in
the mid-80’s with de-regulation,
Financial profits have taken a
45.0%
larger share of GDP and Profits
3. If you look at aggregate Profit
40.0% growth mainstream businesses
1950Q1 1955Q1 1960Q1 1965Q1 1970Q1 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1 experienced profit growth that
lagged overall economic growth
3000.0%
4. Finance on the other hand grew
Aggre ga te Grow th: GDP vs Profits slightly faster until the mid-80s
2500.0% when it suddenly jumped non-
GDP NonFin Finance linearly. But beginning with the
2000.0% Tech Bubble there was an
exponential increase in Finance
1500.0% Profits.
5. It would appear that much of the
1000.0%
“capital” raised was actually used
to support trading and
500.0%
speculation and DID NOT directly
0.0%
contribute to the growth of the
Economy.
-500.0% 6. Capital allocation was, therefore,
1950Q1 1955Q1 1960Q1 1965Q1 1970Q1 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1 Inefficient and Ineffective.
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 Key Elements Finance Industry Sectors Financial Business Models –
Value Proposition time to re-examine, re-think and
•Business Model re-design business models
•Strategy - leveraged trading, proprietary
•Plans trading w/o subsidies?

Global Wealth Management

- lower demand for IB services?
Execution

Securities and Banking

•Marketing & Sales Same umbrella?

Transaction Services
- Credit Cards & Consumer

Consumer Banking
•Service

Business Banking
•Operations finance ~ de-leveraging?
•Infrastructure - Business Finance – lower

Global Cards
•IT growth = lower demand
•HR
What are the risks and what are
Management System
•Budgets
the opportunities?
•Controls Why aren’t they being seized?
•Compensation

Five Major Causes for the Crisis Finance Industry Sectors

1. A worldwide savings excess created by Securities Global
trade imbalances and a frantic search for
Drucker’s Business
Management Wealth
Consumer Credit
Banking Banking Cards
return in a world of excess liquidities Principles & Services Management
2. Over-development and exploitation of
SSD’s coupled with a severe failure of 1.Deliver Performance
quality control & risk management. and Value
2. Make Work Effective
3. A failure of Regulatory oversight caused by 1. Make the Worker
ideological misunderstandings and a failure Efficient
to understand how markets work. 2. Make the
Working effective
4. Breakdowns in controls, management 3. Meet Social
systems, performance measurement and Responsibilities
compensation practices – terminally bad 1. Do NO Harm
2. Proactively
business practice manage externals
5. HUBRIS – a failure to understand the risks, 3. Recognize social
impacts & lead re-
a focus on the short-term and pursuit of dress
individual gainwithout
Strategy at enterprise AND
execution public Execution without Strategy is thrashing. And without a Management System
is fantasy.
cost. both are improbable
Things to Think About – and Take Away!
Some Major Take-Aways

1. You can understand how the

economy and markets work. There are
simple patterns that are based on
deep theory and results
2. There are overall patterns and models (think
Cycles and YoY) for the economy as a whole,
and there are sub-models that help with key
component issues
3. Much of the headline news, commentary and
suggestions distort more than they help
because they don’t use the recurring
patterns.
4. In truth much of the commentary is distorted
by narrowness by the commenter, often due
to discipline stovepipe or ideological biases
5. We all have such and our thinking will be
driven by our Hindbrains (the “Lizardbrain) to
get what it wants unless we train it, discipline
it and learn the patterns.
6. Learning the Patterns is like learning any
discipline it takes time, work and practice.
7. But it’s also like martial arts training –
how you react in an emergency will
depend on whether or not you know
how to react or have to make it up in
the crisis.
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
The Recovery is underway but will be weak and slow … we
haven’t reached takeoff velocity to self-sustaining growth
E c o n o m i c A lt e r n a tiv
-s t re us :c Rt uer e v s . S t a g n a t io n 1. We’ve avoided a
O u tp u t Depression and, likely,
P ro s p e ro u s R e c o ve ry
an L-shaped Japanese
(R e q u i r e s-bRa es i n g E c o n o m y ) malaise
2. But are facing a broad
M o d e ra te
and shallow U-shaped
R eco very recovery that will play
( L i k e ly O u t c o m e ) out thru the rest of the
decade
U-S h a p e d R e c o v e r y 3. The two primary
causes are credit
constraints and the
severity of job losses;
L-S h a p e d R e c o v e r y plus the time it will take
get them back, if ever.
D e p r e s s io n
4. This follows the pattern
T im e
of recent cycles
because of lower long-
term growth potential
and under-investment
5. What averted GD2.0
was the combination of
lower interest rates,
massive capital
injections and fiscal
stimulus.
6. The Economy is still
weak and the chances
of a double-dip W are
rising.

