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Inspiration for Investors

Trade like a professional with the help of Warren Buffett, John Mauldin, Andrew Smithers & more...

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Table of Content

006

The Warren Buffett Way, Third Edition . . . . . . . .

026

Angela Merkel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Go to chapter

042

The Road to Recovery . . . . . . . . . . . . . . . . . . . . . . .

Go to chapter

053

Code Red . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Go to chapter

074

The Manual of Ideas . . . . . . . . . . . . . . . . . . . . . . . .

Go to chapter

096

The Dao of Capital . . . . . . . . . . . . . . . . . . . . . . . . . .

Go to chapter

112

Bonds are Not Forever . . . . . . . . . . . . . . . . . . . . . .

Go to chapter

135

The Essays of Warren Buffet, Fourth Edition . . .

Go to chapter

151

The Trader’s Guide to the Euro Area . . . . . . . . . .

Go to chapter

173

The Secret Millionaire’s Club . . . . . . . . . . . . . . . .

Go to chapter

181

Celebrate 100 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Go to chapter

196

The Aftershock Investor, Second Edition . . . . . . .

Go to chapter

215

An Embarrassment of Riches . . . . . . . . . . . . . . . .

Go to chapter

Go to chapter

Robert G. Hagstrom Chapter 1: A Five Sigma Event - The World’s Greatest Investor Alan Crawford and Tony Czuczka Chapter 2: Revelation (Five Minutes to Midnight)

Andrew Smithers Chapter 2: Why the Recovery Has Been So Weak John Mauldin & Jonathan Tepper Chapter 1: The Great Experiment

John Mihaljevic Chapter 1: A Highly Personal Endeavour

Mark Spitznagel Chapter 1: The Daoist Sage - Klipp’s Paradox

Simon Lack Chapter 1: From High School to Wall Street - The Bull Market Begins Lawrence A. Cunningham Chapter 1: Corporate Governance

David Powell Chapter 2: Gross Domestic Product

Andy & Amy Hayward Chapter 1: Don’t Be Afraid To Make Mistakes

Steve Franklin & Lynn Peters Adler Chapter 1: Today’s Centenarians - Celebrities and National Treasures David Wiedemer, Robert A. Wiedemer & Cindy S. Spitzer Chapter 1: This “Recovery” Is 100 Percent Fake - Why the aftershock has not been cancelled Alexander Green Chapter 1: Introduction

Some of these chapters are from advance uncorrected first proofs and are subject to change. All information and references must be checked against final bound books.

5


The Warren Buffett Way, 3rd Edition Robert G. Hagstrom 978-1-118-50325-6 • Hardback • 320 pages • October 2013

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A Five-Sigma Event

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race yourself,” Buffett said, with a sly grin. He was sitting in a Manhattan living room on a spring morning with one of his dearest and oldest friends, Carol Loomis. A New York Times best-selling author and an award-winning journalist, Carol is senior editor-atlarge at Fortune magazine, where she has worked since 1954, and is considered to be the magazine’s resident expert on Warren Buffett. It is well known among the Buffett faithful that she has also been editing Berkshire Hathaway’s annual reports since 1977. On that spring day in 2006, Buffett told Carol that he had changed his thinking about how and when he was going to give away his fortune in Berkshire Hathaway stock. Like most people, Carol knew that Buffett, after a small allocation to his three children, was going to leave 99 percent of his wealth to charity, but it was always thought it would go to the Buffett Foundation established by his late wife, Susan. Now he was telling Carol he had changed his mind. “I know what I want to do,” he said, “and it makes sense to get going.”1 So, shortly before lunch, on June 26, 2006, Warren Buffett, who was then the second richest man in the world, stepped up to the microphone inside the New York Public Library. The audience— hundreds of the wealthiest people in the city—greeted him with a standing ovation. After a few brief words, Buffett reached inside his 1

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jacket pocket and pulled out five letters. Each one announced the disposition of his fortune, and only awaited his signature. The first three letters were easy; he just signed “Dad” and then handed them to his children: daughter Suze, eldest son Howard, and second son Peter. The fourth letter was turned over to a representative of his late wife’s charitable foundation. Together, these four letters promised to give away a combined $6 billion.2 The fifth letter was the surprise. Buffett signed it and handed it to the wife of the only man on the planet who was richer than himself, Bill Gates. With that last letter, Buffett pledged over $30 billion in Berkshire Hathaway stock to the world’s largest philanthropic organization, the Bill and Melinda Gates Foundation. It was by far the single greatest amount of money ever given away, miles bigger than the contributions by Andrew Carnegie ($7.2 billion when adjusted to current dollars), John D. Rockefeller ($7.1 billion), or John D. Rockefeller Jr. ($5.5 billion). In the days that followed, there were countless questions. Was Buffett ill, perhaps even dying? “No, absolutely not,” he said. “I feel terrific.” Did his wife’s passing have anything to do with his decision? “Yes, it does,” confessed Buffett. It was well known that Susie would have inherited Buffett’s fortune for the Buffett Foundation. “She would have enjoyed the process,” he said. “She was a little afraid of it, in terms of scaling up. But she would have liked doing it, and would have been very good at it.”3 But after his wife’s death, Buffett changed his thinking. He realized that the Bill and Melinda Gates Foundation was a terrific organization, already scaled to handle the billions of dollars Buffett was going to send its way. They “wouldn’t have to go through the real grind of getting to a megasize like the Buffett Foundation would—and they could productively use my money now,” he said. “What can be more logical, in whatever you want done, than finding someone better equipped than you are to do it?”4 It was quintessential Buffett. Rationality prevailed. At Berkshire Hathaway, Buffett reminds us there are scores of managers running businesses that do a much better job of running their operations than he ever could. Likewise, the Bill and Melinda Gates

