It is easy to take the sense of sight for granted. We simply open our eyes and see. But, in fact, the process of capturing the light that falls onto the retina of each eye and transforming it into an understanding of the physical world in front of us is nothing short of amazing.

Typically, when we walk into a room and look around, we identify virtually every object in our area of vision within just a few hundred milliseconds, regardless of the lighting or our angle of sight. Yet, despite decades of advancements in sensor technology and artificial intelligence, the visual ability that seems so easy for any human who is not blind is still well beyond the capability of computers.

The hurdle has not been in designing computers to see, that is, to capture light and translate the photons into an electronic pattern. Any $20 webcam can do that. The challenge has been in creating computers that can recognize and understand what it is that they are seeing. In fact, the processing that we do so quickly is an incredible feat for a machine and requires an enormous amount of computing compressed into a tiny sliver of time.

Since computers excel at pattern recognition and iterative processing, scientists once believed that machines were perfectly suited to this task. But, the fit doesn't exist because there is so more to it than simply looking for patterns in the pixels.

For example, beyond simply crunching numbers, machine vision requires the computer to make sense of ambiguous visual data about objects, while separating any movement of those objects from the movement of the observer, or the movement of the other items in the room.

Another problem is the enormous degree of variation in images. That variation has become the Achilles heel of every optical recognition algorithm. Why? Because a computer algorithm looks at an object as a pixel outline. When the object or the observer moves even just a bit, the computer code "sees" it as a totally new thing.

A human can recognize a desktop keyboard, for instance, at any angle and in virtually any light. We also recognize other versions of keyboards, such as ones on smart phones and laptops. On the other hand, recognizing a "phone's keypad" as a type of keyboard is tough enough. But turn the phone to a side view, and the new angle will invariably stump the computer.

This is a significant challenge, because for computers to be useful as stand-alone visual tools or as part of a robotic system, they'll need to recognize objects in a wide variety of lighting conditions, and from the many different angles they will encounter in the real world.

That's not the only challenge. Current algorithms operate by statistically matching the outlines of an object to ones stored in its database. Yet there is still no way make sure that a computer focuses specifically on what it needs to measure when trying to identify an object. For instance, when viewing a picture of a car with a mountain as a backdrop, the computer may zero in on the mountain when it is the car we would like identified.

Another difficult task for computers is perceiving in 3-D, which is something we do effortlessly. We accomplish this by separating an object into segments, such as seeing a hand as a palm and fingers. This way, it does not matter how these segments move relative to each other; we can still see that it's a hand.

Existing computer models can only do this if they know ahead of time how many segments an object has. Needing to have this type of prior information limits the usefulness of the system for general purpose applications.

That brings up an additional challenge that causes computers to fail when applying pattern-matching techniques outside a limited context, like a factory floor. Most methods focus on similarities in shapes, colors, and composition. This can be successful for making exact or very close matches within a limited domain.

But those same methods are typically rendered useless when faced with matching objects in different domains. For example, different domains often involve seemingly minor factors, such as:

• Images collected at different seasons of the year.
• Images viewed under different lighting conditions.
• Images observed in different types of media, such as photographs, color paintings, or black-and-white sketches.

As noted earlier, these domain differences seldom cause problems for human observers. But so far, computers are not capable of comparing similar objects in different domains.

Fortunately, technological advances are slowly addressing these challenges, moving computers closer to the point where robotic systems will be able to "look at" the world around them and know what's going on.

One recent advance is a neural network that mimics key visual functions of the human brain.¹ Neuroscientists and cognitive scientists studied the visual systems of advanced mammals, primates, and humans. Their findings were then incorporated into neural networks and used to refine mobile robots that were created by a team of computer scientists and roboticists. The goal of this collaboration was to devise a system that a robot could use to move quickly and safely through a crowded room.

The scientists tracked how different areas of the human brain interacted as people performed tasks, hoping to understand how our visual system scans our environment, detecting objects and discerning between the movement of objects and our own movement. They used this as a model to build a network with three levels that mimic the brain's primary, mid-level, and higher-level visual subsystems.

Early results have been promising, with a robot making very controlled and deliberate movements toward specific objects, all directed by the neural network rather than pre-programming.

Another research team is working on a new approach designed to help robots identify objects, which they can then manipulate.² The core of this research involves "machine learning," where a computer is programmed to observe events and generalize based on commonalities in what it sees.

For example, it might start by observing a wide variety of cups to determine what they have in common. It is subsequently able to identify new cups it sees based on characteristics shared in common with the observed cups.

Another feature of the machine learning system is the ability to discern the presence of objects through their contextual relationships.³ Using this capability, a computer might rapidly and reliably identify a keyboard, regardless of the lighting and angle of vision, by recognizing that the keyboard is located under a computer monitor.

To address the difficulties computers have in perceiving three-dimensional shapes, two novel techniques have been developed. They are called "heat mapping" and "heat distribution."

Both techniques use principles borrowed from physics and involve mathematical equations that relate to how heat diffuses over surfaces. These techniques capitalize on the fact that heat captures the precise contours of a shape when it diffuses over it.

For example, when a computer employs heat mapping, it breaks the object it "sees" into a mesh of triangles, and then calculates the flow of heat over the object. These calculations generate a signature called a histogram, which enables the computer to recognize the object regardless of its configuration.

In light of this trend, we offer the following three forecasts:

First, over the next 5 to 10 years, the slow but steady progress in improving computer vision will lead to a wide range of practical applications.

One of the earliest and most common uses will be to simplify searches for images. Finding information about an object based on its appearance rather than a textual description will become as easy as snapping a picture and then waiting for the results. Facial recognition software will also enable someone to take a picture of a stranger on the street and match his or her face to a database of images and even being led to that person's profile on Facebook.

Second, improved machine vision will enhance robots' ability to navigate, which will increase their value for use in dangerous and hard-to-reach locations.

This improved perceptual ability will also make them useful and reliable in assisted-living situations where they will be used to perform basic tasks for the disabled or elderly.

Third, within 15 years, three-dimensional machine recognition will open the doors for unique and beneficial applications.

3D search engines will aid in finding mechanical parts in online databases. Medical imaging will be greatly enhanced in 3D, as will multimedia gaming, the use of military drones, and animating characters for movies. This 3D image recognition capability will also help in science and engineering applications where recognizing patterns is required.

While many analysts bemoan the decline of the middle class, the reality is that the middle class isn't declining any more than the poor or the affluent.

As highlighted in our profile of the so-called "class affluent,"¹ medium-term trends have made it harder for the "working affluent" — including business owners, managers, lawyers, and physicians — to make the leap beyond a household income of $200,000.

Even more stressful, many of the formerly-affluent have fallen below the $100,000 per year mark. And even those making between $200,000 and $1 million a year often find themselves squeezed by the overhead of multiple houses and other luxuries that once seemed like necessities. That's why you'll often see them shopping at Sam's and Costco rather than Nordstrom and Whole Foods.

At the other end of the spectrum, poor Americans increasingly compete with the long-term unemployed segment of the middle class for charitable services and part-time seasonal jobs. But, because of the social safety net, their lives have changed less than those of others in society.

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The middle class gets lots of attention because it is such a large group, representing about 70 percent of the population. Furthermore, many of those who are now either affluent or poor still identify with it because that's where they started out.

More importantly, middle-class Americans have suffered not only falling home values, unemployment, and wage cuts, but they've also been shocked by the perception that "the rules have changed."

Since World War II, the American middle class has been the "locus of stability and certainty." There was an unwritten promise that those who graduated from high school, obeyed the law, and avoided risky personal behaviors would land in secure jobs paying enough to fund a comfortable home, one or more automobiles per adult, and annual vacations. Job benefits usually included health insurance and retirement benefits that supplemented the government's Social Security and Medicare promises.

However, the rise of globalization in the '90s put an end to that guarantee. With instant online access to literate workers in China, India, Taiwan, and other countries who were paid a fraction of what Americans were used to earning, many Americans found it hard to compete.

Today, most of the jobs that can be cost-effectively performed in Asia or Latin America have moved there, shrinking the pool of jobs that middle-class Americans are qualified to perform. Meanwhile, those American companies that have kept jobs in the U.S. have been able to do so only by dramatically increasing their technological sophistication; that's why American manufacturers now produce more goods than in 1980 with a fraction of the workforce. Even more important, semi-skilled jobs, once filled by "lower-middle-class" Americans, are frequently held by illegal immigrants.

For the middle class, the key to medium-term prosperity and security is to equip oneself with skills needed for promising careers and not waste time trying to enter or re-enter dead-end occupations. This is especially important because illiquidity in the housing market makes it nearly impossible for middle-class Americans with families to relocate to where the opportunities are.

As older industries and professions fade, many in the middle class will face hardship, as did the milk man, the telegraph operator, the stagecoach driver, and the switchboard operator in the past. The challenge will be to prepare those who are in the middle class, and those who are moving into the middle class, for the coming changes.

That raises the question, "What are the promising careers and which are the dead-end occupations?"² According to the Bureau of Labor Statistics, between now and 2018, manufacturing will lose 1.2 million jobs, mining and oil/gas extraction will lose 104,000, and utility companies will lose 59,000.

Don't believe it! These forecasts are based on an extrapolation of the recent past. As explained previously, the United States is on the verge of becoming a net energy exporter. As a result, we foresee a 20 percent rise in energy and utility employment by 2018.

At the same time, competitive realities have laid the groundwork for a resurgence in high-value manufacturing. The job losses we've seen in manufacturing have to do with the lag in replacing low-value work that can be easily outsourced to Asia or Latin America with high-value work that still makes sense to perform in the U.S.

For example, the U.S. manufacturing sector has transitioned from making simple household appliances, cars, and textiles to producing cutting-edge medical technologies, life-saving medicines, and top-end computer processors that enjoy a global demand. So, while manufacturing will continue to hemorrhage semi-skilled jobs, it will see a boom in high-skilled, high-wage employment. Coupled with economic growth, this should lead to little, if any, net change in manufacturing employment.

Based on this trend, please consider the following three forecasts:

First, because of dramatic advances in technologies and predictable shifts in demographics, the demand for workers in many jobs that are now held by the middle class will shrink.³

However, even within some of those job categories, the news isn't quite as bad when you take a look deeper into demographic trends.

• Machinist positions will decline as a result of the waning manufacturing industry, coupled with improvements in machine tools, auto-loaders, and high-speed machining centers. But the expected 5 percent decline will be more than offset by the retirement of machinists from the Baby Boom generation. That means companies will hire plenty of young machinists who are ready to operate the new, highly automated machining centers.
• First-Line Supervisors and Managers of Production and Operating Workers will also fall victim to increases in automation and gains in productivity. As with machinists, the heavy preponderance of Boomers in supervisory jobs means that the expected 5 percent decline in positions will be more than offset by retirements.
• Farmers and Ranchers stand to lose 8 percent of their jobs by 2018. This is actually a continuation of the decline due to improved productivity and increased food yields thanks to advancements in fertilizer and technology.
• Computer Operators will see a drop in job opportunities by 19 percent. The rise of "the cloud" means that a few operators in enormous server farms will replace duplicative personnel running in-house data centers.
• The paper goods industry will see a 22 percent decline in positions. Those who install, operate, and repair machines that make paper products will feel the shift away from paper media to electronic. The continued trend toward recycling will also contribute to a drop in jobs in this category.

