The United States is coming out of Phase I of the present economic crisis just at a point where a new and greatly popular President will take office. Where will the economy take us?

Phase I could be defined as everything we've experienced up to Inauguration Day, since the crisis started almost two years ago. It includes the subprime bubble burst, bank collapses, AIG and Bear Stearns, TARP and Capital Injection, and the automakers.

The public is enamored with our new President and a recently published poll suggests his popularity is increasing; for the moment.

Economies have a horrible way of deflating political celebrity and we only hope for the sake of the nation and indeed the world, that Mr. Obama's economic team has what it takes to steer this nation towards true recovery. We believe he does, provided the economy gives his team the opportunities they need.

The next phase will be worse than the previous one. It is in this phase that all the problems started in the first catch up and coagulate. Unemployment will rise considerably, probably exceeding 10% and perhaps as much as 15% as more small businesses collapse and in turn, bring a decline in overall spending, forcing larger corporations to scale back production and services. This in turn will mean those large companies will need even fewer employees to do the work.

Compounding the increasing unemployment rate, de-risking and de-leveraging continue to take a toll on valuations of products as well as services. This means we will see prices decline, but equally, new hiring, if there is any, will be at lower salaries and cost of living allowances will decline, as inflation in effect, disappears. Employers, seeing a glut of potential, qualified candidates are likely to attempt to de-leverage their own employees, taking the risk of terminating employees that are paid a higher wage than they could pay new hires.

The risk of deflation becomes serious, as everything starts to shift backwards in time, as the dollar strengthens considerably.

We expect to see many banks fail in the future months as depositors begin to look seriously at the loan portfolios of their banks and make judgement calls whether to maintain accounts if the bank's portfolio is deemed risky.

The days of the superbank are done. When banks attempted to be all things to all people, they created huge needs for staffing and costs that they could not support through their own customer base. Departments full of people, doing very little volume became cost heavy and ineffective. A concomitant consequence of these excessive expansions is that banks lost their focus, and created cost savings incentives that ultimately created the market for subprime. Factually, the reason banks put management staff on commissions was the cost of their multiple divisions.

The consequence of the superbank model was the creation of greed and avarice among many bank managers who were all too willing to engage in risky deals in order to earn commissions, disregarding the consequence of their actions. Without a system of checks and balances, and that greed reaching the pinnacles of superbank management offices, the system collapsed. Today, the unfortunate situation remains to a certain extent and thus the break-up of the superbanks is a good thing. We believe it will bring banking back to safer, more secure levels for depositors and investors alike.

There's a reason community banks didn't get hit with the same problems that the large commercial banks suffered. This is it. They didn't over reach for every possible opportunity and mess up the core operation in the process.

In de-risking and de-leveraging, there comes a process that once started is difficult to stop. Each event or action has its own effect. Each individual or business affected by de-leveraging or de-risking will have a unique story, but these too will have only a few degrees of separation. XYZ Corp closes, Joe and Mary lose their jobs. Joe’s wife worked for a company that sold products to XYZ, and they’re forced to cut payroll, reduce hours, trim benefits and scale back bonuses. Joe’s household income drops considerably, and he eventually defaults on his mortgage and other bills. His kids, going to public school can’t have money for lunch, books or school supplies and eventually, new clothes. Their education suffers.  Mary, Joe’s former co-worker, is forced to move away from town to live with relatives as her spouse has already lost a job and their two kids require special medical attention. Eventually, one of those children will die for lack of proper medical services. The town will see a loss of tax revenue from both, but each will stop shopping in local stores, forcing retailers to shut down or, at the very least, curtail purchasing inventory.

With the reduction of purchasing, other manufacturers, importers and brokers, wholesalers and suppliers will be forced to trim their staff as well, continuing the erosion of the employment base in the town, and nationally.

Trimming back on risk, insurers refuse to provide Joe or Mary with insurance coverage for their cars while they’re in a bad financial state. They, and their family life insurance policies lapse. Their health insurance is dropped, and when insurers realize the dramatic drop in premiums is making the cost of insuring those still paying higher, premiums across the nation will rise to a point where health insurers will collapse.

Coincidentally, the banks, seeing a significant risk in lending to any new businesses that may wish to open in that town, refuse loans, keeping stores, offices and plants closed even longer. There being no means for a bank to safely qualify the business that’s seeking to open, commercial space will remain empty. With that, crime rises. The town can’t afford new police and by attrition, reduces its police force. Crimes become progressively worse, making the town less desirable for new businesses or new residents. Eventually, the town itself cannot sell its bonds and is forced into bankruptcy.

Of course Joe and Mary, who, with their spouses and families, used to take annual vacations have no money to do so anymore. The hotels they used to stay in see that happening with thousands of regular customers. The airlines don’t book flights, and some of them are forced to cut staff and routes, further isolating some communities.

Suddenly, the unemployment rate for 2008 is looking like the good ol’ days, as unemployment reaches 15%. Healthcare, one of the few industries presently doing well, suffers extensively as people default on their bills, insurers refuse to cover them, and doctors file for bankruptcy. Before the end of 2009, several hospital corporations file for Chapter 11.

Mr. Obama’s stimulus package was passed, and provided a range of projects to stimulate the national economy. However, no-one realized the money would not be forthcoming immediately. Capital projects require planning, and that takes time, so funding in the pipeline for major projects produces little money except for those who plan them until the project is ready to proceed.

The reason we proposed a capital injection program for small to mid-sized businesses as early as September was that by direct injection, government can infuse cash into a cash-strapped economy, bypassing the banks, and permitting businesses to trade.

The obverse of de-leveraging, direct cash injection into small business would mean that the company Joe and Mary worked for could continue operating, perhaps using the funds for marketing, research and development or as a payroll offset to insure continued operations.

Unlike banks, small business is unlikely to hoard cash, and would pay their bills, including their payroll. With the latter, they would keep Joe and Mary working, and stabilize the workforce.

How does one inject capital into small to mid-sized businesses?  Quite simply: by existing systems. Either you make direct investments or low interest loans directly from SBA. Either way, a business plan should be provided and reviewed, as SBA currently requires. The applicant for such funds agrees to use the funds for a list of approved purposes with the understanding that a violation of such use has criminal penalties (as the laws presently allow). Government simply implies additional rules, preventing business owners or management from taking golden parachute payments, or other excessive compensation. 

The added benefit of this is that it compels the business owner to file their taxes correctly, and include the capital injection. It could and should also require that all state taxes and fees are paid in full prior to approval, ensuring that the states receive a short burst of payments.

Now here’s the clincher… where do businesses hold their money? In banks; where those deposits would become a secondary injection of funds. As banks generally lend at a rate of 12:1, compelling banks to lend that money, these funds would spur bankers to begin lending again, and businesses and their employees would again seek lending.

Admittedly, this doesn’t solve the core issue of this crisis – bad lending. However, it does buy sufficient time to implement banking system reform that includes checks and balances to prevent banks from lending to under-qualified borrowers.

So, in conclusion, where we go is up to government. Whether we go in the right direction is up to our new President. May divine providence guide him and Congress along the right path.

Hold on... Phase II is going to be a very bumpy ride.