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Foundation would do a better job of managing his philanthropy than he could do himself. Bill Gates said of his friend, “Warren will be remembered not only as the greatest investor, but the world’s greatest investor for good.”5 This will most certainly be true. But it is important to remember that the good his philanthropic generosity will do was made possible in the first place by his unparalleled investing skill. When Buffett handed the letter and check for $30 billion to Melinda Gates, I immediately thought back to another check he had written 50 years earlier—for $100, his initial investment in the Buffett Partnership, Ltd. Buffett has always claimed he won the ovarian lottery. He figures the odds of him being born in 1930 in the United States were about 30:1. He admits he couldn’t run fast and would never have been a good football player. Neither, despite his talents at plucking a ukulele, would he ever become a concert violinist. But he was “wired in a particular way” that would allow him “to thrive in a big capitalist economy with a lot of action.”6 “My wealth has come from a combination of living in America, some lucky genes, and compound interest,” said Buffett. “My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well.” To keep it all in perspective, Buffett humbly reminds us that he happens to work “in an economy that rewards someone who saves lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect the mispricing of securities with sums reaching into the billions.” He called it fate’s capricious distribution of “long straws.”7 That may be true. But in my mind, Buffett carved his own destiny, which determined his own fate—not the other way around. This is the story of how Warren Buffett made his own long straw.

Personal History and Investment Beginnings Warren Edward Buffett was born August 30, 1930, in Omaha, Nebraska. He was the seventh generation of Buffetts to call Omaha home. The first Nebraskan Buffett opened a grocery store in 1869.

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Buffett’s grandfather also ran a grocery store and once employed a young Charlie Munger, the future vice chairman of Berkshire Hathaway. Buffett’s father, Howard, was a local stockbroker and banker who later became a Republican Congressman. It was said that as soon as Warren Buffett was born he was fascinated by numbers. That may be a stretch, but it is well documented that before he entered kindergarten he was already a calculating machine. As young boys, he and his best friend Bob Russell would sit on the Russell family porch recording license-plate numbers of the cars that passed by. When darkness fell, he and Bob would go inside, spread the Omaha World-Herald on the floor, and count the number of times each letter appeared in the paper. They then tallied their calculations in a scrapbook, as if it was top-secret information. One of young Buffett’s most prized toys came from his Aunt Alice, who was quite fond of her peculiar but immensely likable nephew and made him an irresistible offer: If he would agree to eat his asparagus, she would give him a stopwatch. Buffett was mesmerized by this precise counting machine and used it in endless little-boy ventures, like marble races. He would summon his two sisters into the bathroom, fill the tub with water, and then direct them to drop their marble into one end. The one whose marble reached the drain stopper first was the winner (utilizing the tub’s sloped shape). Buffett, stopwatch at the ready, timed and recorded each race. But it was the second gift from Aunt Alice that sent six-yearold Buffett into a new direction—a fascination not with just numbers, but with money. On Christmas day, Buffett ripped open his present and strapped onto his belt what would become his most treasured possession—a nickel-coated money changer. He quickly found many ways to put it to good use. He set up a table outside his house and sold Chiclets to anyone who passed by. He went doorto-door selling packs of gum and soda pop. He would by a six-pack of Coke at his grandfather’s grocery store for 25 cents and sell the individual bottles for a nickel: 20 percent return on investment. He also sold, door-to-door, copies of the Saturday Evening Post and Liberty magazines. Each weekend he sold popcorn and peanuts at

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local football games. With him through all these enterprises was his money changer, taking in dollars and making change.8 What now sounds like an idyllic childhood took an abrupt turn when Buffett’s father returned home one night to inform the family the bank where he worked had closed. His job was gone and their savings were lost. The Great Depression had finally made its way to Omaha. Buffett’s grandfather, the grocery store owner, gave Howard money to help support his family. Fortunately, the sense of hopelessness did not last long. Howard Buffett soon pulled himself up and got back on his feet, announcing that Buffett, Sklenicka & Company had opened for business at the Union State building on Farnam Street, the same street where Buffett would someday buy a house and start his investment partnership. The effect of the Great Depression, albeit brief, was hard on Buffett’s family. It also made a deep and profound impression on young Warren. “He emerged from those first hard years with an absolute drive to become very, very, very rich,” wrote Roger Lowenstein, author of Buffett: The Making of an American Capitalist. “He thought about it before he was five years old. And from that time on, he scarcely stopped thinking about it.”9 When Buffett turned 10, his father took him to New York. It was a birthday gift Howard gave to each of his children. “I told my Dad I wanted to see three things,” said Buffett. “I wanted to see the Scott Stamp and Coin Company. I wanted to see the Lionel Train Company. I wanted to see the New York Stock Exchange.”10 After an overnight ride on the train, Buffett and his dad made their way to Wall Street, where they met with At Mol, a member of the exchange. “After lunch, a guy came along with a tray that had all these different kinds of tobacco leaves on it,” recalled Buffett. “He made up a cigar for Mr. Mol, who picked out the leaves he wanted. And I thought, this is it. It doesn’t get any better than this. A custom-made cigar.”11 Later, Howard Buffett introduced his son to Sidney Weinberg, a senior partner at Goldman Sachs, then considered the most famous man on Wall Street. Standing in Weinberg’s office, Buffett was mesmerized by the photographs and documents on the wall. He took note of the framed original letters, knowing full well they were

