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Making Money vs Creating Wealth - Migrating to New Energy Paradigms Part 5

Economics / Global Financial System Aug 11, 2007 - 10:27 PM GMT

By: Brian_Bloom

Economics

Making money is not the same as creating wealth. The objective of this article is to facilitate an understanding of this deceptively simple statement which, in turn, will facilitate an understanding of the dimensions of the problems now being faced by humanity. Hopefully, this will lead to a realization that these problems – most of them – are soluble within a relatively short space of time.

Perhaps this anecdote will help to set a mental framework:

A long, long time ago I was number two ‘opening bat' for my school's First XI cricket team. I played sport six days a week in those days and had great hand/eye co-ordination. In my mind I can still recall the pleasure of opening my shoulders and smacking a loose ball for six over the bowler's head. The ball would connect with the “sweet spot” of the bat and soar into the bleachers above the sight screen at the far end of the field. It didn't happen often – but when it did, wow!


The relevance of this anecdote?: It is impossible to hit the sweet spot unless you keep your eye on the ball! 

The ball, dear reader, is wealth creation activity. Wealth Creation activity builds nations. Money making activity is what the bowler, or pitcher (the banks) would have us believe is the ball.

If we want to solve the problems now facing humanity in the shortest possible time; if we want to hit sweet spot; if we want to smack the ball out of the stadium; we need to keep our eye on the ball.

Shifting slightly away from the ball metaphor, let's focus on the game. By contrast to wealth creation activities, making money is essentially a self-indulgent game, the rules of which will be outlined below. Bankers felt encouraged to devise the rules of this game because they are the prime beneficiaries of the game.

Happily, in the early expansionary phase of an economic megacycle the bankers' game in fact offers a win/win opportunity to everyone. Loose monetary policies and debt add an afterburner of momentum to wealth creating activities.

Time passes. As the economic megacycle matures, and the previous generation of wealth creating activities loses its dynamism, the ageing economy begins to slow. Economic momentum deteriorates. Cracks begin to appear. Unhappily, At this point, loose monetary policies and debt become destructive.

Wealth Creating Activity

The chart below shows percentage market penetration (Y axis) over time (X axis). Your attention is drawn to the positioning of perpendicular lines indicating T0 T4 below.

Technology/Economic Life Cycle

In a previous article it was demonstrated that the drivers of the economy are technologies which flow from the emergence of a new energy paradigm. Of course, in the late twentieth century there were many technologies that emerged that were not directly related to oil for example microwave ovens and digital electronics. However, these were not core drivers of the economy.

The chart above can be read to represent one single technology (an individual business) or a suite of technologies which, taken together, represent the economy as a whole. The Table below summarises the points of importance which emerge from this chart.

Time Period Phase of Commercialisation or Economic Development Dominant management personality profile required Examples of leading individuals
T0 T1 Conceptualisation Phase Abstract Thinker/Visionary (Sees things well ahead of their time) Thomas Paine, Thomas Jefferson, Nikola Tesla
T1 T2 Establishment Phase Visionary/Entrepreneurial (Sees how he/she might turn a profit from, or leverage off the vision. Inspirational salesman) FD Roosevelt, Thomas Edison, Henry Ford.
T2 T3 Expansion Phase Entrepreneurial (Rolls up his sleeves and builds the business/economy solving problems on the fly) Harry Truman, Dwight Eisenhower, Andrew Carnegie, JD Rockefeller, JP Morgan, Sam Walton,
T3 T4 Corporatisation Phase Entrepreneurial/Professional (Values predictability and  systems) John Kennedy, Bill Gates
T 4 onwards Maturation Phase Professional/Highly disciplined (Emphasises the importance of box ticking and political correctness. Does things by the book.) Ronald Reagan, George H W Bush, Warren Buffet

 

f course, the above is a kitchen table explanation for the purpose of communicating a principle. (There is a body of psychological theory which underpins the broad brush statements).

In summary, the principle is this: Wealth is predominantly created within the economy as a result of activities which commence in T1 and continue to the end of T3. The people who create and build wealth have visionary and/or entrepreneurial personality profiles. Clearly, no money can be made between T0 and T1 because no wealth has yet been created. This can be very frustrating for the Visionary particularly because the conceptualisation phase is also a phase of incubation. It takes a looong time for non-visionary people to understand what the Visionary is on about. Typically, no one is listening anyway, because they are fat and happy and are wrapped up in their own day-to-day activities. It is only when burning issues begin to manifest (as they are currently doing given our economic, social, environmental and climate change problems) that people start to pay attention.

Wealth creating activities facilitate the making of money from T1 up to the end of T3. The nature of the game changes in T4.