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 Potential economic growth will determine how we come out of
the crisis …. And prevent it from becoming a malaise
GDP Comparisons: Potential vs. Actual 1. Potential economic
600.0 16000.0 growth is the
Difference GDPPOT GDP
Economy’s L.T. speed
400.0 14000.0 limit.
200.0
12000.0
2. It has been roughly 3.3-
3.5% historically
0.0
10000.0 3. It’s projected to be
-200.0 2.5% by the Fed, OBM,
8000.0 CBO and numerous
-400.0 public and private
6000.0 forecasters.
-600.0
4. The difference between
4000.0
-800.0 Actual and Potential
GDP was more severe
-1000.0 2000.0
this crisis by far than at
any time since WW2
-1200.0 0.0
1950Q1 1955Q1 1960Q1 1965Q1 1970Q1 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1 5. The US has had several
different L.T. growth
GDP: Potential vs. Actual Differences periods
2000.0 600.0
• A “Golden Age” of
0.0 400.0 sustained high, near
potential growth
-2000.0 200.0
• A drawn out secular
-4000.0 0.0 decline triggered by
the shocks of the 70s
-6000.0 -200.0 but made worse by
accumulated private
-8000.0 -400.0 debt and under-
AggDiff Difference
-10000.0 -600.0
investment
• An Indian Summer
-12000.0 -800.0 during the Tech Bubble
• And a return to “Naked
-14000.0 -1000.0
Swimmers” where
-16000.0 -1200.0 there’s no hiding
1950Q1 1955Q1 1960Q1 1965Q1 1970Q1 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1 places left.

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
That LT assessment is supported by the trends in YoY GDP growth … yet to
address our second major problem after credit we need to restore higher LT
growth 1.One way to assess LT
economic growth is to
12.0%
examine the trends in
Economic Growth:1960-2009 YoY growth rates
10.0%
GDP Trend1 Trend2
• LT trend has been
8.0% downward since the 50s
6.0%
• The non-linear trend
followed it until this
4.0%
decade when it “fell off
2.0% a cliff”
0.0%
2.There is a circular
relationship between
-2.0%
Growth and
-4.0% Employment. Higher
growth increases
-6.0%
1960Q1 1964Q1 1968Q1 1972Q1 1976Q1 1980Q1 1984Q1 1988Q1 1992Q1 1996Q1 2000Q1 2004Q1 2008Q1
Employment which then
raises demand and
increases growth
GDP vs Employment (YoY%)
6.0%
• We need ~ 2.5%
Employment growth for
4.0% breakeven
• We need 3.0%+ to return
2.0%
to prosperity
y = 0.538x + 0.001
Employment

R2 = 0.573 • At 4.0% GDP growth

0.0%
we’ll get only 2.5%
Employment growth
-2.0%
• To get higher growth
means more Savings,
-4.0%
more Investment and
Output creating new Industries
-6.0% and Jobs.
-6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
We know that NO private sector jobs were created this decade but the structural
downtrend in Employment growth goes back farther and reflects the weakness in
GDP growth
Private Employment Trends:1960-2009
160000
Public
Private
140000

120000

1.There have been

100000
two previous
80000 periods of poor job
growth but neither
60000
was as long and
40000 both were followed
by sustained
20000
1960Q1 1965Q1 1970Q1 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1
increases.
6.0%
2. The 90’s increase
Employment Trends:1960-2009 Em ploy
was semi-artificial
Trend1