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written by famous people. While Howard and Sidney talked about financial issues of the day, Buffett was oblivious, walking around and around Weinberg’s office staring at the artifacts. When it was time to go, Sidney Weinberg put his arm around Buffett and jokingly asked him what stock he liked. “He’d forgotten it all the next day,” Buffett recalled, “but I remembered it forever.”12 Even before Buffett traveled to New York, he was already intrigued with stocks and the stock market. He was a frequent visitor to his dad’s brokerage office, where he would stare at stock and bond certificates that hung on the wall, just like in Sidney Weinberg’s office. Often he would bounce down the two flights of stairs right into the Harris Upham brokerage firm. Many of the brokers became fond of the pesky kid who never seemed to stop asking questions. From time to time they would allow young Warren to chalk the prices of stocks on the blackboard. On Saturday mornings, when the stock exchange was open for two hours, Buffett would hang out with his paternal great-uncle Frank Buffett and his maternal great-uncle John Barber at the brokerage office. According to Buffett, Uncle Frank was a perpetual bear and Uncle John was the ever-optimistic bull. Each competed for Buffett’s attention with stories of how they thought the world would unfold. All the while, Buffett stared straight ahead at the Trans-Lux stock ticker, trying to make sense of the continually changing stock prices. Each weekend he read the “Trader” column in Barron’s. Once he finished reading all the books on his father’s bookshelf, he consumed all the investment books at the local library. Soon he began charting stock prices himself, trying to understand the numerical patterns that were flashing by his eyes. No one was surprised when 11-year-old Buffett announced he was ready to buy his first shares of stock. However, they were shocked when he informed his family he wanted to invest $120, money he had saved from selling soda pop, peanuts, and magazines. He decided on Cities Service Preferred, one of his father’s favorite stocks, and enticed his sister Doris to join him. They each bought three shares, for an investment of $114.75 each. Buffett had studied the price chart; he was confident.

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That summer the stock market declined, hitting its yearly low in June. The two junior Buffetts saw their stocks decline 30 percent. Not a day went by when Doris did not pester Warren about their loss, so when Cities Service Preferred recovered to $40 per share, he sold their holdings, for a $5 profit. To Buffett’s chagrin, Cities Service Preferred soon soared to $202 a share. After commissions, Buffett calculated he had forgone a profit of over $492. Since it had taken him five years to save $120, he figured he had just given up 20 years of work. It was a painful lesson, but ultimately a valuable one. Buffett swore that, first, he would never again be sidetracked by what he paid for the stock, and, second, he would not settle for small profits. At the wise age of 11, Buffett had already learned one of the most important lessons in investing—patience. (More about this crucial quality in Chapter 7.) In 1942, when Buffett was 12, his father was elected to the U.S. Congress and moved the family to Washington. The change was hard on the young boy. Miserable and hopelessly homesick, he was allowed to return to Omaha for a year, to live with his grandfather and Aunt Alice. The following year, 1943, Warren gave Washington another chance. With no friendly brokerage firms to hang out in, gradually Buffett’s interest moved away from the stock market and toward entrepreneurial ventures. At age 13, he was working two paper routes, delivering the Washington Post and the Washington Times-Herald. At Woodrow Wilson High School, he made friends with Don Danly, who quickly became infected with Buffett’s enthusiasm for making money. The two pooled their savings and bought reconditioned pinball machines for $25. Buffett convinced a local barber to let them put a machine in his shop for half the profits. After the first day of operation, they returned to find $4 in nickels in their very first machine. The Wilson Coin-Operated Machine Company expanded to seven machines, and soon Buffett was taking home $50 per week. By the time Buffett graduated from high school, his savings from various endeavors totaled $9,000. He promptly announced that he saw no reason to go to college, as it would interfere with his business ventures. His father overruled him, and by the fall