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• Desktop Publishers are being replaced by general-purpose office workers who are becoming proficient in basic desktop publishing skills. Jobs lost by 2018 will be 23 percent.
• Jobs for Fabric and Apparel Pattern-Makers will fall victim to advancements in textile manufacturing technology that are enabling fewer workers to generate more output. Combined with stiff competition from foreign textile manufacturers, this will cut jobs by 27 percent and cause a significant drop in wages of 48 percent.

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• Well Pumpers will also see a 28 percent drop in jobs. These workers extract oil or gas from the fields. Demand for these positions is declining because of increased productivity and an increase in the use of automated storage and retrieval systems. However, this will be more than offset by growth in other parts of the energy supply chain.

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• Postal Service Employees will find many of their jobs replaced by new automated equipment. As a result, there will be a reduction of 30 percent in these jobs.
• Semiconductor Processor jobs will decrease by 32 percent. As the size of components continues to shrink, it is becoming too difficult for humans to interact with them during production. Instead, machines will increasingly take over this job.

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Second, the convergence of trends in demography and technology are also increasing the demand for workers in several other categories.

The Bureau of Labor Statistics estimates the U.S. will add 15.3 million new jobs between 2008 and 2018, with half of those projected openings paying above the national median wage.⁴ The Trends editors believe that these estimates are extremely conservative if people have the skills needed to fill them. Here are some examples:

• Carpenters, one of the hardest-hit occupations of the past five years, will see employment opportunities through 2018. A wave of older carpenters will be retiring just as home construction reverts to the long-term trend line. Once today's excess inventories are worked off, demolition and population growth will require new construction to triple from current levels. At the same time, the demand for new, energy-efficient buildings will increase. As a result, expect nearly 170,000 new job openings for carpenters by 2018.
• There will be at least 175,000 new openings for Computer Software Engineers by 2018. These professionals will be needed to develop applications and system programs for use by businesses and governments.
• Management Analysts and Consultants who help organizations increase efficiency through improved operations will grow by about 200,000. Few companies can justify the in-house resources needed to optimize their strategies, processes, and personal development capabilities. Consultants are the obvious solution.
• Contrary to what people used to believe, Executive Secretaries and Administrative Assistants are not going away. To make the most of the time and talents of top professionals and executives, companies need the communications and organizational skills these key support people offer. Consequently, these jobs are projected to grow by over 200,000.
• Bookkeeping, Accounting, and Auditing Clerks are also expected to increase their numbers by over 200,000. These openings will be created by workers moving up or retiring, as well as by growth in the economy.
• Almost 250,000 big-rig Truck Drivers will be needed by 2018 to move additional goods needed by a growing economy. This number would be higher if not for the more efficient use of rail, maritime, and air shipments.

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• The Bureau of Labor Statistics expects the economy to add about 250,000 new openings for Elementary School Teachers by 2018. However, this is almost entirely due to current teachers who will be retiring. The Trends editors expect this to be a peak, followed by a steep decline due to the introduction of interactive learning technologies and cost pressures brought about by "school choice." Those who jump on this bandwagon may be sorry.
• On the other hand, Post-Secondary Teachers will benefit from nearly 260,000 job openings by 2018, as many of the unemployed return to school at the same time many Baby Boomers are retiring from post-secondary teaching positions. However, those seeking such positions should expect to demonstrate genuine teaching prowess coupled with a true mastery of their subject areas.

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• By 2018, there will be nearly 300,000 openings for Accountants and Auditors needed to fill new positions created by new businesses in a growing economy.
• There will be about 600,000 openings for Registered Nurses in the U.S. by 2018. This demand will be driven by the sheer size of the aging Baby Boomer population, coupled with the push for more preventative care and better access to healthcare.

Third, the solution to the unprecedented mismatch between available job skills and job requirements will demand a new approach to education.

One problem is that too few college and vocational students are choosing fields of study that match the current job demands. A recent survey of companies by the McKinsey Global Institute⁵ revealed that, even at a time of 10 percent unemployment, two-thirds of businesses can't find qualified applicants for open positions. Managers, scientists, and computer engineers were at the top of the list. Another problem is the rapidly rising cost of college tuition. As a result, expect the number of students attending college remotely to increase dramatically. An online degree will be the only option for many, but it will lose any stigma it had of being inferior, especially to employers. Students will have access to some of the top educators across the country, and they will target their learning specifically to the jobs they are pursuing. Through online learning, the next generation of middle-class employees will have the potential to be better educated and better prepared than this one.

Any discussion about climate change should be framed by two questions. First, is global warming actually happening? And, if so, is it the result of human activity?

To date, neither of these questions has a conclusive answer. Yet, companies are being forced to comply with costly, productivity-robbing regulations handed down by an overly powerful Environmental Protection Agency as if these issues had been settled. Worse yet, the solutions themselves have never undergone rigorous cost-benefit analysis and they are, for the most part, based on totally outdated approaches to dealing with the problem.

Despite decades of research, there are varying opinions on whether global warming is, in fact, taking place, as well as the extent of the warming. And, a growing number of experts are beginning to acknowledge this reality.

A paper recently published by Dr. Nigel Fox of The National Physical Laboratory, the UK's National Measurement Institution, explains the weakness in relying on complex measurements to understand climate change and basing forecasts on them.¹ These measurements include ice cover, cloud cover, sea levels and temperature, chlorophyll levels, and the radiation balance of energy entering and leaving the Earth.

For the purpose of forecasting, these measurements need to be taken from space and they need to be made over long time periods. These constraints face two major problems. The time scales needed are beyond the life of the typical space mission, and at launch, instruments, particularly optical ones, typically lose their calibrations and then drift further during their time in space. Fox does not doubt that there is climate change, but he believes the speed of this change is unclear and is currently not measurable.

At present, the best research seems to indicate that global temperatures have risen 0.5 degree Celsius since 1979. While it seems reasonable to accept this historical result, it's a lot harder to get people to agree on any climate change forecasts.

Because of this inherent limitation of precise measurement of any change, predictions vary wildly about how quickly — or even if — temperatures will rise. Estimates range from less than 2 degrees Celsius to 10 degrees Celsius by the year 2100. That's a big uncertainty on which to base expensive solutions today.

If the historical evidence and forecasts about global warming are unclear, the question of human involvement is even murkier. The centerpiece of the argument for human-caused warming, known as Anthropogenic Climate Change, is that we are causing an increase in the amount of airborne carbon dioxide. This increase is then creating a "greenhouse effect," which is causing global warming. Most climate models not only assume this speculation to be a fact, they also assume that airborne carbon dioxide will increase because of our activity. Predictions of future changes are based on these assumptions.

In 2009, Wolfgang Knorr of the Department of Earth Sciences at the University of Bristol conducted research to determine if the airborne fraction of carbon dioxide was indeed increasing. He reanalyzed atmospheric carbon dioxide and emissions data available since 1850, taking into account the uncertainties of the data. He concluded that there has been no increase in the airborne fraction of carbon dioxide over the past 150 years — not even in the most recent 50.

How can this be? Knorr concluded that the bulk of the carbon dioxide released through human activity does not stay in the atmosphere. Instead it is absorbed by the oceans and terrestrial ecosystems. This means it is improbable that man is responsible for global warming.

For those who have long bought into the theory of Anthropogenic Climate Change, many seem to have a hard time accepting that it might not be true — as if there could be no other explanation for warming.

The truth is, the Earth's climate is quite capable of very rapid transitions and has been making them since long before man began driving cars and burning fossil fuel. An international team of scientists, led by Dr. Stephen Barker of Cardiff University has offered evidence of this through the study of drill cores taken from Greenland's vast ice sheets. According to the research, which was published in the September 2011 issue of the journal Science,² abrupt climate change has been a recurring feature of the Earth's climate for thousands of years.

Studies, such as the one from Cardiff University, provide strong evidence that there are indeed factors beyond human activity that explain climate change.

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In spite of the lack of concrete evidence of human-caused global warming, a general perception remains that it's a real problem well-supported by "settled science." Alone, this perception would not in itself be destructive, especially since there is some chance that it's actually true. However, when this perception becomes a de facto "article of faith" enforced by a powerful government agency, namely the EPA, the negative effects on our economy can be profound.

That's particularly true when the economic drag undermines society's ability to ameliorate the consequences of climate change, regardless of its cause.

Today, this agency is reaching way beyond its original charter to assess and manage the risks posed by pollutants. It is expanding its power to regulate businesses, communities, and ecosystems in the name of "sustainable development."³

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The agency takes its cue from the Obama administration, which defines sustainability as the ability "to create and maintain conditions, under which humans and nature can exist in productive harmony, that permit fulfilling the social, economic, and other requirements of present and future generations."

In a recent study put out by the EPA, it is stated that sustainable development "raises questions that are not fully or directly addressed in U.S. law or policy." Among them: "how to define and control unsustainable patterns of production and consumption and how to encourage the development of sustainable communities, biodiversity protection, clean energy, environmentally sustainable economic development, and climate change controls."

In its rationale for making and enforcing policy not fully addressed by U.S. law, the agency has claimed legal authority to foster sustainable development in the wording of the National Environmental Policy Act of 1969, all without further Congressional approval.

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So the EPA, under the guise of creating conditions where humans and nature can exist in productive harmony, has been forcing unneeded and costly solutions on American industry.

In the face of possible warming for which there is a lack of evidence that man is a causal agent, implementing policies that put the brakes on our economy is a response that is totally irrational and irresponsible.

A more helpful and productive response is to focus on adaptation.⁴ The Earth has experienced rapid natural climate transitions many times before, and it is quite possible this is what's happening now. Furthermore, regardless of whether the cause is human-based or not, stopping it is likely cost-prohibitive and even counter-productive. Therefore, a growing number of experts are recognizing that adaptation is the wisest strategy.

That's why outmoded thinking by slow-thinking bureaucrats is so dangerous. Consider, for example, the assertion that global warming will cause a 7 percent decrease in crop yields in the developing world in the coming century. The knee-jerk reaction of bureaucrats is to minimize fossil fuel use, which would then cripple the economic development of these countries and doom their citizens to continued poverty.

The obvious alternative is to develop technologies that will increase overall yields in spite of climate change — and this is exactly what will happen if the Luddite regulators will simply get out of the way. The best estimates indicate that world food production will increase by 270 percent by 2100. Nothing could be more foolish than jeopardizing this 270 percent growth by restricting fossil fuel usage in the hopes of avoiding a 7 percent decrease in yield. Yet the UN and the EPA think that this makes perfect sense.

An example of the type of adaptation that offers a real solution is drought-tolerant crops. These crops are being developed for regions where climate change might reduce precipitation. Sean Cutler, an associate professor of plant cell biology at the University of California, and his team have been working to develop such plants.⁵ They've discovered that a plant activates a set of protein molecules called receptors when it encounters drought. This reaction helps it cope by closing guard cells on leaves to reduce water loss and temporarily stops plant growth to reduce water consumption. The team has discovered a way to rewire a plant's cellular machinery to increase this stress response. This discovery is being used to create crops that can thrive under drought conditions, actually increasing yields.