4.0%
Trend2
because of the Tech
Investment boom.
2.0% 3. The L.T. trend in
Employment growth
0.0% follows the same
downtrend that GDP
-2.0% growth has
exhibited.
-4.0%

-6.0%
1960Q1 1964Q1 1968Q1 1972Q1 1976Q1 1980Q1 1984Q1 1988Q1 1992Q1 1996Q1 2000Q1 2004Q1 2008Q1

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
Recovery from this downturn and getting traction back to sustained growth will
be especially challenging because of the depth of the downturn and structural
weaknesses in Employment.

1. Both the average and median

duration of Unemployment
have trended upward over
the last several decades
2. But sky-rocketed in this
downturn to historically
unprecedented levels.
3. Part, a large part of that, is
due to the diversion of
Employment to Housing,
Construction and Finance
because of the last two
decades distortions.
4. What is beyond worrisome
though is that the levels of
Unemployment lasting longer
than 26 weeks are extremely
high AND break all previous
historical patterns. Another
sign of structural weakness
and long-term problems.
5. As the result of structural
shifts and legislative
changes more of the
population entered the
workforce in the 70s and 80s.
6. The Participation Rate fell off
a cliff; I. E. a lot of people
have been driven from the
labor force by the downturn’s
severities.

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 The other major driver of L.T. growth is real wages but those have
been in a secular decline since the 1970s.
14% 56%
Profts vs Ca pe x vs W a ge s (%GDP) 1. The initial decline was likely
12% 54% caused by the capital
10% 52%
spending required to deal
with adjustments to the
8% 50%
Energy crisis of the 1970s.
6% 48% 2. Since then Capital

4% 46% Investment has not shown a

secular increase.
2% 44%
P r o ft%
W Tr end
Ca pEx
P Tr end
W a g es(R)
CT r en d
3. Under those pressures
0%
Jan-47 Jan-52 Jan -57 Jan-62 Jan-67 Jan-72 Jan -77 Jan -82 Jan-87 Jan-92 Jan-97 Jan-02 Jan -07
42%
Profits showed a decline
thru the mid- to late-80s but
3000.0%
have since climbed back to
Aggregate Growth: GDP vs Profits there historically highest
2500.0% levels; arguing that profits
GDP NonFin Finance
2000.0%
have displaced both
Investment and Wages.
1500.0%
4. Yet those profits were not
1000.0% the result of the Industries
that created job growth,
500.0%
wage increases or LT
0.0% prosperity but were
concentrated in Finance.
-500.0%
1950Q1 1955Q1 1960Q1 1965Q1 1970Q1 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
 What has grown at far above LT economic growth rates is total
private debt – Consumer, Business but especially Finance
Total Real Debt Oustanding ($M) Total Real Debt Oustanding (GDP Multiple)
60000000 4.00
Household Business
Household Business
S&L Gov Fed Gov
Finance RoW 3.50 S&L Gov Fed Gov
50000000
Finance RoW
3.00
40000000
2.50

30000000 2.00

1.50
20000000
1.00
10000000
0.50

0 0.00
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Overall total debt, private and public, grew at a relatively low rate until The relative growth behaviors are even clearer when looked at as GDP
the mid-80s, though Public debt decreased relative share. Beginning multiples. Until 1985 Consumer:GDP was about 0.6 and then exploded
with de-regulation Consumer and Business debt accelerated while this decade to ~ 1.0. Business debt grew from .3 in 50 to .6 in 85 and
Finance debt – largely used for internal industry speculation? – then. Meanwhile Finance debt went form 0.1 to 0.3 and then exploded to ~
metastasized! .9 by 2000 and then soared to 1.2 by 2008! In other words the biggest
growth in debt occurred this last 2+ decades for entirely non-productive
140.0
Real Debt Relative Growth (Normalized) uses. Real Debt Relative Growth (Normalized)
1400.0
RoW
120.0
Fed Gov 1200.0