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Buffett found himself enrolled at the University of Pennsylvania’s Wharton School of Business and Finance. Despite Wharton’s emphasis on business and finance, Buffett was unimpressed with the university. “Not exactly turned on by it,” he confessed; “it didn’t seem like I was learning a lot.”13 The Wharton curriculum stressed the theoretical aspects of business; what interested Buffett were the practical aspects of a business—how to make money. After two years at Wharton (1947–1949), he transferred to the University of Nebraska. He took 14 courses in one year and graduated in 1950. He was not yet 20 years old. Back in Omaha, Buffett reconnected with the stock market. He started collecting hot tips from brokers and subscribed to publishing services. He resurrected his price charts and studied books on technical analysis. He applied the McGee point-and-figure system and every other system he could think of, trying to figure out what would work. Then one day, browsing in the local library, he came across a recently published book titled The Intelligent Investor by Benjamin Graham. “That,” he said, “was like seeing the light.”14 Graham’s treatises on investing, including Security Analysis (1934), cowritten with David Dodd, so influenced Buffett that he left Omaha and traveled to New York to study with Graham at the Columbia University Graduate School of Business. Graham preached the importance of understanding a company’s intrinsic value. He believed investors who accurately calculated this value and bought shares below it in price could be profitable in the market. This mathematical approach appealed to Buffett’s love of numbers. In Graham’s class were 20 students. Many were older than Buffett and several were working on Wall Street. In the evening, these Wall Street professionals sat in Graham’s class discussing which stocks were massively undervalued, and the next day they would be back at work buying the stocks analyzed the night before and making money. It was soon clear to everyone that Buffett was the brightest student. He often raised his hand to answer Graham’s question before Graham had finished asking it. Bill Ruane, who later cofounded

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the Sequoia Fund with Rick Cuniff, was in the same class. He recalls that there was an instantaneous chemistry between Graham and Buffett, and the rest of the class was primarily an audience.15 Buffett’s grade for the class was an A+—the first A+ Graham had awarded in 22 years of teaching. After graduating from Columbia, Buffett asked Graham for a job but was turned down. At first he was stung by the rejection but later was told that the firm preferred to fill the slots at GrahamNewman with Jewish analysts who, it was perceived, were being treated unfairly on Wall Street. Undeterred, Buffett returned to Omaha, where he joined Buffett-Falk Company, his father’s brokerage. He hit the ground running, eagerly recommending stocks that met Graham’s value criteria. All the while Buffett stayed in touch with Graham, sending him stock ideas after stock ideas. Then, in 1954, Graham called with news: The religious barrier had been lifted and there was a seat at Graham-Newman if he was still interested. Buffett was on the next plane to New York. During his tenure at Graham-Newman, Buffett became fully immersed in his mentor’s investment approach. In addition to Buffett, Graham also hired Walter Schloss, Tom Knapp, and Bill Ruane. Schloss went on to manage money at WJS Ltd. Partners for 28 years. Knapp, a Princeton chemistry major, was a founding partner in Tweedy, Browne Partners. Ruane cofounded the Sequoia Fund. For Buffett, Graham was much more than a tutor. “It was Graham who provided the first reliable map to that wondrous and often forbidding city, the stock market,” wrote Roger Lowenstein. “He laid out a methodological basis for picking stocks, previously a pseudoscience similar to gambling.”16 Since the days when 11-yearold Buffett first purchased Cities Service Preferred, he had spent half of his life studying the mysteries of the stock market. Now he had answers. Alice Schroeder, author of The Snowball: Warren Buffett and the Business of Life, wrote, “Warren’s reaction was that of a man emerging from the cave in which he had been living all his life, blinking in the sunlight as he perceived reality for the first time.” According to Schroeder, Buffett’s original “concept of a stock was derived from the patterns formed by the prices at which pieces of

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paper were traded. Now he saw that those pieces of paper were simply symbols of an underlying truth.”17 In 1956, two years after Buffett arrived, Graham-Newman disbanded and Graham, then 61, decided to retire. Once again Buffett returned to Omaha. Armed with the knowledge he had acquired from Graham, and with the financial backing of family and friends, he began a limited investment partnership. He was 25 years old.

The Buffett Partnership Ltd. The Buffett Partnership began with seven limited partners who together contributed $105,000. Buffett, the general partner, started with $100. The limited partners received 6 percent annually on their investments and 75 percent of the profits above this bogey; Buffett earned the other 25 percent. But the goal of partnership was relative, not absolute. Buffett’s intention, he told his partners, was to beat the Dow Jones Industrial Average by 10 percentage points. Buffett promised his partners that “our investments will be chosen on the basis of value not popularity” and that the partnership “will attempt to reduce permanently capital loss (not short-term quotational loss) to a minimum.”18 Initially, the partnership bought undervalued common stocks based on Graham’s strict criteria. In addition, Buffett also engaged in merger arbitrage—a strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless profit. Out of the gate, the Buffett partnership posted incredible numbers. In its first five years (1957–1961), a period in which the Dow was up 75 percent, the partnership gained 251 percent (181 percent for limited partners). Buffett was beating the Dow not by the promised 10 percentage points but by an average of 35. As Buffett’s reputation became more widely known, more people asked him to manage their money. As more investors came in, more partnerships were formed, until Buffett decided in 1962 to reorganize everything into a single partnership. That year Buffett moved the partnership office from his home to Kiewit Plaza in