As an aside, the above table shows why George H W Bush had trouble with The Vision Thing. If his personality profile is skewed towards conservative professionalism and discipline then he will have little entrepreneurial flair. This is neither good nor bad. It is in the nature of a fingerprint. It just is

Further, one suspects that Bush the younger is merely a front man for the disciplined professionals who want to make absolutely certain that the status quo is maintained in a paternalistic, steady as she goes, brook no interference format. There is a raft of evidence to validate that he is implementing a no substantial change policy. Examples are:

  • Failure to ratify Kyoto Protocols thereby protecting vested interests of the fossil fuel industries
  • Invasion of Iraq to protect both the oil industry and the integrity of world's financial system which is underpinned by the US Dollar
  • Radio Frequency Identity Documents (subcutaneous chips next?)
  • Detention without trial
  • Legalised wire tapping

From T4 onwards, very little new wealth is created, but large amounts (rivers actually) of money are to be made by the players' by virtue of wealth re-distribution  as will be demonstrated below. Unfortunately, it is typically the policies of Central Bankers (who have only hazy understanding of the concept of wealth creation) which give rise to these rivers of money. That is why debt levels start to rise from the commencement of T4 onwards, as capital structuring, financial engineering and money become the primary focuses of attention.

A 100,000 foot view:

Wealth is created by the application of human ingenuity to natural resources. Neanderthal man took a piece of flint, sharpened it on a rock, tied it with a flexible vine to a dead animal's shin bone, and created a tool. The possession of this tool represented wealth. Using the axe, he could cut branches and fashion them into pointed spears. Now that he had an axe and also some spears to increase his effectiveness in hunting for food, he was wealthy. Wealth should build on itself but, if the axe wears out, you're back to square one; unless you make a second axe as a back-up when you come to realise your total dependence on the first one. Maybe, if you make a third, you can trade it for a dead rabbit or two.

If you get members of the tribe to compete against each other to bid for your axe, maybe it will fetch up to six rabbits. It depends on how badly the other Neanderthals want (or need ) an axe. And thus economic activity was born. Of course, when everyone in the tribe owns an axe, the price of rabbits will rise. It may take three axes to buy one rabbit. That's what happens when markets saturate. Economic activity falls, until someone invents the bow and arrow.

Since the mid 1700s, the foundational base for wealth creation activity has been fossil fuel energy which humanity has in-spanned to augment and add power to the application of our ingenuity. Whilst money supply and credit facilitates the acceleration of this wealth creation process across society, it does not create wealth itself.

When Wealth Creation activity peaks as a consequence of market saturation of technologies associated with the previous energy paradigm, continuing to add yet more money and credit to the system accelerates the pace at which capital is consumed . Previously accumulated wealth is liberated and/or recycled and/or destroyed as was the case with the Leveraged Buyout mania which began in the 1980s, when the price of money (interest rates) began to fall as a result of Central Bank policies.  Whilst it might or might not make money for the promoters, the most recent bout of multi billion dollar LBO's is not going to add any wealth to society as a whole.

Unfortunately, debt leverage is also a two way street. It magnifies profits when the economy is growing and it magnifies losses when the economy enters recession. At this late stage of the ageing economic cycle, the odds favour the loss of up to 100% of the promoters' capital in a fairly short space of time even if the economy tracks sideways for a couple of decades. The key to making money in the late stage of an economic cycle is that there has to be background inflation (as you will see below)

There are some who genuinely and passionately believe that the economy is heading for boom times because China and India have joined the economic community. I guess these folk haven't heard of peak oil or thought through what a decreasing output of energy per capita might mean to the world economy. Perhaps they might want to think about this:

For nearly three hundred years, fossil fuels worked brilliantly as a driver of value-add activity, but there were three fundamental flaws with fossil fuels which are now beginning to manifest:

  1. Whilst Fossil Fuels were adequate to augment the ingenuity and efforts of roughly 1 - 1.5 billion people in the Developed/Developing world, the world's population is approaching 6.5 billion people. Fossil Fuels do not have the power to do for 6.5 billion people what they did successfully for 1 billion people.
  2. If the ecological environment was severely damaged by the activities of 1.5 billion people leveraging off Fossil Fuels, it is likely to be all but destroyed by the broadening of such activities to embrace a further two billion people currently residing in China and/or India, let alone bring the African countries into the community of productive nations
  3. Supplies of the most recent Fossil Fuel driver of wealth creation activities, namely oil, have peaked and will soon begin to wane. 