100.0 S&L Gov

1000.0
Business
Finance
80.0 Household
800.0

60.0 600.0

40.0 400.0

20.0 200.0

0.0 0.0
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Total Non-finance Debt grew over 120% from 1945 to 2008 with
Household debt growing about 63% and Business debt 24%. Yet by
1997 Household debt had “only” grown ~30% and Business debt by
13%. In other words the real acceleration occurred in the last 15 or so
years. The Grasshoppers definitely decided to partay!
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
Financial debt is entirely a different story. Since 1945 it has grown
about 1200%. From 1945 to 1983 it grew less than 10%. But beginning,
coincidently of course with De-Regulation, it grew to 266% by 1990, to
678% by 2000 and to 1200%, almost a doubling in eight years, by 2008.
The beginning coincided with De-regulation but the the explosion
coincided with the growth of Structured Synthetic Debt and Financial
Engineering. None of which seems to have contributed to the long-term
health of the overall Economy.
TANSTAFFAL – what did playing Grasshopper cost us? Our
future growth possibly!?
S a vings Drive s Grow th:
C u m u lative C h an g e C on su m e r D e b t vs S a vin g
1200% (C u m u lative G r o w th )
2500%
Pe r Save C o n De b t
1000%
GDP PC E De b tT r n d Sav T r n d
In ve s t Pe r Save 2000%
800%

600% 1500%

400%
1000%
200%
500%
0%
0%
-200%

-400% -50 0%
1948Q11953Q1 1958Q11963Q11968Q1 1973Q11978Q11983Q1 1988Q1 1993Q11998Q1 2003Q12008Q1 1954Q1195 8Q11962Q119 66Q11970Q11974Q1197 8Q11982Q11 986Q11990Q11994Q11998Q12002Q12 006Q1

Until approximately 1993 GDP, Consumption, Savings and Investment Not surprisingly there is a strong inverse relationship between Savings
all grew roughly in line with each other, with Savings running ahead. and Consumer Debt. As the latter exploded the former began its
Then we began a secular decline in Savings as Grasshopper secular decline.
Syndrome triumphed though Investment was artificially stimulated by
two major bubbles (Tech and Housing – both funded by Financing, not
Savings). Eco nom ic Grow th vs S a vings Ra te s Tre nds D e b t S a v in g s G ro w th T re n d s
12.0% 15.0% 10 .0% 10 .0 %

9.0 %
5 .0%
10.0% 10.0%
8.0 %
0 .0%
7.0 %
8.0% 5.0%
-5.0 %
6.0 %

6.0% 0.0% - 1 0 .0% 5.0 %

4.0 %
- 1 5 .0%
4.0% -5.0%
3.0 %
- 2 0 .0%
P e r Sa v e C o n De b t 2.0 %
2.0% -10.0% De b tT r n d S a vT r n d
GDP SavRate - 2 5 .0%
1.0 %
In ve s t(R) In ve s tRat e
Gr w th Savin g s
0.0% -15.0% - 3 0 .0% 0.0 %
Jan -48 Jan -53 Jan -58 Jan -63 Jan -68 Jan -73 Jan -78 Jan -83 Jan -88 Jan -93 Jan -98 Jan -03 Jan -08 1 95 4 Q 1 19 5 9Q 1 1 96 4 Q 1 1 96 9 Q 1 1 9 74 Q 1 1 9 79 Q 1 1 9 84 Q 1 19 8 9Q 1 1 99 4 Q 1 1 99 9 Q 1 2 0 0 4 Q 1

In the short-run reduced Consumption reduces Demand but in the Looking at the L.T. trends in YoY growth rates shows us Savings
long-run Aesop was right. Long-term sustainable growth results from averaging 5.0%/Yr until ~ 1984 when it began its decline followed by a
Savings turned into Investment. Basically when we quite saving and trip off the cliff beginning around 1998. Nothing’s so expensive as
then started borrowing to consume we ate our seed corn, damaged the keeping up with the Jones except borrowing to do it!
farm and made it really
Strategy hard execution
without to keep growing new jobs.
is fantasy. Execution without Strategy is thrashing. And without a Management System
both are improbable
Disabusing some more mis-understandings: in the short- and intermediate-
terms government spending, deficits and debt are NOT the problem you think
Start with some
historical realities on the
Deficits. The problems of
the 70s grew them but
we were recovering until
the 80s when they were
enormously accelerated.
In the 90s we paid them
down, partly thru the
“Peace Dividend”. This
decade though
completely destroyed
that frugal legacy before
the downturn began and
the Crisis happened.