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Omaha, where his office remains today. The following year, Buffett made one of his most famous investments, one that served to boost his already growing reputation. One of the worst corporate scandals in the 1960s occurred when the Allied Crude Vegetable Oil Company, led by Tino De Angelis, discovered it could obtain loans based on the inventory of its salad oil. Using one simple fact—that oil floats on top of water— De Angelis rigged the game. He built a refinery in New Jersey, put in 139 five-story storage tanks to hold soybean oil, then filled the tanks with water topped with just a few feet of salad oil. When inspectors arrived to confirm inventory, Allied employees would clamber up to the top of the tanks, dip in a measuring stick, and call out a false number to the inspectors on the ground. When the scandal broke, it was learned that Bank of America, Bank Leumi, American Express, and other international trading companies had backed over $150 million in fraudulent loans. American Express was one of the biggest casualties of what became known as the salad oil scandal. The company lost $58 million and its share price dropped by over 50 percent. If Buffett had learned anything from Ben Graham, it was this: When a stock of a strong company sells below its intrinsic value, act decisively. Buffett was aware of the $58 million loss, but what he did not know was how customers viewed the scandal. So he hung out at the cash registers of Omaha restaurants and discovered there was no drop-off in the use of the famous American Express Green Card. He also visited several banks in the area and learned that the financial scandal was having no impact on the sale of American Express Travelers Cheques. Returning to his office, Buffett promptly invested $13 million—a whopping 25 percent of the partnership assets—in shares of American Express. Over the next two years, the shares tripled and the partners netted a cool $20 million in profit. It was pure Graham, and pure Buffett. In the beginning, Buffett confined the partnership to buying undervalued securities and certain merger arbitrage announcements. But in the fifth year, he purchased his first controlling interest

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in a business—the Dempster Mill Manufacturing Company, a maker of farm equipment. Next he began buying shares in an ailing New England textile company called Berkshire Hathaway, and by 1965 he had control of the business. ■ ■ ■ In differential calculus, an inflection point is a point on a curve at which the curvature changes from being plus to minus or minus to plus. Inflection points can also occur in companies, industries, economies, geopolitical situations, and individuals as well. I believe the 1960s proved to be Buffett’s inflection point—where Buffett the investor evolved into Buffett the businessperson. It was also a period when the market itself reached an inflection point. Since 1956, the valuation strategy outlined by Graham and used by Buffett had dominated the stock market. But by the mid-1960s a new era was unfolding. It was called the “Go-Go” years—the “GoGo” referred to growth stocks. It was a time when greed begin driving the market and where fast money was made and lost in the pursuit of high-flying performance stocks.19 Despite the underlying shift in market psychology, the Buffett Partnership continued to post outstanding results. By the end of 1966, the partnership had gained 1,156 percent (704 percent for limited partners), blitzing the Dow, which was up 123 percent over the same period. Even so, Buffett was becoming increasingly uneasy. Whereas the market had been dancing to the principles outlined by Graham, the new music being played in the stock market made little sense to Buffett. In 1969, Buffett decided to end the investment partnership. He found the market highly speculative and worthwhile values increasingly scarce. By the late 1960s, the stock market was dominated by highly priced growth stocks. The Nifty Fifty were on the tip of every investor’s tongue. Stocks like Avon, Polaroid, and Xerox were trading at fifty to one hundred times earnings. Buffett mailed a letter to his partners confessing that he was out of step with the current market environment. “On one point, however, I am clear,” he said.

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“I will not abandon a previous approach whose logic I understand, although I find it difficult to apply, even though it may mean forgoing large and apparently easy profits, to embrace an approach which I don’t fully understand, have not practiced successfully and which possibly could lead to substantial permanent loss of capital.”20 At the beginning of the partnership, Buffett had set a goal of outperforming the Dow by an average of 10 percentage points each year. Between 1957 and 1969, he did beat the Dow—not by 10 percentage points a year but by 22! When the partnership disbanded, investors received their portions. Some were given an education in municipal bonds and others were directed to a money manager. The only individual whom Buffett recommended was Bill Ruane, his old classmate at Columbia. Ruane agreed to manage some of the partners’ money, and thus was born the Sequoia Fund. Other members of the partnership, including Buffett, took their portions in Berkshire Hathaway stock. Buffett’s share of the partnership had grown to $25 million, and that was enough to give him control of Berkshire Hathaway. When Buffett disbanded the partnership, many thought the “money changer’s” best days were behind him. In reality, he was just getting started.

Berkshire Hathaway The original company, Berkshire Cotton Manufacturing, was incorporated in 1889. Forty years later, Berkshire combined operations with several other textile mills, resulting in one of New England’s largest industrial companies. During this period, Berkshire produced approximately 25 percent of the country’s cotton needs and absorbed 1 percent of New England’s electrical capacity. In 1955, Berkshire merged with Hathaway Manufacturing, and the name was subsequently changed to Berkshire Hathaway. Unfortunately, the years following the merger were dismal. In less than 10 years, stockholders’ equity dropped by half and losses from operations exceeded $10 million. During the next 20 years, Buffett, along with Ken Chace, who managed the textile group,