Other research is being conducted to produce crops that can better cope with sudden changes in weather conditions.⁶ This solution will avert any problems that might arise if climate changes alter weather patterns in what are now the world's prime growing areas.

Another discovery may actually provide a cost-effective way to deal with global warming by directly removing carbon dioxide from the atmosphere.⁷ It's a bowl-shaped molecule that could be genetically engineered into CO₂ catching microbes. Widespread production of these molecules by the microbes could be quite useful as an industrial-scale absorbent for removing carbon dioxide.

This is just the beginning. As we've explained previously in Trends, the upcoming phase of the Fifth Techno-Economic Revolution, playing out by 2030, will provide cost-effective solutions to hunger, poverty, and disease that will make adapting to natural or man-made climate change almost trivial. In fact, technology is developing so briskly in the fields of nanotech and biotech that the worst decision possible is to let bureaucrats undercut economic growth, forcing us to rely on expensive solutions from the previous century.

Considering this trend, we provide the three forecasts that follow:

First, consumer and business frustration with the EPA is likely to lead to its demise in the coming years.

Voters are already approaching the tipping point where they will say enough is enough; environmental regulations that don't pass the cost/benefit test must go. This will be especially true the longer the economic recovery continues to lag, and regulations are increasingly seen for what they are: job killers. Depending on who wins the presidency in 2012, this demise could come sooner rather than later.

Second, the longer the argument for man-made global warming goes on without irrefutable proof, the stronger the "adaptation-only" case will become.

The consensus is slowly, but surely, growing that Anthropogenic Climate Change was simply another product of "apocalyptic fantasy" like the "population bomb" and "depletion of the world's oil supply in the 20^th century." As adaptation is embraced, we'll see solutions emerge that are job and business creators, in contrast to attacks on business masquerading as environmental solutions. Rather than being a drag on the economy, these adaptation solutions will provide an economic stimulus, in addition to dealing with any potential effects of higher global temperatures.

Third, every country will need to assess how prepared it is for adaptation — and then take action.

Fortunately, a research organization is already focusing on this issue. The Global Adaptation Institute, with former World Bank Managing Director Juan Jose Daboub at the helm, issues the Global Adaptation Index to depict how vulnerable countries are to global warming and how prepared they are to respond to it. As Bjorn Lomborg, Copenhagen Business School professor and author of The Skeptical Environmentalist,⁸ points out, "The first step in focusing on adaptation is measuring it. . . . The challenge lies not merely in reducing vulnerability but also in getting the structures in place so governments and investors can tackle adaptation in the most effective manner possible. The good news is we can improve lives today while building the crucial infrastructure needed for tomorrow. . . . If our concern is with saving lives and helping the planet's most vulnerable populations, then we need to focus first on how we can build more resilient, adaptable communities."⁹

Ask the average person on the street if most of the oil used in the U.S. is domestic or imported, and the answer will most likely be "imported." Ask where most of the imported oil comes from, and the answer will most likely be "from the Middle East."

Both of these answers would be wrong — and moving forward, they will be increasingly wrong.¹

It is true that by 2005, when the U.S. reached a peak in petroleum imports, those imports represented a majority of our usage, but even at the peak, the share was 60 percent, not as high as most people believe — and, it has since dropped to 46 percent.

Of these imports, many would be further surprised to learn that only 16 percent comes from the Persian Gulf. The largest foreign supplier, at 25 percent and growing, is Canada. Consequently, North America is quickly moving toward energy independence.

Two factors are causing this enormously important shift:

• The first factor is a drop in the demand for petroleum. Part of this drop is unambiguously good news: We're using substantially less energy for every dollar of GDP we generate. As vehicle fuel economy continues to rise, this efficiency will continue to improve.
• The second reason for the drop in demand is not such good news. The prolonged downturn in the economy has caused a sizable
  reduction in demand.

But more important than the decreasing demand is the rapidly accelerating rise in domestic production of energy. Petroleum production, for instance, has risen by 18 percent since 2008, despite government regulations that have impeded new oil production.

In fact, the increased production is not from oil that was recently discovered under the United States and its territorial waters. We've known for decades that it's been there. However, government restrictions have prevented their development.

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These restrictions have been kept politically viable by confusing the definitions of certain terms. For instance, Senate majority leader Harry Reid and others have argued that "Since the U.S. has only 3 percent of the world's oil reserves but uses 25 percent of its oil production, it is pointless to develop these reserves." Instead, it is argued, "The available energy development dollars should go into renewable energy sources like wind and solar."

In this argument, politicians use terms with specific legal definitions to mislead the general public. The term "reserves" refers to a country's proven and economically available energy supplies. "Resources" refer to the much larger, untapped supply, which represents a country's potential energy.

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The untapped resources of North America dwarf those of the nations of the rest of the world combined. Our energy shortages, crises, and insecurities have never been the result of a scarcity of resources, but rather a surplus of bad government policies, as well as a lag in the technologies needed for extracting that energy cost-effectively.

What has changed in the last decade is the commercial availability of innovations that let us harvest these previously untapped resources at competitive prices. Fortunately for the future of America, these technologies are already being applied to private and state lands, which are under limited Federal government control. Therefore, the innovations are not being stifled and greater energy production is already in North America's future.

North American Oil V. World’s Oil

One of these new technologies extracts what is called "tight oil." That is oil that is trapped in dense rocks. Without the latest technology, extracting this oil would not be economically viable. In 2000, output from this source was about 200,000 barrels a day. Today, it has risen to 1 million per day, and by the end of the decade, it is expected to exceed 3 million barrels a day. That is equivalent to over half of our current domestic crude oil production.

The process of extracting this tight oil is called "fracking."² It involves drilling a seamless horizontal pipe thousands of feet into underground shale deposits that contain both oil and natural gas. Water and chemicals are pumped through the pipe, breaking up the shale. Then, when the water is withdrawn, the oil and natural gas come out as well.

The potential for using this method for tapping natural gas resources is especially huge. As oil analyst Phil Flynn of PFGBest puts it, "We're the Saudi Arabia of natural gas. This single-handedly can change the U.S. economy." The biggest barrier to fully and quickly unleashing this research is the concern raised by some environmentalists about the safety of the chemicals used in the process; however, when all is said and done, Trends predicts that fracking-related health problems will prove illusory.

Another promising North American energy source is our nearly inexhaustible supply of coal. Burning coal to produce electricity directly is a relatively dirty proposition. However, using coal-derived methanol to power electric vehicles via state-of-the-art fuel cells is both super-clean and super-efficient.

Fuel cells have been around for decades; they generate electricity quite efficiently; they have no moving parts to wear out; and they produce virtually no pollution. But, until now, they've been expensive and they generally worked well only when burning hard-to-store, hard-to-transport hydrogen fuel.

The big hurdles to fixing the problem surround the high-priced catalyst that makes the process fast enough for practical applications. But recently, a new metal nanoparticle catalyst has been developed that will permit the use of 60 percent less catalyst material. It will also permit the replacement of very costly platinum metal with much less expensive palladium.³

North American Natural Gas V. World’s Natural Gas

At the same time, clean and efficient processes for manufacturing methanol from coal are being scaled-up for commercial use.⁴ Once past this hurdle, these fuel cells can combine the use of low cost, easy-to-store, coal-derived methanol with the elimination of heavy and expensive storage batteries. Best of all, methanol can be stored, transported and delivered to consumer vehicles using the same kind of equipment and procedures now used for gasoline.

So that leaves us with the inevitable question: "How large are our resources?" This is where the government's own reports paint a very positive picture. The United States has by far the largest combined "resource" of recoverable petroleum, natural gas, and coal of any country on Earth.⁵

• Estimates put our current natural gas reserves at 272.5 trillion cubic feet. But, total recoverable resources are over 4 quadrillion cubic feet. That means that at our current rate of consumption, we have enough resources to last 175 years — and the North American supply of this valuable resource dwarfs that of all other regions combined.
• Recoverable petroleum in the United States is estimated to be more than 1.4
  trillion barrels. Adding resources from Canada and Mexico, the North American figure jumps to over 1.7 trillion barrels. To put this number into context, it is more oil than the whole world has used since the first oil well was drilled over 150 years ago. It's also roughly seven times the 260 billion barrels of oil in Saudi Arabia's proven reserves. At our current rate of oil consumption, this supply would meet all of our needs for around 250 years.
• As impressive as our oil and gas resources are, they pale in comparison to our coal resources. North America has over 497 billion short tons. This is larger than the combined non-North American resources, which are found in Russia, China, Australia, India, and Germany. At our current rate of consumption, these resources could provide enough electricity for the U.S. for about 500 years.

North American Coal V. World’s Coal

Some may argue that these supply predictions are overly optimistic. However, a look at the history of predictions shows they always tend to be low. In 1980, for example, it was estimated that the U.S. had about 30 billion barrels of proven oil reserves. From 1980 through 2010, however, 77 billion barrels of oil were produced in the U.S.

The fact that we're able to produce more than 250 percent of our total estimated reserves is not due to a bad estimate, but rather, the result of innovations in exploration and production technology. Today's estimates are based on today's technologies. Knowing there will be future advances, we can safely assume that today's projections are a fraction of what will be produced.

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The benefits of America relying on its own home-grown energy solutions are undeniable. They include:

1. Job creation in energy-related industries
2. Indirect job creation across the broader economy
3. Greater national security
4. A favorable impact on global energy prices

First, and perhaps foremost, it means jobs will be created directly in energy-related industries. North Dakota, along with Ohio, Pennsylvania and West Virginia are already experiencing this benefit.⁶ North Dakota currently has the lowest unemployment rate in the nation at 3.5 percent, thanks to a shale oil boom. In Pennsylvania, this boom has already produced 72,000 new jobs since 2009. And the supply chain of goods needed for this new oil and gas extraction process is generating manufacturing jobs outside oil fields in states such as Ohio and California.

Second, the production of domestic energy products will indirectly contribute to job creation across the broader economy. When dollars flow out of the country to buy oil, but do not flow back in to buy U.S. goods, there is a loss of demand that could otherwise be creating American jobs.

Right now, even though imported oil has dropped from its peak, there are still a lot of dollars flowing out that will only return as loans to fund the purchase of more imports. On the other hand, domestic production of the energy we need will keep those dollars circulating in our economy as wages and dividends.

Real GDP per Unit of Energy Has Improved Drastically

Energy Industry Wages Are Among the Highest

Another key benefit of expanding domestic energy supplies is greater national security. It stands to reason that domestic oil supplies, plus oil from friendly nearby countries such as Canada and Mexico, will be much more reliable, especially in times of global crisis. Not being so dependent on hostile and unstable countries will give us much more flexibility in the midst of any crisis. The recent Iranian threat to close the Strait of Hormuz underscores this point.

A fourth benefit of transforming North America from an energy importer into a leading energy exporter would be its favorable impact on global energy prices. A significant factor limiting economic growth in recent years is the proportion of global wealth absorbed by energy exporters. An overall rise in supply could bring the price of oil down sharply. This would not only be a boon to developing nations like India and Taiwan that promise to be the main engine of 21^st century growth, but it would also help the United States minimize inflation.