There is a fourth issue: In an environment of Global Cooling, the implications of 1-3 above will be magnified. Very likely, under such circumstances, the World Economy will collapse - irretrievably. In an article entitled Global Warming Wrap Up (http://www.marketoracle.co.uk/Article1486.html) it was concluded that Global Cooling is indeed a high probability outcome post 2012).

The evidence is overwhelming. It is essential that we migrate away from our dependence on Fossil Fuels. It is equally essential that we do not embrace the wrong energy paradigm.

With all the above in mind, it should now be obvious (to anyone with even a smidgeon of entrepreneurial flair) why Nuclear Fission Energy cannot be regarded as the next generation energy paradigm.  Quite apart from philosophical problems inherent therein, Nuclear Fission cannot be leveraged to support the development of associated technologies or products. (Nuclear powered motor cars, farm equipment, trains and aeroplanes? Nuclear powered portable generators? Let's get real!).

In article #4 in this series it was demonstrated that time is of the essence. We do not have the luxury of time to take a scatter gun approach to solving the problems with which are now faced. We need to keep our eye on the wealth creation ball, as opposed to the money making ball.

Let's re-examine Solar Power, as an example, in the context of wealth creation. Whilst it does have the ability to provide collateral value-add if/when it is coupled with other technologies; resulting products such as special purpose lighting, water heating, indoor climate control, other, will also likely only have niche applications. Of course, this may change if/when a new electric charge storage technology is developed to be coupled with solar power, and there are such technologies in the wings. We should not throw out the baby with the bath water.

Having said this, whilst solar power will have a supportive role to play, what is desperately needed is a new energy driver of the world economy. Going forward, the world economy will need to embrace another 5 billion people who will need to be empowered to create wealth. We need mainstream energy technology/ies which can fully replace fossil fuels; which will have low operating costs;  which can be leveraged to have spin-off technologies/products and without damaging our environment.

During the course of the past twenty years, this analyst has identified two (possibly three) technologies that hold the promise of satisfying all these requirements - including the ability to facilitate wealth creation. I have no financial interest in any of them. The objective here is to solve problems.

To get a flavour of the power of these technologies, the reader should visit http://www.beyondneanderthal.com/sample-chapter.html and register interest. A sample chapter will be automatically emailed which will provide this flavour. Details of these technologies will not be provided within these articles because it is necessary to finesse the Not Invented Here syndrome. There is a natural prejudicial predisposition on the part of most non-entrepreneurial people to want to reject anything new. All you need to do to validate this resistance to change is refer above to the manner in which George W Bush is implementing his policies. The new energies need to be presented in a bullet proof manner.

Making Money

The following section is fairly technical in nature. It may not be of interest to some readers who may wish to jump ahead to the next section below.

From an investor/financier's perspective, the rules for making money are fairly simple, and depend on the point at which you find yourself within the life cycle (S Curve) of the investee business. In simple terms, however, the making of money boils down to one word: Leverage. To make big money you have to leverage off other people's efforts or other people's capital or both.

In the early phases of the S curve of a new business, the risks of failure are extraordinarily high. You will therefore be entitled to expect extraordinarily high returns. However, in the end analysis, success is more a function of the quality of the business' management than the idea in which you are investing. If you back the right management, (you will be leveraging off other people's efforts), then you might expect your five year return to look something like this:


Example 1:
High Growth Rate Business (T2 - T3)
Assumptions:
Business' Purchase Price 1 X Revenue
Business' Selling Price 8 X Earnings Before Interest and Tax (EBIT)
Revenue Growth Rate 35% p.a.
Target EBIT:Revenue 20%
Interest Rate 7.5%
Tax Rate 30%
Dividend Policy 0% of Net Profit After Tax
0% 100%
Yr Revenue EBIT Purchase Debt Interest Dividends Investment
0  $     1,000,000 0 -$    1,000,000 -$     1,000,000
1  $     1,350,000 0 0 0
2  $     1,822,500 0 0 0
3  $     2,460,375 0 0 0
4  $     3,321,506 0 0 0
5  $     4,484,033  $      896,807 0  $     7,174,454
Internal Rate of Return (ROI) 48% p.a.

 

Summary: $1 million dollars is invested by buying into a business at a valuation of one times revenue. This will become worth $7.2 million in year 5 if the management delivers on its promise. Because the business is young, and because it represents high risk with no current profits, the acquisition needs to be funded 100% by equity. Because it still has high growth prospects when it comes time to sell, the price you can get is based on a high multiple of (say) 8 X EBIT.

The Investor's main risk here will be that because the management will be highly entrepreneurial in personality profile, they (management) will likely be undisciplined in nature. It requires a hands-on approach by investors to address this, and this type of investment is not for amateurs. Also, the amount of money that you can actually invest is limited because the business is young and small. Therefore, this is not an attractive proposition for large Financial Institutions. Angel investors are typically attracted to this type of opportunity.