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labored intensely to turn around the New England textile mills. Results were disappointing. Returns on equity struggled to reach double digits. By the 1970s, shareholders of Berkshire Hathaway began to question the wisdom of retaining an investment in textiles. Buffett made no attempt to hide the difficulties and on several occasions explained his thinking: The textile mills were the largest employer in the area; the workforce was an older age group that possessed relatively nontransferable skills; management had shown a high degree of enthusiasm; the unions were being reasonable; and, very importantly, Buffett believed that some profits could be realized from the textile business. However, he made it clear that he expected the textile group to earn positive returns on modest capital expenditures. “I won’t close down a business of subnormal profitability merely to add a fraction of a point to our corporate returns,” said Buffett. “I also feel it is inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition and Karl Marx would disagree with my second; the middle ground,” he explained, “is the only position that leaves me comfortable.”21 As Berkshire Hathaway entered the 1980s, Buffett was coming to grips with certain realities. First, the very nature of the textile business made high returns on equity improbable. Textiles are commodities, and commodities by definition have a difficult time distinguishing their products from those of competitors. Foreign competition, employing a cheap labor force, was squeezing profit margins. Second, in order to stay competitive the textile mills would require significant capital improvements, a prospect that is frightening in an inflationary environment and disastrous if the business returns are anemic. Buffett was faced with a difficult choice. If he made large capital contributions to the textile division in order to remain competitive, Berkshire would be left with poor returns on what was becoming an expanding capital base. If he did not reinvest, Berkshire’s textile mills would become less competitive with other domestic textile

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manufacturers. Whether Berkshire reinvested or not, foreign competition continued to have an advantage by employing a cheaper labor force. By 1980, the annual report revealed ominous clues for the future of the textile group. That year, the group lost its prestigious lead-off position in the Chairman’s Letter. By the next year, the textile group was not discussed in the letter at all. Then, the inevitable: In July 1985, Buffett closed the books on the textile group, thus ending a business that had begun some 100 years earlier. Despite the misfortunes of the textile group, the experience was not a complete failure. First, Buffett learned a valuable lesson about corporate turnarounds: They seldom succeed. Second, the textile group did generate enough capital in the early years to buy an insurance company, and that is a much brighter story.

Insurance Operations In March 1967, Berkshire Hathaway purchased, for $8.6 million, the outstanding stock of two insurance companies headquartered in Omaha: National Indemnity Company and National Fire & Marine Insurance Company. It was the beginning of Berkshire Hathaway’s phenomenal success story. To appreciate the phenomenon, it is important to recognize the true value of owning an insurance company. Insurance companies are sometimes good investments, sometimes not. They are, however, always terrific investment vehicles. Policyholders, in paying premiums, provide a constant stream of cash; insurance companies invest this cash until claims are filed. Because of the uncertainty of when claims will occur, insurance companies opt to invest in liquid securities—primarily short-term fixed income securities, longerdated bonds, and stocks. Thus Warren Buffett acquired not only two modestly healthy companies, but also a cast-iron vehicle for managing investments. In 1967, the two insurance companies had a bond portfolio worth more than $24.7 million and a stock portfolio worth $7.2 million. In two years, the combined portfolio approached $42 million. This was a

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handsome portfolio for a seasoned stock picker like Buffett. He had already experienced some limited success managing the textile company’s securities portfolio. When Buffett took control of Berkshire in 1965, the company had $2.9 million in marketable securities. By the end of the first year Buffett had enlarged the securities account to $5.4 million. In 1967, the dollar return from investing was three times the return of the entire textile division, which had 10 times the equity base of the common stock portfolio. It has been argued that when Buffett entered the insurance business and exited the textile business, he merely exchanged one commodity for another. Insurance companies, like textiles, are selling a product that is indistinguishable. Insurance policies are standardized and can be copied by anyone. There are no trademarks, patents, advantages in location, or raw materials that distinguish one from another. It is easy to get licensed, and insurance rates are an open book. Often the most distinguishable attribute of an insurance company is its personnel. The efforts of individual managers have enormous impact on an insurance company’s performance. Over the years, Buffett has added several insurance companies to the Berkshire insurance group. One prominent addition, now well known thanks to a clever advertising campaign, is GEICO. By 1991, Berkshire Hathaway owned nearly half of GEICO’s outstanding common shares. For the next three years, the company’s impressive performance continued to climb; so did Buffett’s interest. In 1994, Berkshire announced it owned 51 percent of the company, and serious discussion began on GEICO joining the Berkshire family. Two years later, Buffett wrote a check for $2.3 billion and GEICO became a wholly owned business. Buffett was not done. In 1998, he paid seven times the amount he had spent to buy the remaining outstanding shares of GEICO— about $16 billion in Berkshire Hathaway stock—to acquire a reinsurance company called General Re. It was his biggest acquisition up to that date. Over the years, Buffett has continued to buy insurance companies, but without question his smartest acquisition was a person—Ajit Jain, whom he hired to run the Berkshire Hathaway Reinsurance

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Group. Ajit, born in 1951, earned an engineering degree at the prestigious Indian Institutes of Technology. He worked for IBM for three years, then enrolled at Harvard to gain a business degree. Although Ajit had no insurance background, Buffett quickly recognized his brilliance. From a starting point in 1985, Ajit built the Reinsurance Group’s float (premiums earned but losses not paid) to $34 billion in a little over 20 years. According to Buffett, Ajit “insures risks that no one else has the desire or the capital to take on. His operation combines capacity, speed, decisiveness, and most importantly, brains in a manner that is unique in the insurance business.”22 Not a day goes by without Buffett and Ajit having a conversation. To give you an idea of Ajit’s value, in the 2009 Berkshire annual report, Buffett wrote, “If Charlie, I and Ajit are ever in a sinking boat—and you can only save one of us—swim to Ajit.”