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Considering this trend, we offer the following four forecasts for your consideration:

Oil Price Spikes Preceded Every Recession Since 1970

First, the United States will become a net exporter of energy by 2025, if not sooner.

Even though oil imports have dropped, they still contribute significantly to our trade deficit, countering gains in other exports we made in 2011. An 8 million barrel per day decrease in U.S. oil imports would eliminate nearly all of our growth-sapping trade deficit. This could readily be achieved by increasing our domestic oil production and replacing foreign oil with domestic natural gas and methanol made from domestic coal.

Second, shifting to home-grown energy will give the United States effective control of world energy prices.

The U.S. is the world's leading consumer of energy. But imports put Americans at the mercy of outside forces. Since energy is a fundamental driver of our economy, that lack of control touches every aspect of our lives. As North America begins providing for its total energy needs, our costs will be based primarily on readily predictable factors impacting the U.S., Canada, and to a lesser extent Mexico. By eliminating a major source of uncertainty, this will serve as a huge boon to the rebuilding of American industry.

Third, the rapid expansion of the domestic energy sector will create high-paying jobs for both blue-collar and white-collar employees.

As domestic energy production increases, we'll see a rapid rise in relatively high paying jobs. These higher wages will have a multiplier effect in the communities where the jobs are located. We're seeing it already; a recent HIS Global Insight study determined that "shale gas" has already provided over 600,000 jobs in the Midwest. In Ohio alone, the Youngstown Warren Regional Chamber of Commerce estimates that the shale oil industry will ultimately create over 400,000 jobs — and every one of these high-paying jobs will be funded by money that didn't flow to a foreign economy.

Fourth, energy independence gained from domestic energy production will decouple U.S. foreign policy from short-term energy concerns.

Offshore Areas

Because of our current dependence on foreign oil, our view of global events and how we must react to them is always filtered through the prism of short-term national energy interests. This has led to costly and reluctant support of nations engaged in undesirable activity. By freeing ourselves from this bondage, our foreign policy decisions can better reflect American ideals without fear of negative economic impact. Most significantly, we could reduce our role in the Middle East and pass that responsibility on to other countries that will still be foreign-oil dependent, such as China and Japan.

1. The Wall Street Journal, December 12, 2011, “America's New Energy Security," by Daniel Yergin.  © Copyright 2011 by Dow Jones & Company, Inc.  All rights reserved.  http://online.wsj.com
2. FoxNews.com, December 27, 2011, “Shale Oil in America: Economy Fix or Dangerous Fantasy?" by Ruth Ravve.  © Copyright 2011 by Fox News Network, LLC.  All rights reserved. http://www.foxnews.com
3. The Journal of Physical Chemistry C, November 24, 2011, Vol. 115, Iss. 46, "Atomic Layer Deposition Preparation of Pd Nanoparticles on a Porous Carbon Support for Alcohol Oxidation," by Emma Rikkinen, et al.  © Copyright 2011 by the American Chemical Society.  All rights reserved. http://pubs.acs.org
4. You can access the study "Coal-to-Methanol Conversion" by visiting the University of California-San Diego website at: http://maecourses.ucsd.edu
5. You can access the study "North American Energy Inventory" by visiting the Energy for America website at: http://energyforamerica.org
6. The Wall Street Journal, December 12, 2011, “America's New Energy Security," by Daniel Yergin.  © Copyright 2011 by Dow Jones & Company, Inc.  All rights reserved.  http://online.wsj.com

Our economy has been staggering under the dual burdens of paying the growing direct costs of supporting the welfare state, as well as the indirect costs of its intervention in the economy.

On one hand, massive government spending programs have taken money out of the private sector, depriving the "invisible hand of the free market" of its full potential to create jobs and fuel a robust economy. The growth of these programs since the official beginning of the recession in December 2007 has been breathtaking.¹

The number of economically significant rules (costing more than $100 millino a year) in the prerule, proposed or final stages, published each fall and spring in the Unified Agenda

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• The number of Americans now on Medicaid jumped to 50 million since December 2007, a rise of 17 percent.
• Food-stamp recipients rose to more than 40 million, an increase of nearly 50 percent.
• During this same time, those receiving unemployment insurance grew by nearly four times, now approaching 10 million.
• The original unemployment insurance benefit of 26 weeks has been extended eight times, now providing 99 weeks of benefits to the long-term unemployed.
• One in six Americans is now served by government anti-poverty programs.

Of course, the cost to fund these programs has risen to meet the demands of these expanded programs. Consider:

• The cost of Medicaid rose 36 percent in twoyears to $273 billion.
• The cost of providing food stamps has jumped 80 percent to $70 billion.
• Jobless benefits have sky-rocketed from $43 billion to $160 billion.

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The important thing to remember is that welfare state programs give people money to do nothing. If those same resources were being paid to the same people to do productive work in the market economy, they would be creating economic value. So, whether these programs are funded from taxes, borrowing, or printing money, it is money that is not available to the market to create real, economy-growing jobs.

There is a ray of hope, however, for this drain on the economy. It now appears that attitudes are shifting away from this destructive welfare spending, both in the U.S. and abroad. Voters are increasingly rebelling against spending policies that are choking economies and in the long run, doing more harm than good to the people they are intending to help.

However, this still leaves us with the second burden of public-sector value destruction: government regulations.

• According to the Small Business Administration, the costs to comply with regulations rose to $1.75 trillion in 2010, the latest year for which we have full data.²
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  Government Share (spending + regulatory compliance cost) of Economy vs. Private Sector’s Shares

  That amounts to 12 percent of the U.S. gross domestic product, estimated at $14.6 trillion in 2010.

• Combining regulatory costs with federal outlays of $3.5 trillion in 2010 reveals that the Federal government's share of the entire economy is now 36 percent.

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To get an idea of just how overwhelming regulations have become, consider just a few facts drawn from the latest edition of "Ten Thousand Commandments: An Annual Snapshot of the Federal Regulatory State."³ As this report explains:

• The Federal Register stands at an all-time record high of 81,405 pages.
• In 2010, federal agencies issued 3,573 final rules. That's about 16 times the number of laws passed by Congress and signed by the president. That means that enormous "law-making power" has been delegated to unelected agency bureaucrats.
• Notably, this is a situation that's getting worse very quickly as proposed rules in the Federal Register surged from 2,044 in 2009 to 2,439 in 2010, a jump of 19.3 percent.
• Admittedly, many of these rules are obscure and will have limited impact. However, of the 4,225 rules now in the regulatory pipeline, 224 are "economically significant," meaning that they will have at least $100 million in economic impact. That's an increase of 22 percent over 2009's 184 "economically significant" rules.
• While the economic impact of corporate taxes gets a lot of attention, regulatory costs, at $1.75 trillion, dwarf corporate income taxes, at just $157 billion. More notably, these regulatory costs are 87 percent higher than 2010 individual income taxes, which totaled $936 billion.

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While pro-business analysts see this state of affairs as disastrous, there are many others who see things differently. Rather than seeking to address the problem, the current administration is doubling down on its pro-regulation, anti-business strategy.

Some of these regulations are merely reversals of rules put in place under the Bush administration, with no clear economic reason given for the change. Other regulatory initiatives arise from the Department of Labor's new enforcement strategy called "Plan, Prevent, Protect."

This three-step strategy is designed to ensure that a company complies with a regulation by creating a plan to fix the problem; implementing the plan to prevent a problem; and ensuring the implementation is actually protecting employees. The chilling aspect of this strategy is that the Department of Labor has the power to determine the effectiveness of a company's plan and any level of noncompliance.

OSHA, for example, is using "Plan, Prevent, Protect" to develop a regulation mandating that companies implement a new safety and health program, called an "Injury and Illness Prevention Program." A "Plan, Prevent, Protect" enforcement strategy is giving OSHA investigators additional power by enabling them to substitute their judgment on how to achieve compliance for a particular employer's plan.

This heavy hand of agency enforcement underscores the truth of Thomas Jefferson's warning that "The natural progress of things is for liberty to yield and government to gain ground."

As the government gains regulatory ground, the negative effect it is having on the economy is profound. For one thing, companies are missing business opportunities because their capital and labor are tied up in unproductive efforts to comply with regulation. Companies are jumping through hoops and filling out forms, having to dedicate scarce resources, which can waste creativity.

But that's not all. Beyond the direct cost of compliance with excessive regulations are the potential costs of increased litigation and payouts of plaintiff damages.

Worst of all, it is putting a clamp on business growth by making companies increasingly risk-averse. The constant threat of even more regulations has created an atmosphere of uncertainty.

According to virtually every business survey, the uncertainty regarding implementation of existing regulations and the future of pending regulations is keeping companies from hiring more people, discouraging them from investing in new plants and equipment, and forcing them to reconsider their plans to launch new products.

An excellent example is seen as uncertainties about the recently enacted Obamacare legislation have made businesses reluctant to take on any more employees than absolutely necessary. For millions of Americans looking for work, the government has created a climate where hiring more workers is an unacceptable choice.

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But, just as the administration has decided to make a stand, business leaders and pro-business politicians are taking a stand on the other side. Recently, a group of CEOs launched an effort called the Job Creators Alliance. Notable members include Brad Anderson, former CEO of Best Buy, and Tom Stemberg, founder of Staples.⁴

The battle between excessive government regulation and free-market wealth creation is part of a broader civil war. This bloodless civil war pits the welfare state and organized labor against entrepreneurs and the free market. It will be the defining conflict of our era, changing our reality to a degree analogous to the Napoleanic Wars, the American Civil War, and World War II.

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In light of this trend, we ask you to consider the following three forecasts:

First, between now and 2017, expect to see the greatest roll-back of regulatory authority in human history.

Pragmatism virtually ensures victory for the private sector, even before the battle begins. As explained previously, demography and human nature make it inevitable that the welfare state comes crashing down. Dramatically reducing the regulatory and tax burdens can enable a controlled restructuring and a soft landing. However, an escalating regulatory burden will only hasten a catastrophic hard landing. This hard landing would precipitate the kind of capital flight from the United States that we're seeing in California and New York.

Second, a key battle will be fought over regulatory sunset legislation with tough cost-benefits review criteria.

Legislation has already been proposed that would automatically sunset all regulations and require a clear cost-benefits analysis prior to any re-authorization. Such legislation could provide the same moral clarity to the current struggle that the Emancipation Proclamation did for the U.S. Civil War.

Third, the unprecedented regulatory roll-back, coupled with sharp reductions in the direct costs of government, will unleash a pent-up boom based on demography, technology, and psychology.

Today, roughly 12 percent of our economy is devoted to regulatory compliance. When combined with the costs of related private litigation and the drag created by the associated risk-aversion, that number grows to at least 20 percent. Eliminating just half of that cost and letting it flow to the bottom line could more than quintuple business earnings. The impact on capital spending and R&D would jump-start entire new industries and reinvigorate existing ones.