Moving along the S Curve: As the new business becomes established and its reaches T3 , the risk of failure recedes and the investor can now leverage off both other people's efforts and (some) other people money.


Example 2:
Medium Growth Rate Business (T3 - T4)
Assumptions:
Purchase Price 6 X Earnings Before Interest and Tax (EBIT)
Selling Price 5 X EBIT
Growth Rate 20% p.a.
Target EBIT:Revenue 20%
Interest Rate 7.5%
Tax Rate 30%
Dividend Policy 10% of Net Profit After Tax
65% 35%
Yr Revenue EBIT Purchase Debt Interest Dividends Investment
0  $   10,000,000  $   2,000,000 -$  12 million -$   7,800,000  $               -   -$     4,200,000
1  $   12,000,000  $   2,400,000  $                 -   -$   7,800,000 -$     585,000  $     127,050 -$        457,950
2  $   14,400,000  $   2,880,000  $                 -   -$   7,800,000 -$     585,000  $     160,650 -$        424,350
3  $   17,280,000  $   3,456,000  $                 -   -$   7,800,000 -$     585,000  $     200,970 -$        384,030
4  $   20,736,000  $   4,147,200  $                 -   -$   7,800,000 -$     585,000  $     249,354 -$        335,646
5  $   24,883,200  $   4,976,640  $                 -   -$   7,800,000 -$     585,000  $     307,415  $   16,805,615
Internal Rate of Return (ROI) 27% p.a.

 

n this case, the purchase price has been predicated on paying six times Earnings Before Interest and Tax. This is a reasonable multiple given that the business' revenue line is still growing at 20% p.a. Also, it has been assumed that $7.8 million of the $12 million purchase price can be financed by debt at 7.5% p.a. Interest is payable annually, and the company pays a dividend of 10% of its profits after tax and interest. The reason for this low dividend number is that high growth businesses need working capital to be ploughed back. Nevertheless, after paying back the debt in year five, and assuming the business has been sold at only five times EBIT (because, by this time growth rate will have slowed down) the Return on your $4.2 million investment is anticipated at 27% p.a. before tax. The lower return than in example #1 flows from the lower risk.

This type of transaction is attractive to Financial Institutions and, because of this, the pure theory starts to break down. With loose monetary policies there is too much money around. Financial Institutions start to compete against each other for deals. They pay too high a price at entry relative to the intrinsic worth of the business. Well, never mind. The Stock market will likely represent the exit for investors and it is currently trading at 18X Price:Earnings. On an un-leveraged Balance Sheet this represents 12.6X EBIT. Of course this is insane, but aren't we having fun playing this money-making game using other people's money and other people's efforts to make ourselves rich?

This brings us to Example 3

Example 3:
Low Growth Rate Business ( T4 +)
Assumptions:
Purchase Price 5 X Earnings Before Interest and Tax (EBIT)
Selling Price 5 X EBIT
Growth Rate 5% p.a.
Target EBIT:Revenue 15%
Interest Rate 7.50%
Tax Rate 30%
Dividend Policy 40% of Net Profit After Tax
90% 10%
Yr Revenue EBIT Purchase Debt Interest Dividends Investment
0 $100,000,000 $15,000,000 -$75 million -$67,500,000  $               -   -$7,500,000
1 $105,000,000 $15,750,000 -$67,500,000 -$5,062,500 $2,992,500 -$2,070,000
2 $110,250,000 $16,537,500 -$67,500,000 -$5,062,500 $3,213,000 -$1,849,500
3 $115,762,500 $17,364,375 -$67,500,000 -$5,062,500 $3,444,525 -$1,617,975
4 $121,550,625 $18,232,594 -$67,500,000 -$5,062,500 $3,687,626 -$1,374,874
5 $127,628,156 $19,144,223 -$67,500,000 -$5,062,500 $3,942,883 $27,101,500
Internal Rate of Return (ROI) 17% p.a.

This example goes to the heart of the money making game.

Note that although the EBIT:Revenue ratio has fallen from 20% to 15% (quite natural in an increasingly competitive environment) and even though the growth rate has fallen to 5% p.a., the Return on investment is still a very healthy 17% p.a. This ROI flow from four facts:

  1. The EBIT:Revenue ratio of 15% is significantly greater than the 7.5% interest payable on borrowings
  2. This latter fact allows for 90% of the purchase price of this stable business to be financed by debt
  3. The 5% p.a. growth in revenue is virtually guaranteed by Central Bank monetary policies because it is driven largely by population growth and inflation. (Unless the economy goes into recession, in which case your equity will probably be wiped out)
  4. The business is stripped of 40% of its after tax profits to pay dividends.