The Man and His Company Warren Buffett is not easy to describe. Physically he is unremarkable, with looks that are more grandfatherly than corporate titan. Intellectually he is considered a genius, yet his down-to-earth relationship with people is truly uncomplicated. He is simple, straightforward, forthright, and honest. He displays an engaging combination of sophisticated dry wit and cornball humor. He has a profound reverence for those things logical and a foul distaste for imbecility. He embraces the simple and avoids the complicated. Reading his annual reports, one is struck by how comfortable Buffett is quoting the Bible, John Maynard Keynes, or Mae West. Of course the operable word is reading. Each report is 60 to 70 pages of dense information: no pictures, no color graphics, no charts. Those disciplined enough to start on page 1 and to continue uninterrupted are rewarded with a healthy dose of financial acumen, folksy humor, and unabashed honesty. Buffett is very candid in his reporting. He emphasizes both the pluses and the minuses of Berkshire’s businesses. He believes that people who own stock in Berkshire Hathaway are owners of the company, and he tells them as much as he would like to be told if he were in their shoes.

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The company that Buffett directs is the embodiment of his personality, his business philosophy (which is identically tied to his investment philosophy), and his own unique style. Berkshire Hathaway, Inc. is complex but not complicated. There are just two major parts; the operating businesses and the stock portfolio, made possible by the earnings of the noninsurance businesses and the insurance companies’ float. Running through it all is Warren Buffett’s down-to-earth way of looking at businesses he’s considering buying outright, a business he’s evaluating for common stock purchase, or the management of his own company. Today, Berkshire Hathaway is divided into three major groups: its Insurance Operations; its Regulated Capital-Intensive Businesses, which includes MidAmerican Energy and the railroad Burlington Northern Santa Fe; and Manufacturing, Services and Retailing Operations, with products ranging from lollipops to jet airplanes. Collectively, these businesses generated, in 2012, $10.8 billion in earnings for Berkshire Hathaway compared to the $399 million Buffett the businessperson earned in 1988. At yearend 2012, Berkshire Hathaway’s portfolio of investments had a market value of $87.6 billion against a cost basis of $49.8 billion. Twenty-five years ago, in 1988, Buffett the investor had a portfolio valued at $3 billion against a cost basis of $1.3 billion. Over the past 48 years, starting in 1965, the year Buffett took control of Berkshire Hathaway, the book value of the company has grown from $19 to $114,214 per share, a compounded annual gain of 19.7 percent; during that period, the Standard & Poor’s (S&P) 500 index gained 9.4 percent, dividends included. That is a 10.3 percent relative outperformance earned for almost five decades. As I said earlier, when the “money changer” shut down the Buffett Partnership, he was just getting started.

Five-Sigma Event For years academicians and investment professionals have debated the validity of what has come to be known as the efficient market theory. This controversial theory suggests that analyzing stocks is a

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waste of time because all available information is already reflected in current prices. Those who adhere to this theory claim, only partly in jest, that investment professionals could throw darts at a page of stock quotes and pick winners just as successfully as a seasoned financial analyst who spends hours poring over the latest annual report or quarterly statement. Yet the success of some individuals who continually beat the indexes—most notably Warren Buffett—suggests that the efficient market theory is flawed. Efficient market theoreticians counter that it is not the theory that is flawed. Rather, they say, individuals like Buffett are a five-sigma event, a statistical phenomenon so rare it practically never occurs.23 It would be easy to side with those who claim Buffett is a statistical rarity. No one has ever come close to repeating his investment performance, whether it was the 13-year results from the Buffett Partnership or the almost five-decade performance record at Berkshire Hathaway. When we tabulate the results of almost every investment professional, noting their inability to beat the major indexes over time, it prompts the question: Is the stock market indeed unassailable, or is it a question of the methods used by most investors? Last, we have Buffett’s own words to consider. “What we do is not beyond anyone else’s competence. I feel the same way about managing that I do about investing: it is just not necessary to do extraordinary things to get extraordinary results.”24 Most would dismiss Buffett’s explanation as nothing more than his special brand of Midwestern humility. But I have taken his word on the matter, and it is the subject of this book.

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Angela Merkel A Chancellorship Forged in Crisis Alan Crawford & Tony Czuczka

Buy Now!