Capitalism's great strength is that unfettered competition leads to efficient use of resources, as those who create the most value win — and those who don't create enough sufficient value lose.  The result is the creation of the largest possible economic pie. 

The welfare state was designed to ensure those who could not generate sufficient economic value — due to age, health or other limitations — would not suffer excessively.  As originally formulated, it was not only compassionate but it promoted social stability and served as another mechanism for maintaining power and control.  And for several generations, demography and rapidly rising productivity have enabled the welfare state to operate and greatly expand in scope. 

Annual Federal Welfare Spending 1950 to 2008

Unfortunately, those who have promoted and engineered this system of welfare, and continue to do so today, lack a fundamental understanding of both human nature and the unintended consequences that have arisen from the system.  It is these factors that have made the welfare state unsustainable.

It all started simply enough in Germany in the 1880s with government insurance to cover health, old age, and accidents.  Throughout the 20^th century, wealthy nations created programs to cover education, health care, unemployment insurance, public housing, and income redistribution, all of which were virtually non-existent at the beginning of the century. 

Initially, this growth of government accelerated due to the incorrect perception that the Great Depression was caused by a failure of capitalism and the resulting belief that a broader safety net was needed to offset the problems with a market economy.  Following World War II, communist and socialist politicians were elected in much of Europe, largely because of their perceived role in wartime resistance movements. 

Also during the 1950s and '60s, annual economic growth in Europe's richest countries averaged 4.5 percent, versus a 2.1 percent average growth rate from 1820 to 2010.  Rapid economic growth, coupled with left-leaning governments and a lack of confidence in markets, created the perfect environment for the size of the welfare state to explode. 

Meanwhile, the United States experienced 4 percent average annual growth in the '50s and '60s.  This growth made the policies of "economically liberal" Presidents like Kennedy, Johnson, Nixon, Ford, and Carter seem reasonable.  As a result, welfare programs including Medicare, Medicaid, AFDC, and food stamps proliferated and expanded. 

The bottom line is that Federal payments to individuals increased from 26 percent of government spending in 1960 to 66 percent in 2010.  Even more disturbing was the dramatic rise in government spending as a percentage of national income, both in North America and Europe.

• In 1870, this percentage for the U.S. was only 7.3.  For Britain, it was 9.4.  It was 10 percent for Germany and 12.6 percent for France. 
• However, by 2007, these numbers had risen dramatically to 36.6 percent for the United States, 44.6 percent for Britain, 43.9 percent for Germany, and 52.6 percent for France. 
• Social spending now eclipses military spending as a share of the government budget in all developed Western countries.

Expanding Safety Net

And that increase comes despite brief periods of success in reversing the growth in spending.  Notably, from 1980 to 1990, the share of government spending in the UK fell four percentage points under Margaret Thatcher.  Similarly, Ronald Reagan was able to halt the growing trend in U.S. non-defense spending over that same period.

Why does this matter so much? 

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Historically, there has been a strong negative correlation between economic performance, as measured by real GDP per capita, and the share of GDP devoted to government spending.  That is, the higher the spending, the less affluent the country. 

To see this pattern in action, let's examine long-term results for France, Great Britain, the United States, and Canada.  Among the four economies, France leads in government spending per capita, followed by the UK, then Canada, and finally the U.S.  Ranking these same countries by real per capita income reverses the order, with the U.S. about 22 percent higher than Canada, 31 percent higher than Great Britain, and 40 percent higher than France.¹ 

This pattern has unfolded consistently.  From 1980 until the present, government spending as a share of GDP increased in France, but remained largely stable in the U.S., that is, until 2008.  During this same time, the U.S. economic performance advantage over France grew from 25 percent to 40 percent.  This shift represents the loss of an entire generation of economic progress in France and should serve as a warning for leaders who believe redistributive government programs actually make people better off.  Similarly, reductions in Canadian government spending have made Canada far more competitive in recent years.

Unfortunately, this warning has gone unheeded, and increased welfare spending has created bloated governments that have become too large to be supported, leading to a growing crisis.  This economic axiom was pointedly summed up years ago by Margaret Thatcher in her remark that "Socialist governments eventually run out of other peoples' money."

The only way to sustain a welfare state is with favorable economics and demographics.  Social benefits can only be maintained through rapid growth in an economy and growth in younger populations that support the aging.  In Europe and the U.S., both of these factors, which had been robust in the '50s and '60s, have since stalled.

Fiscal Snapshot

In Europe, economic growth from 1973 to 2000 reverted to the historical rate of 2.1 percent; however, welfare commitments were predicated on the growth remaining at its high of 4.5 percent.  The same is true for the U.S., where growth has reverted to around 2.4 percent.

Just as significantly, changing demographics simply will not support existing welfare structures.²  In Italy, for example, 18 percent of the population was over 65 in the year 2000.  In 2010, that number had risen to 21 percent, and projections for 2050 set this number at 34 percent.  The over-65 figures for most of the European Union's 27 countries closely mirror Italy's numbers.  In the U.S., the numbers are not as dire, but they show a trend in the same direction:  13 percent in 2010, with an estimate of 20 percent by 2050.

These figures represent large segments of both European and U.S. populations that are counting on promised benefits, and get irate at even the hint of cutbacks.  Fearing for their political careers, politicians have made decisions that appease these groups, rather than making the hard choices that could correct the problem. 

 In general, European countries have chosen so far to fund their growing welfare system by borrowing.  For years, this debt accumulation obscured an enormous systemic crisis in the lesser European states of Portugal, Ireland, Italy, Greece, and Spain.  They borrowed to compensate for their inability to generate adequate income through production and commerce. 

Although this borrowing kept the cash flowing, it has finally led to economic collapse due to rising debt, deficits, and taxes.  Furthermore, as this unsustainable debt further cripples Europe's welfare state, it is becoming clear that many of Europe's unfunded entitlements have no chance of ever being paid.

Meanwhile, as the U.S. edges down a similar path, it must answer extremely important and inescapable questions.

First, we have to ask a classic chicken-and-egg question.  Did the lack of growth cause the problems with the European welfare state, or did the problems with the welfare state cause the lack of growth?  An honest assessment of human nature leads to the conclusion that the latter is true. 

Projected Annual Means-Tested Welfare Spending

As a welfare state grows, higher taxes and a glut of transfer payments erode incentives to work, save, and invest.  The decline of these fundamental economic activities by a country's population inevitably creates a huge roadblock to economic growth.  Thus, the first lesson we can draw from the European welfare experiment is that an excessive welfare system kills the very thing it needs most to survive:  a robust and growing economy.

The second major question is whether it is inevitable that the U.S. will slide into the same welfare-state-induced economic crisis as Europe.  The answer is that it is not inevitable as long as action is taken soon to avert that outcome.  Doing nothing is not an option.

One part of the solution is revealed by differences in the level of the crisis currently facing each of the 27 EU countries.  For example, Germany adopted policies that favored increasing international competitiveness over social programs.  Ironically, this will enable Germany to provide the most benefits to its citizens in the long run.  By taking steps now to maximize its long-term competitive advantage, the U.S. can generate the resources needed to fund the transition to a sustainable model, with minimal pain for its citizens.  Beyond that, it needs to take specific steps to transition away from a welfare-state model to a market-driven model favoring private charity and greater self-reliance.

As it stands, we don't have a lot of time to act.  Left unchecked, the U.S. government will consume one-third of GDP by the time those being born today are college graduates, and this will put an enormous drag on GDP growth.  Worse yet, an unreformed welfare state would inevitably lead to widespread "structural unemployment" that has become the norm in Europe.  That would be especially tragic in the terms of its effect on the young and relatively poor; robbing them of their dignity and sense of achievement. 

In 2009, the Heritage Foundation formulated a reasonable proposal for managing U.S. Welfare Spending after the end of the Great Recession. That proposal called for Congress to reduce aggregate federal means-tested welfare spending to the prerecession levels and cap total spending growth in the more than 70 federal welfare programs at the inflation rate. Within this overall limit on welfare spending, funding for individual programs could be increased or decreased, depending on changing priorities and program effectiveness. Obviously, the earliest that this could now be put into effect would be FY 2014.

Now is the time to begin reining in and reforming entitlements, and rolling back non-defense discretionary spending.  If we don't, we may become like Europe, with an unsustainable welfare state heading over an economic cliff. 

Given this trend, we offer the following three forecasts:

First, over the next 20 years, there will be a global effort to reverse the growth of the welfare state because today's promises are simply unaffordable. 

When insurmountable obstacles arise, smart people wake up and make a course correction.  We've seen this in Canada and the UK, where leaders recently won elections based on a platform of rolling back the excesses of the welfare state.  In the U.S., the 2010 elections were largely a referendum on the size and scope of the government in the wake of the massive expansion of public-sector spending since the 2008 financial panic.  Disenchanted with big-spending administration policies, Democratic party registration has declined by 21 percent since the 2008 election.  If spending growth and the unsustainable welfare state are made key issues in the 2012 election, Republicans will win both houses of Congress and the Presidency.

Second, the results of the ongoing battle over the rights of public sector unions will signal which direction our country is headed with respect to entitlements and government spending in general. 

To date, we've seen battles in Wisconsin, Ohio, New Jersey, and California.  At issue is whether private-sector workers are willing to provide lucrative entitlements to government employees.  An interesting parallel is taking place in the European Union.  Many are wondering how long workers and taxpayers in the more fiscally prudent countries in northern Europe, such as Germany, will accept working well into their 60s to provide for workers in neighboring countries where retirement before age 55 with generous state-funded pensions is the norm.  These excessively generous benefits have led to a less productive Europe.  For Americans, the lesson is that excessive wages, benefits, and other entitlements doled out by the government are a drag on the private sector, which is our economic engine.  The degree to which voters understand this relationship will determine the extent we'll be able to fix the U.S. welfare state. 

Third, as the American welfare state diminishes, there will be a resurgence of private charities that will act as society's safety net for the genuinely needy. 

It is clear that Americans respond in times of need, especially if they feel the need is beyond the government's ability to provide.³  Hurricane Katrina is a prime example of money and labor being volunteered to those in need.  Since private charities are so much more cost-effective than government aid programs, this shift will be good for donors, recipients, and the broader society.  The current mandated "Robin Hood" model could be called "enforced government charity."  It involves stealing from the successful to give to the unsuccessful.  Instead of feeling good that they have helped their fellow man, those who fund the programs feel they've been ripped off.  Similarly, some recipients become permanently dependent on programs like AFDC, food stamps and Medicaid which create well-documented adverse consequences.  It's no coincidence that, according to several studies, about one in three recipients of unemployment find jobs as soon as their benefits run out.  Too often, it becomes easier to collect unemployment checks than it is to work for a living.  By contrast, help from a private charity supported by individuals is typically viewed as a temporary hand up, motivating recipients to do what they can to improve their lot through education or taking on whatever work can be found.

It's one of the first lessons learned in Economics 101:  the difference between elasticity and inelasticity.  It appears some state administrators and legislators have either forgotten that lesson, or never learned it. 

As they continue to create environments that are increasingly hostile to affluence and business, they seem to ignore the fact that these individuals and companies still enjoy elasticity — that is, the ability to react to a changing environment.  This includes the ultimate reaction of moving to states that are friendlier.