Unfortunately, this business is no longer building wealth. It is ticking over as a cash generator, and its ability to prepare for a new phase of entrepreneurial growth has been stultified by financial engineering. Nevertheless, by the use of 90% debt leverage at an interest rate of less than the EBIT:Revenue ratio, money can be made merely by passing the parcel between one set of investors and another until, eventually, the business itself starts to decay. From society's perspective, however, wealth is destroyed in the process. From society's perspective, if core mature businesses (which drive the economy) are protected from competition by Government policy (as seems to be the case with the Bush Administration's policies) then the entire economy is put at threat because it is rendered incapable of adjusting in areas where adjustment is critically important in this case, the Energy Industry.

Gold Standard, Fiat Currency, Free Enterprise, Socialism

The alert reader will have understood that the relative importance of a Gold Standard' vs Fiat Currency' etc. waxes and wanes depending on where we find ourselves in the Economic S Curve. Fiat currency is attractive in Phases T1 -T3 of the economic cycle but can cause havoc from phase T4 onwards.

Similarly, Free Enterprise is highly productive in Phases T0 -T3, but can become counterproductive and become an impedance of the interests of society as a whole from phase T4 onwards, because Managers of mature businesses use their superior market position to tilt the playing field in their business' favour. (As demonstrated in a  previous article). We should avoid the urge to embrace solutions in search of problems. Life is an ever changing dynamic process.

Summary and Conclusions

The above spreadsheets demonstrate that making money is not the same as building wealth and, from T4 onwards, making money is dependent on the permanent existence of inflation.  Further, by artificially stimulating the economy with fiat currency and debt from T4 onwards, the Central Banks artificially prolong the existence of the old economic drivers which action is likely to become dangerously counterproductive.

Central Banks appear to not understand this or, if they do, they don't care. From their perspective as long as a background inflation rate of between 2% and 5% can be assured, and companies can earn EBIT:Revenue percentages which are higher than prevailing interest rates, the spreadsheets show that the money making game can continue ad infinitum.

Unfortunately, this is a grievous error of judgement because, in a maturing economy, an extra innings of the money making game erodes wealth at society level. It's like killing the goose that lays the golden eggs.

Normally, the natural course of events would allow for appropriate personality profiles to manifest in our political and business leaders as the needs of society change. Today, the world is desperately in need of visionaries and entrepreneurial personality profiles in its leaders. Unfortunately, their emergence to fill the void has been blocked by the conscious attempt of the professionals to hold onto power.

Ethics has been a casualty in the process.

Author's note:

The previous articles in the series entitled Migrating to New Energy Paradigms have hopefully led to a better understanding of the nature of the real problems with which humanity is being faced. The next and last article will set out a proposed road map for solving these problems  - by migrating away from our dependence on oil within a decade, and from coal within 25 years.

By Brian Bloom
www.beyondneanderthal.com

Since 1987, when Brian Bloom became involved in the Venture Capital Industry, he has been constantly on the lookout for alternative energy technologies to replace fossil fuels. He has recently completed the manuscript of a novel entitled Beyond Neanderthal which he is targeting to publish within six to nine months.

The novel has been drafted on three levels: As a vehicle for communication it tells the light hearted, romantic story of four heroes in search of alternative energy technologies which can fully replace Neanderthal Fire. On that level, its storyline and language have been crafted to be understood and enjoyed by everyone with a high school education.  The second level of the novel explores the intricacies of the processes involved and stimulates thinking about their development. None of the three new energy technologies which it introduces is yet on commercial radar. Gold, the element , (Au) will power one of them. On the third level, it examines why these technologies have not yet been commercialised. The answer: We've got our priorities wrong.

Beyond Neanderthal also provides a roughly quantified strategic plan to commercialise at least two of these technologies within a decade across the planet.  In context of our incorrect priorities, this cannot be achieved by Private Enterprise. Tragically, Governments will not act unless there is pressure from voters. It is therefore necessary to generate a juggernaut tidal wave of that pressure. The cost will be peppercorn' relative to what is being currently considered by some Governments. Together, these three technologies have the power to lift humanity to a new level of evolution. Within a decade, Carbon emissions will plummet but, as you will discover, they are an irrelevancy. Please register your interest to acquire a copy of this novel at www.beyondneanderthal.com . Please also inform all your friends and associates. The more people who read the novel, the greater will be the pressure for Governments to act.

Brian Bloom Archive

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