The Stimulus is a small and disappearing part of the LT The inherited deficits are reduced in the In any case, while not good,
deficits. The primary sources are revenue shortfalls from current, 2011 budget proposals, and largely the current deficits and
the downturn, Bush’s tax cuts (far and away the biggest reduce the intermediate impacts of inherited intermediate outlook is not out
and growing factor) and Iraq/Afghanistan. A return of problems. The real problem is long-term of line with either affordability
growth AND eliminating the tax cuts would make it deficits and accumulated debt. or int’l comparisons.
Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System
manageable.
both are improbable
 The real L.T. problem is not with immediate challenges or discretionary
spending – it is with mandatory entitlement programs and hidden costs.

Most people haven’t a clue as to the real structure of Federal spending or the sources of the deficits. Surveys
show that a majority of the voting public thinks Foreign Aid takes 50% of the budget – it’s actually more on the
order of 0.3%, or so.
1. The long-term deficit outlook does threaten to explode but the primary sources are metastatic growth in Entitlement
programs, which are non-discretionary. Discretionary spending, other than Defense, is a small part of the Budget and can never
make up the shortfall.
2. Fixing Social Security and related programs is relatively straight-forward, largely by adjusting age eligibility limits to roughly
match what they were at creation. The real problem is exponentiating Healthcare costs – either we bend the cost curve or
nobody will have insurance of any form AND no coverage plus the Country will be bankrupt in the great bye-n-bye.
3. A third major source of deficits is simply to return tax rates to what they were under Clinton.
4. A fourth is to reduce or eliminate tax expenditures – otherwise known as exemptions or loopholes. That’s a pool of $1T, larger
than Social Security and almost twice Medicare. It’s also growing at 3-4X the inflation rate, which is even faster than HC costs!
5. The bottomline
Strategy here is
without that the L.T.
execution Deficit and
is fantasy. Debt problems
Execution withoutare eminently
Strategy is addressable if wewithout
thrashing. And choose atoManagement
address them.System
both are improbable
 The other, real L.T. problem is restoring prosperous growth
To fix out long-term problems will not happen
overnight but it is feasible and workable. It
From Crisis to Recovery: Four Phases
will take time, awareness and commitment –
Output
the political will to act.
1. The Economy is not out of the woods short-
Re-base term, not having reached sustainable take-off
Economy
and in some risk of a double-dip.
2. If and when we reach organic growth that L.T.
Self-sustaining
potential is still going to be below a rate which
Stimulate &
Organic Growth returns us to general and widespread
Grow prosperity.
Arrest &
3. A key requirement is to shift from a nation of
Stimulate debt-fueled Consumption to a nation of
productive investors, fueled by Savings.
4. But to really return to higher than 2.5% growth
Time
will require the creation of new
Economic Recovery: Multi-phase Stimulus & Investment
Innovations,Industries and Jobs.
5. A key intermediate-term requirement is to
Government
Spending repair the accumulated damage of three
decades of neglect to things like our
•Energy Infrastructure.
•Healthcare
•Education Strategic 6. in the long-run to regain higher rates of growth
•INNOVATION Investment requires fixing Healthcare, Education and
Energy.
7. And a concerted national effort at Innovation.
Efficiency Investments
Infrastructure … 8. All of which is affordable by doing four things:
a.Re-structure existing entitlement programs.
Follow-on
b.Bend the cost curves on Healthcare
Direct Spending Spending c.Modestly increase taxes
Emergency Time d.Reduce tax expenditures (which carried far
Strategy without execution is fantasy. Execution without Strategy is thrashing. enough might actually
And without allow taxesSystem
a Management to be
both are improbable lowered!!)