Anti-business states act as if their borders are nonporous and that no matter what restrictions, taxes, and regulations they impose, businesses won't leave — that the relationship is inelastic.  But of course, it's not, and in some cases the only choices are to leave the state or to go out of business.  Either way, the state loses.

The degree of business freedom found in a state often reflects the degree of personal freedoms as well.  To quantify these differences on a state-by-state basis, George Mason University's Mercatus Center has developed two indices.¹  The first index is a "knowledge economy index" that assesses a state's standing in the emerging knowledge economy. 

Freedom In The 50 States

The other is an "overall freedom index" which addresses economic freedom as well as personal freedom.  Economic freedom is measured in terms of government size and spending, regulation, as well as tax burden.  Personal freedom is a function of "state paternalism," which restricts people's activities. 

The Mercatus study shows that people relocate in response to these indices. 

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However, the implications are somewhat different when we compare international migration vs. domestic relocation.  Whereas international moves are driven by both the knowledge index and overall freedom index, domestic moves only correlate with the overall freedom index. 

But, even there, the researchers discovered differences, stating, "We found that international movers seem to be sensitive to personal freedom, whereas domestic movers are not.  Apparently, domestic movers are sensitive to the other components of the overall freedom index:  economic and regulatory freedom." 

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That is, states that have high economic and regulatory freedom act as domestic relocation magnets.

This phenomenon of people, as well as businesses, seeking states that offer the most freedom to realize their potential can be a doubly detrimental to high-tax, high-regulation states.  Not only do they lose jobs and revenue-generating businesses, but they also experience an exodus of the more productive residents, labeled "Go-Getters." 

In the Mercatus study's most recent ratings, New York was at the bottom of the state freedom list because it has:

• The highest taxes of all types
• High government spending
• The strictest health insurance community-rating regulations in the country
• Rampant eminent domain abuse

New Hampshire is at the top of the index with the highest marks for limited taxes and spending, plus "fiscal decentralization" that is better than average. 

If there is one state, however, that is the poster child for states driving out businesses, it is California, with its high taxes and copious regulations.  So it's no surprise that the ratio of businesses leaving California to those entering has risen to three-to-one.  But, that's not the whole story.  Even those that stay are reluctant to expand their operations in California, choosing instead to grow elsewhere. 

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Map of Freedom Scores

Consider these high-profile examples:²

• According to Joseph Vranich, a business relocation coach, "[Intel] has publicly stated that costs are so high in California that they will not build a new plant in California."  Intel has, in fact, announced it will be building a new factory in Oregon and upgrading factories in Arizona, representing a loss to California of $8 billion, as well as between 6,000 and 8,000 construction jobs and 800 to 1,000 high-tech factory jobs.
• California-based Google also chose to expand outside the state when it built a new generation of server farms in Oregon, giving employment to 200 people there instead of California.
• In early 2011, San Jose-based eBay announced that over the next decade, it will be adding 1,000 back-office jobs in Austin, Texas.

Number of Companies Leaving California Per Week: 2009-2011

But it's not just large firms that are reacting to California's anti-business climate.  The relocation or out-of-state expansion of smaller firms resulted in the loss of one-quarter of the computer, microchip, and communications-equipment manufacturing jobs in Silicon Valley between 2001 and 2008.

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There are many causes for this flight from California: 

Business tax burdens are a key factor, which, according to the Tax Foundation, are the nation's second-heaviest.  According to Gino DiCaro of the California Manufacturers and Technology Association, on average, "The tax burden for a company to operate a business in California is 13 to 14 percent higher than the rest of the country."³

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In addition to a high corporate income tax, California is one of the few states that have their own "alternative minimum tax," which limits deductions at a certain point.

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Regulations are another factor strangling businesses and giving them incentives to leave.

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Vranich points out that because of today's environmental regulations, Intel can pay around 60 percent less for electricity in Oregon, and the cost savings will reach 80 to 90 percent when new regulations cause rate increases next year in California.

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CKE Restaurants, which operates more than 3,000 Hardee's and Carl's Jr. restaurants, has stopped building restaurants in California, because regulations have stretched the process to two years.  Conversely, CKE will open 300 new restaurants in Texas, where the process can take just six weeks. 

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Michael Beeuwsaert, CEO of a California medical-technology company that moved to Salt Lake City, Utah, explains how regulations drove them out.  "The tipping point was when someone from the Orange County tax [assessor] wanted to see our facility to tax every piece of equipment I had."⁴

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On top of the burdensome taxes and regulations, California has the distinction of being the state with perhaps the most expensive litigation environment for businesses.  Lawyers are using the state's infamous consumer rights laws to sue companies over minor violations of California's complex labor and environmental regulations.  Because of these rampant lawsuits, California is gaining a reputation as a "shakedown state," which certainly does not attract businesses. 

But that's not all.  In addition to the extremely strict labor laws, health-insurance coverage mandates raise the cost of premiums about 49 percent.

As a result of these high taxes and onerous regulations, companies can locate a new employee outside of the state's borders for a 30 to 40 percent lower cost than in California.

The impact of companies responding to this increasingly hostile business environment has been profound:

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• According to a study by the California Manufacturers and Technology Association, 10,763 industrial facilities were built or expanded across the country between 2007 and 2010.  But, only 176 of those were in California.⁵  That represents 4.8 facilities per 1 million people, well below the national average of 40 per million.  $350 billion was spent on these facilities, of which only $8.7 billion was spent in California, less than one-fifth the national per-capita average. 

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• A 2009 study by two California State University finance professors estimated that California state regulations cost businesses $493 billion annually.⁶  That's nearly $135,000 per company.  Worse yet, the study further estimated that these regulations suppress employment by a staggering 3.8 million jobs.
• Despite the success of well-known corporations such as Google and Apple, there are 130,000 fewer jobs in Silicon Valley now than a decade ago.
• In Los Angeles, businesses from garment factories to aerospace companies are closing, including Toyota, which abandoned its Fremont plant.⁷ 
• The Milken Institute reports that as businesses pulled out of California between 2000 and 2007, nearly 400,000 manufacturing jobs were lost.  Meanwhile, Texas and Arizona's industrial employment grew.⁸ 

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• In what might be the ultimate irony, even many green manufacturers are fleeing the state — a state famous for championing green initiatives.  One example is Bing Energy, a fuel-cell maker, which earlier this year announced it would move from Chino in San Bernardino County to Tallahassee, Florida, taking along 250 jobs.⁹ 

The dissatisfaction of California companies has inspired other states to offer incentives for them to move.  One such battle over a prized company looking to relocate was recently won by the state of Virginia, when Northrop Grumman announced plans to move its headquarters there from Los Angeles, taking with it 300 jobs.¹⁰ 

The attitude that helped earn the move was summed up by Virginia Governor Robert F. McDonnell, "This Administration will keep taxes and regulations and litigation at a minimum to attract job-creators from around the world to our state [in order] to ensure more new opportunities for all Virginians."

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Given this trend, we offer the following three forecasts:

First, states that offer high levels of economic freedom will emerge from the Great Recession stronger than they were before. 

The leaders of these states understand that the best way to address social challenges is to create an environment that encourages job creation.  Instead of viewing businesses as either a target to plunder or a villain to penalize, these states welcome them as the solution to many of their citizens' woes. 

Second, public and private sector leaders in anti-business states such as California will struggle to bring about reform. 

With so many people dependent on state governments to offset the slide that already has begun, genuine reforms will not come easily; many groups will paint reforms as favoring businesses over people.  Nevertheless, a key step will be to evaluate all proposed regulations for their impact on employment before legislators vote on them.  Another productive change would be a sunset clause on existing regulations that drops them from the books within four or five years unless they are renewed.  At this renewal date, they would again be evaluated for their employment impact.  Shorter-term tax reforms could stem the tide of both residents and businesses leaving a state.  California, for example desperately needs to lower its sales tax to keep more of its retail sales in-state.  Additionally, tort reform is needed in order to discourage frivolous lawsuits against businesses.  States such as California will also do well to restructure their lavish state pensions so they can instead commit resources to improving the infrastructure that supports the growth of businesses.  All these reforms, and more, are desperately needed, but the political will may not exist. 

Third, aggressively tapping their fossil fuels and mineral reserves could give many states a second chance. 

California, for example, is literally sitting on the solution to its financial problems:  oil.  Unfortunately for the state residents, the current legislature not only plans to block expanded oil production, but it plans to increase taxes on oil producers.  The state has unrealistically pinned its hopes on green jobs from solar panels and windmills.  But, the truth is, oil and gas could create a jobs boom as new technologies make previously untouchable oil supplies available.  North Dakota, Pennsylvania, Texas, Louisiana, and Oklahoma are already benefiting from this boom and attracting both new businesses and new residents.  If California can tear itself away from punitive environmental regulations and tap its fossil fuel potential, the state may yet be able to turn around its fortunes.

As the Digital Revolution continues to drive costs down relentlessly, it has disrupted business models and transformed one industry value chain after another.  One inescapable lesson from the carnage of the 20^th century companies it has destroyed is that, just as in a tornado, the worst place to be when a revolution erupts is right in the middle. 

For example, the Internet has disintermediated bricks-and-mortar bookshops, music retailers, and video stores, allowing consumers to order or download content from Web sites like Amazon.  It has also enabled online services like Match.com and eHarmony to replace the human matchmakers who personally paired their clients with prospective romantic partners; for users of these digital services, the result is a lower-cost way to sort through a multitude of potentially compatible
people.

Over 5,100 companies engaged in buying, selling, lending to, or advising private companies using AxialMarket online. These companies include corporate buyers, lenders, investment firms, investment banks, and private companies. They use the network to source, manage, prepare for, and execute private M&A transactions.

Now, the same disruption is threatening the traditional providers in the middle of another type of matchmaking: the linking of investors with
entrepreneurs who need capital.

The emergence of private market networks (PMNs) is driving this change.  PMNs offer platforms that allow investors and businesses to find each other after narrowing down a vast number of potential partners.

For example, a PMN called AxialMarket allows business owners to list their companies for sale to hundreds of institutional buyers.  These potential buyers can include public corporations that are hunting for new technologies or products, as well as private equity firms. 

When the owner joins the network, AxialMarket's system automatically creates a brief that describes the investment opportunity without identifying the company, and then suggests potential buyers based on their preferences. 

The business owner can select which of these buyers should receive the offer.  The ones that are interested in the opportunity can then digitally sign online nondisclosure agreements to gain access to company management and virtual diligence rooms.  By using the platform, both parties can track the progress of the deal until they are ready to negotiate in person. 

According to Bob Rice, a managing partner of Tangent Capital Partners, PMNs offer many user-friendly options, such as: 

• Opportunity discovery and recommendation engines
• Analytics and evaluation tools
• 

  EquityNet is a business funding and support network that offers patented business plan software and analysis tools for entrepreneurs. Angel investors, government entities, business incubators, service providers, and other members of the entrepreneurial community use EquityNet to capitalize and support young, privately-held businesses.

  Secure virtual diligence rooms with tiered access rights

• Industry benchmarks and comparables
• Standardized documentation and fee terms
• Deal flow management systems for both the buy and sell sides
• Lists of experienced service providers to consummate transactions

Among the most prominent PMNs today are:

• Gust (formerly called Angelsoft), IndieGoGo, and Kickstarter, which offer early-stage funding
• SecondMarket, which is the largest PMN and spans several asset classes
• SharesPost, which focuses on later-stage prepublic stock
• AxialMarket, which facilitates lower mid-market mergers and acquisitions
• Xpert Financial, which provides growth capital
• EquityNet, which concentrates on multi-stage equity
• Hedgebay and Lincoln Square Advisors, which specialize in hedge fund investments

As Rice pointed out in a recent Strategy+Business¹ article, PMNs are growing at blazing speed.  Consider: 

• In 2010, SecondMarket closed about $10
  billion in illiquid securities transactions, a 400 percent increase from one year earlier. 
• The number of ventures applying for funding through Angelsoft now exceeds 4,000 globally every month.
• Companies listed for sale via AxialMarket have combined revenues approaching $50 billion.
• 

  Tangent is a merchant bank focused on alternative assets and pre-public equities. Tangent emphasizes its ability to help clients exploit new opportunities created by regulatory changes that have impacted investors, fund managers, and entrepreneurs.

  The bid and ask listings on SharesPost have surpassed $1 billion.

One reason for the rising power of PMNs is simply creative destruction.  Whenever a new technology emerges, it inevitably topples long-standing ways of doing business and threatens entrenched market leaders.  In this case, the breadth of the Internet, and its inherent network effects, allow for a broader range of parties to make potential connections with each other.  The frictionless flow of data over electronic networks reduces or even eliminates human activity, slashing costs while accelerating speed.

Another factor is the bearish mood in the capital markets.  Due to the recession, large investors have generally become adverse to big risks, while lending from banks has all but dried up.  In fact, banks are sitting on more than $1 trillion in reserves, a huge increase from the $50 billion in reserves they held as recently as the middle of 2008.  With few prospects for traditional business loans, entrepreneurs
desperately need a new source of funding.

The nature of the business life cycle is yet another reason why PMNs are growing.  In the Deployment phase of the Digital Revolution, the Internet and e‑commerce have now finally reached the point at which the costs of information technology have dropped and functionality has soared.  One result is that the costs of launching a company have plunged dramatically. 

Gust.com is the largest and most successful multisided platform for bringing early-stage investors and entrepreneurs together. By being one of the first entrants into the industry, Gust was able to build critical mass on both sides of the market.

According to David S. Rose, the founder of Gust, the amount of capital needed to start a new business is dropping by more than an order of magnitude every 10 years.  For venture capital firms, this means that investments in startups are rarely worthwhile; the entrepreneurs simply don't need to borrow enough money to give up a big chunk of equity in exchange.  Many VCs won't get involved for less than $10
million, and today there are relatively few startups that need that much capital.²

How will the rise of PMNs play out?  In the four forecasts that follow, we'll examine what this trend means for the four groups that will be affected:

1. Entrepreneurs
2. Investor
3. Private market networks
4. Traditional intermediaries

First, for entrepreneurs, PMNs will provide easy access to growth capital, merger partners, and strategic buyers. 

Investments from PMNs will become the equivalent of micro-loans in India:  a way for entrepreneurs to get relatively small amounts of capital, with a minimum of interference from investors, just when it is needed.  Moreover, because the network allows business owners to select from a large number of potential partners, the likelihood of finding the right "fit" with investors is increased, thereby reducing the stress, conflicts, and even bankruptcy that can occur when a mismatch exists between the personalities and long-term goals of entrepreneurs and investors.  This will spur the growth of small businesses, which will create jobs and provide a boost to the overall economy.

Second, for investors, PMNs offer an opportunity to maximize returns by spreading risk among several small investments that each offer the potential of high ROI. 

For example, more than 750 groups of angel investors are using Gust to evaluate potential investments and negotiate deals with more than 125,000 entrepreneurs.  Angels traditionally participate in the first stage of investment in a startup; in the later stages, VC firms have always provided the big infusions of capital that was needed to keep the business growing.  But today, the costs of starting a business have fallen so fast that a consortium of angels can finance a firm on their own.  Better yet, through the network, each of them can spread his or her investments across several startups.

Third, for the PMNs themselves, this is only the beginning of a paradigm shift that will unfold in their favor. 

Venture capital firms will increasingly become irrelevant to the funding of new businesses.  PMNs will disintermediate the traditional brokers in several industries, from financiers to art dealers.  As they expand their power, however, expect a vigorous effort from banking and VC lobbyists to persuade the SEC to impose regulations and restrictions to slow their growth. 

Fourth, for the traditional intermediaries, the emergence of PMNs will force them into specialized niches in order to survive.  

VC firms will have to focus on a shrinking number of startups that need big infusions of capital — but the competition for these opportunities will be intense, and several VCs will have to exit the industry or consolidate with their competitors.  To survive, look for VCs and banks to establish their own private market networks in an attempt to remain relevant while capitalizing on their brand identity.

As off-shoring gained momentum over the past two decades, there was little expectation, especially in manufacturing, that the pendulum would ever swing back.  In fact, off-shoring seemed relentless.  Consider that, by 2003, up to one-half of manufacturing companies in Western Europe were off-shoring some or all of their production.  According to the Duke Offshoring Research Network, over 50 percent of U.S. companies were off-shoring production by 2008, double the figure for 2005.¹  It addition, it was reported that of those companies, 60 percent had aggressive plans to expand their off-shoring activities.

Large, small and mid-sized companies were motivated largely by price.  However, smaller and mid-sized companies had an additional motivation:  Unable to effectively compete for top domestic talent, these companies turned offshore in their search for "innovation support."  Small companies have been particularly successful at finding and tapping into new geographical talent clusters, such as those found in Brazil, Egypt, Sri Lanka, and Russia.

Because the off-shore model encompasses such an extensive number of nations, products, and practices, it's difficult to determine the total dollar size of the activity.  But it's easy to understand what drove the practice.

It was kick-started by customer demands for lower prices and by the need to compete with companies that were already experiencing the cost advantages delivered by aggressive off-shoring.  It was a simple economic equation.  Suppliers in China and other low labor-cost countries were offering prices that appeared to be 25 to 40 percent lower than those of domestic suppliers.  Other factors included favorable exchange rates, access to cheap commodities, and low shipping rates.

But saving money was just one part of the equation.  To make off-shoring a winning strategy, companies also needed to meet target service levels as well as maintain and improve coordination with the foreign providers.  Many found that to be truly successful required a senior-level champion for off-shoring efforts, plus buy-in on the part of internal stakeholders and effective procedures for: 

• Selecting off-shore providers
• Conducting visits to provider facilities
• Maintaining a corporate "off-shoring resource center"  

As you'd expect, doing all these things effectively posed big hurdles.  But, the expected return on investment was viewed as worth it — at least, until very recently, when the picture appears to be changing.²

Consider a few examples: 

• Vaniman Manufacturing is a dental equipment producer that has been off-shoring most of its sheet metal fabrication to China since 2002.  However, this fabrication process is now being brought back to the United States. 
• NCR Corporation, which has been producing its ATM machines in China, India, and Hungary, is returning all of its production to a facility in Columbus, Georgia.
• Last year, General Electric announced that it was moving some of its appliance manufacturing from China to Louisville, Kentucky. 

These are not isolated cases.  Rather, they represent a widespread swing of the pendulum.  An Archstone/SCMR Survey of Manufacturers reported that nearly 90 percent of manufacturers are contemplating a change, or have already changed their manufacturing and supply strategy.  This includes shifting from off-shoring to on-shoring. 

The question is, why?  In short, many of the factors that once provided the reduced costs of off-shoring have shifted in such a way that they are now erasing many of the savings, making off-shoring a costly choice for many companies.³

A key factor is labor costs, which have risen by double digits in the past few years in some places.  In China, for example, by mid-2010, many companies found it necessary to raise wages to attract qualified workers in the face of labor shortages. 

Just as China experienced a ten-fold growth in exports from 1978 through 2006, personal income also increased.  According to World Bank figures, back in 1981, more than 600 million Chinese were living on less than $1 per day.  But, adjusted for inflation, that number had dropped to about 150 million by 2005.  By 2011, worker shortages, accompanied by strikes and worker unrest, prompted some of the largest companies to increase wages by 24 to 80 percent.

It's not just labor costs that have risen.  Commodity costs have also experienced double-digit increases, ranging as high as 27 percent in one year.  Furthermore, transportation costs, such as ocean freight, have increased by 135 percent in recent years.  Higher oil prices have also driven up other production costs for manufacturers.  One of the big reasons Vaniman Manufacturing, mentioned earlier, is now adopting "on-shoring" is the steep jump in shipping and overseas travel costs, coupled with higher commodity costs.

Upon closer analysis, many companies are even discovering that some of the perceived cost advantages were never really as high as they thought.  They hadn't taken into account so-called "soft costs," such as the inflexibility of the supply chain.

Off-shoring most often requires container-sized minimum orders and months-long order cycle times, neither of which provide much flexibility and responsiveness.  This can lead to a loss of competitiveness when a company loses the ability to tailor products and services to quickly changing customer demands, or to meet unanticipated spikes in product demand.

When GE and NCR announced plans for on-shoring, a key reason cited by both companies was to be closer to the market so responses could be quicker.

There are many other soft costs that eat into the perceived savings of off-shoring.  These include:

• Lack of supply chain visibility
• Insufficient monitoring of suppliers
• Loss of managerial control over issues such as employee turnover

These factors can lead to quality issues, piracy,
intellectual capital theft, and risks to corporate reputation.

As the cost equation tips away from off-shoring, some costly and problematic factors are beginning to be viewed as "no longer worth it."  One is the time and money devoted to traveling between headquarters and foreign suppliers that are required for a company to maintain an effective working relationship.  Another is the extra effort required to work through cultural differences that quite often result in two very different impressions of what was agreed upon in a single conversation. 

Now that rising hard costs, such as labor and commodity prices, are causing companies to re-evaluate off-shoring, they are coming to realize that these soft costs were largely preventing the 25 to 40 percent expected savings from off-shore sourcing from reaching the bottom line.

In light of this trend, we offer the following three forecasts:

First, while we'll never see 100 percent on-shoring of manufacturing, companies will increasingly analyze the whole economic equation before off-shoring. 

In many cases, companies will take a blended approach, employing both models.  The choice of one strategy over another will require weighing costs versus flexibility — that is, the relative value of low production costs versus the value of short lead times.  Increasingly, the jargon is reflecting the reality: 

• Off-shoring is now labeled "efficient sourcing" and meets the need for low production costs.
• On-shoring is labeled "responsive sourcing" as it meets the need for flexibility. 

In addition, executives choosing between off-shoring and onshoring will need to take into account three key factors as they relate to their specific business model: 

1. Consumer demand
2. Market size
3. Supplier and competitor costs

If demand is relatively stable and predictable, off-shoring may still offer attractive cost savings.  If a company is in a market that fluctuates unexpectedly, on-shoring will offer more competitive response times.  Market size is a factor since smaller markets tend to be more competitive, with smaller quantities being sold.  This will dictate a greater need for flexibility, and therefore it is more likely to require on-shoring.  Companies targeting mid-sized markets will benefit from a "blended approach," taking advantage of the cost-savings of off-shoring, but relying on on-shoring to fill short-term needs.  In all cases, supplier and competitor costs will be closely watched, taking into account all costs, both hard and soft.

Second, businesses that don't examine all the factors in the choice between off-shoring and on-shoring will likely choose the wrong method and lose a competitive edge. 

Companies that adopt a so-called "total cost model" will be better able to craft the most beneficial sourcing model — whether off-shoring, on-shoring, or a blended approach.  Key areas they will consider
include:

• Supplier price and terms
• Delivery costs
• Operations and quality costs
• Customer-centric supply capabilities
• A handful of costs that are often excluded from consideration, such as local tax incentives, broker fees, infrastructure technology and facilities, exchange rate differentials, and tooling and mold costs

Third, companies will have to expect more barriers to on-shoring than most people would imagine. 

After many years of off-shore manufacturing migration, the infrastructure that once supported domestic manufacturing has been decimated.  The highly skilled engineering and technical blue collar workforce has been greatly reduced, and much of the supplier network that once serviced certain industries has gone away.  A strong commitment and investment in reestablishing these elements will be needed.  Activities such as re-acquiring workforce skills, industrial site planning, plant construction, and infrastructure rebuilding will be tall hurdles that may need to be overcome with state and local tax incentives.  Relaxing of oppressive government regulations that have put a stranglehold on businesses over the years will be key to helping make on-shoring a major growth trend in both the U.S. and EU. 

Like a cheap toy bathed in lead paint, China's economy is more dangerous than it looks on the surface.

In recent months, despite the best efforts of Chinese technocrats, the world's biggest stimulus program has backfired, and the true state of the Chinese economy is beginning to emerge.  This evidence is revealing symptoms of a crumbling system that was built on an unsustainable growth model that relies on ever-increasing exports, even as demand for those imports is shrinking.

For a time, this growth in exports, and the enormous cash flow it provided, enabled the Chinese to provide employment for a large subset of the population.  Under this system, typical market factors such as profits could be ignored as long as the government was able to keep money flowing down to its population.

The plan was to slowly build a self-sustaining consumer economy like the United States, South Korea, or Japan.  Unfortunately, the financial panic of 2008 disrupted global trade and forced China to shift from exports to capital spending.  The resulting $586 billion stimulus program led China to build railroads, highways, and even entire cities simply to keep people employed.  The main result has been the creation of real estate and commodity bubbles, which now threaten to explode.¹ 

Undoubtedly, China's leaders knew this capital spending boom was unsustainable, but they hoped to prop up the economy, at least through the major party leadership transition in 2012.  But now, things seem to be unraveling faster than expected.  Recent symptoms of this are evident in three key areas: 

1. Industrial activity
2. Housing
3. The banking system

A cooling Chinese economy was indicated by the sharp slowdown in China's industrial activity in November 2011.²  The month saw HSBC's purchasing managers' index, or PMI, drop three points to 48, which is the lowest it's been since the U.S. stock market bottomed in March of 2009.  More significantly, the PMI's industrial production sub-index fell, moving from 51.4 to 46.7.

Exports have also been off, bringing China's annualized export growth in October 2011 down to 16 percent.  While this would be a highly desirable number in a developed economy, it signals trouble for China, where growth was 18 percent in September and 24.5 percent in August. 

Since China's economy is so export-driven, things looked good during the four or five years of tremendous growth in exports leading up to 2009.  But then, China experienced its first significant drop as it emerged onto the global stage.  Exports did improve slightly in 2010.  However, growth in 2010 and 2011 has not been sufficient to sustain targeted employment levels — and as we end 2011, the numbers indicate things are getting worse, rather than better.

This comes as no surprise when we consider that China's largest export market is currently Europe, which is reeling from its own debt crisis.  The Chinese are paying close attention to how the EU handles its current financial crisis, because the outcome could greatly affect how China operates its economy.³ 

The challenge is to maintain a trade surplus in the face of falling export levels and import levels that remain stubbornly high because of China's very large demand for commodities.  These commodities are used not only for the manufacturing of exports, but also to fuel the enormous domestic investment boom.

After the drop in exports in 2009, the Chinese government reacted with a huge increase in domestic investment in hopes of stabilizing its economy.  This move came at a time when there had been a lot of talk of moving away from an export-based economy to a consumer-based economy.  This increase in domestic investment sidetracked this shift and instead coincided with another grand plan already underway:  urbanization.

Despite real efforts to build a consumer-driven economy, China’s success still depends almost entirely on tens of millions of semi-skilled workers assembling products for exports. With the capital spending boom already having created a huge surplus of capacity, China’s success and stability depends heavily on the revival of global demand.

The idea was to promote the growth of cities, which would generate more consumers, who would then drive the consumer-based economy.  To entice citizens to move to the cities, infrastructure was needed, including housing.  As we've outlined in previous issues, the rapid growth in construction led to a housing boom, fueled by speculators.  The boom turned into a bubble, with highly inflated home prices that have prevented the nonurbanized population from buying and moving into the cities.  As The Wall Street Journal⁴ reported in December 2011, the average price of an urban apartment has soared to eight times China's average annual income, and millions of luxury apartments are vacant, while low-income workers can't find affordable housing.

This situation presented the Chinese government with a dilemma.  It needed to slow down the rising home prices so housing would be more affordable, but at the same time needed to keep prices stable.  A large drop would have two undesirable effects: 

• It would undermine the collateral for the loans from state-owned enterprises.
• It would erode the value of the assets that have become the "nest egg" for the middle class and the most popular investment for the wealthiest Chinese.

Through the government's use of credit curbs, it now appears the bubble is beginning to deflate rather quickly.  Recent evidence supports this conclusion:

• Sales of real estate in September and October 2011 were off by 40 to 60 percent from a year earlier.
• Chinese real-estate stocks have dropped by more than 30 percent from their peak.
• The government reported that, of the 70 cities surveyed in October, home prices fell in 33 of them.
• Developers are trying to move unsold inventory by slashing prices by more than 20 percent.

These dropping prices may be good news for those looking to buy, but as IHS Global Insight analyst Alistair Thornton observed, "Aside from the euro zone, the key risk facing the Chinese economy is an unexpectedly sharp drop in the property market."

Recent buyers are panicking over dropping prices, and protests have been common, such as one at a sales office by 200 homeowners demanding a refund from Greenland Group, a leading developer.

This cooling of the housing market is already beginning to have a domino effect on the economy.  With less investment in building, related sectors, such as steel and cement, are taking a hit.  Analysts point out this is one of the factors driving the steep drop in the PMI. 

A recent survey of Chinese construction companies by Credit Suisse revealed additional negative effects of the downturn in the housing market:⁵

• Tight credit and a slowdown of sales have put a squeeze on property developers' cash flow.  This has led to a delay in payments to construction companies for work done.  Around 80 percent of these companies report delays of three months or longer.  This is identified as their biggest business issue. 
• Homebuilders also report that developers have begun asking them to slow down their work on current projects.  In addition, they are expected to pay more of the up-front costs of construction. 

In response to this potential housing meltdown, the Chinese government is planning to overhaul a mortgage-refinance program that would aid homeowners.  This is another clear sign that the real estate market, and therefore the Chinese economy, is in trouble. 

Other symptoms of a crumbling system can be seen in the banking and monetary sector:

• For the first time since October 2007, China's central bank reported a currency capital outflow.  This represents a slowdown in direct foreign investment and a drying up of speculative money into China, leading to growing fears of a hard landing of the Chinese economy. 
• In response to a sell-off of shares of the country's battered banks, China's sovereign-wealth fund stepped forward in mid-October and bought shares.⁶  This sell-off is a symptom of another troublesome factor in China:  a loss of trust in the integrity of corporate earnings and government statistics.
• A surprising change in bank reserve policy is another symptom of a slowing economy.⁷  Analysts shared a long-held consensus that the Chinese government would not relax bank reserves, but rather gradually foster easier credit and liquidity.  They turned out to be wrong.  After beginning to raise bank reserve requirements in 2009, the central bank announced in October that the requirement for 20 rural cooperative banks would revert to 16 percent from 16.5 percent.  Then, in late
  November, in yet another surprising move, China's central bank lowered the reserve ratio for the biggest banks from a record high of 21.5 down to 21 percent.  This was the first cut in three years, and is aimed to ease credit strains and bolster a weakening economy that is at its slowest pace since 2009.  It is seen as a way to make funds available for lending to small, cash-strapped firms.  The move was certainly influenced by concerns over a global economy that is affected by the euro zone's struggle to address its two-year debt crisis.
• In another sign of a faltering economy, local governments with high debt burdens are putting pressure on Beijing to ease monetary policy.  They share a very real concern that the slowdown in exports could raise unemployment, which would spark unrest.

The government's fear of widespread social unrest cannot be overstated.  This is an additional, very vivid sign of collapsing bubbles. 

Balancing central control and free markets relied on a compliant and complacent population.  But recent anti-government protests have become increasingly common.  Issues driving public anger include corruption and police abuses and a general loss of confidence in Chinese government and corporations.  In some regions, riots and demonstrations are being staged by discontented workers.  Perhaps most troublesome for the government is how this violence has exposed its limitations in controlling its urban population through "social management," such as censorship and surveillance.  Instead, it must resort to displays of raw power, including paramilitary police and armored vehicles.

Referring to the growing economic crisis, outspoken Chinese real estate tycoon Ren Zhiqiang asks, "Why doesn't the government work on land supply, land prices, and tax incentives?⁸  Why doesn't it raise wages and lower home purchase taxes, and raise the affordability for the citizens?"  This is what a good Keynesian would ask.  Of course, the answer is:  It won't work.  If this is what the Chinese are relying on to keep their economy afloat, there will indeed be a very hard landing.

Considering this trend, we offer the following three forecasts:

First, the European crisis will force China to rethink its timeline for economic change. 

This crisis, and the fact that it is expanding globally, is moving China's need to change economically to the forefront.  When its economy was booming and exports were flowing, China had the ability to push back economic change.  The flood of money masked a flawed system.  But now, the system has been exposed and reveals the need for change, which may also hasten a political change. 

Second, as the Chinese real estate bubble deflates, the price of commodities will fall. 

Since real estate has been such an important part of China's overall economy for the past several years, any decrease in its value will have widespread repercussions.  The slowdown in the building industry will cause an equal drop in demand for many commodities, such as copper and steel.  A slowdown in industrial output will further depress demand.  Together, these shrinking demands will cause a worldwide drop in commodity prices, which will be a shot in the arm for economies that can benefit from a lower cost of raw materials.

Third, investors in Chinese banks have a bumpy ride ahead. 

With widespread corruption and contracts that are meaningless, investors, particularly foreign investors, are putting their money at great risk.  They need to remember that politics play an integral part of business in China, and that banks are basically instruments of state policy.  To put it in gambling parlance, "the house always wins" when it deals with foreign investors — and China's banks are the house.