978-1-118-64110-1 • Hardback • 214 pages • July 2013

Remember, simply quote promotion code OCT13 when ordering direct through www.wiley.com to receive 30% off! £19.99 £13.99 / €24.00 €16.80 / $32.50 $22.75


Chapter 2

Revelation (Five Minutes to Midnight)

A

ngela Merkel stepped out of her Audi A8 and on to the red carpet at the Cannes conference center to be greeted by Nicolas Sarkozy flanked by French Republican Guards in white breeches and ceremonial plumed helmets, their sabres held aloft in salute. For all the pomp, the mood on the French Riviera in November 2011 was far from celebratory: Merkel shook her head and Sarkozy raised his hands in a gesture of exasperation as they met. It was Greece again. Europe was two years into the sovereign debt crisis that had emerged in Greece and was rippling through the euro area. Governments were toppling as borrowing costs soared, dividing the region into a relatively healthy northern core anchored by Germany and a weaker periphery that ran in an arc from Ireland to Spain and Portugal, through Italy to its focal point, Greece. Each step of the fight to beat back the contagion only ever calmed financial markets for a matter of weeks or less before the flames reappeared somewhere else. Two bailouts worth 240 billion euros for Greece alone, almost the equivalent of its entire annual gross domestic product, the promise of debt relief, enrolling the expertise of the International Monetary Fund (IMF) alongside a 440 billion euro European rescue fund had failed to stop the crisis in its tracks. Now Greece’s Prime Minister George Papandreou had given

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a televised address in Athens announcing his intention to hold a referendum on the latest round of measures approved by European governments to aid his country. A “No” vote would unravel what progress had been made and cause fresh waves of uncertainty to crash over the euro area, throwing the future of the single currency further into doubt. Merkel, as the leader of Europe’s dominant economy, was first in line to stop that from happening. She and Sarkozy met in Cannes on the eve of a Group of 20 summit of world leaders to decide the next move in their campaign to save the euro and defend European unity. Over two days in the Cannes conference center at one end of the palm-lined Boulevard de la Croisette, Merkel joined with Sarkozy to threaten Greece with defenestration from the euro and browbeat Italian Prime Minister Silvio Berlusconi into the humiliation of allowing outside monitoring of his country’s economy. Within a week of being publicly cut loose, the Greek and Italian leaders lost what residual support they had and stood down, twin victims of the crisis. It was regime change by alternative means. Cannes, the Riviera town that hosts the eponymous film festival, was the moment that all strands came together in the crisis, and Merkel was the principal actor. The Greek economy was on a life support system, dependent upon international aid as it faced a fifth straight year of recession. Public backing for Papandreou’s government had collapsed as jobs and spending were slashed in a bid to wrestle down the biggest debt load per capita in the 27-nation European Union,1 measures that were demanded in return for financial help under the terms of Greece’s rescue deal. Papandreou’s way out was to call a referendum in a bid to lance the boil and win some space to press on in the hope that signs of progress would emerge to alleviate the anger at home. His problem was that he failed to inform either his European partners or his own ministers before he made the announcement. “His behavior was disloyal,” said Luxembourg’s Prime Minister Jean-Claude Juncker, who also headed meetings of finance ministers of the euro countries, a role that gained in importance the longer the crisis persisted. “We would like to have been told.”2 Le Monde reported that Sarkozy was dismayed by the revelation. The G-20 summit hosted by France was meant to set the stage for his campaign for a second term. Sarkozy planned to show a united European

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front and win agreement from world leaders for a global effort to restore confidence to financial markets that were losing faith in Europe’s ability to tackle the malaise at its heart. He was going to be photographed with Chinese President Hu Jintao and sign autographs with U.S. President Barack Obama as the crowds cheered. “History is being written in Cannes,” read the G-20 banners going up around the town. Now his plans were threatened by Greece, and it wasn’t even a member of the G-20 club. In Berlin, Chancellor Merkel learned of the referendum at 7:20 p.m. on October 31 and took a moment to consider her response. She called Sarkozy and the two decided to summon Papandreou to Cannes to explain himself. They also agreed to halt the next aid payment to Greece until the referendum was cleared up, money that Greece desperately needed to pay its bills. At 7:15 a.m. on Tuesday morning, German Finance Minister Wolfgang Schäuble called his Greek counterpart, Evangelos Venizelos, in the Athens hospital where he was undergoing treatment for stomach pains and told him of the decision. Finance ministers from the other euro countries rubber stamped the suspension of aid within 90 minutes. Greece was effectively in limbo until Merkel and Sarkozy decided what to do with Papandreou. “Merkel and Sarkozy were upset because they felt they were betrayed,” said Xavier Musca, Sarkozy’s chief economic adviser and G-20 coordinator at the time. “They also felt Papandreou was not reliable, because they had spent one night with him discussing everything, and then he decides to do something he never talked about.”3 The night in question was a 10-hour crisis session of European leaders in Brussels the previous week on October 26–27 again dominated by Greece. Papandreou’s maneuvering was particularly galling for Merkel and Sarkozy because they had sat up half the night to negotiate a deal aimed at saving Greece, the second in almost 18 months. Their backing had secured agreement on a 130 billion-euro bailout for Greece crafted with the IMF on top of a 110 billion-euro rescue agreed in May 2010. They had personally intervened with the banks’ representative, Charles Dallara of the International Institute of Finance, summoning him from his hotel that night to accept losses of 50 percent on Greek government debt held in private hands. When he resisted, he was told the alternative was to allow Greece to go bankrupt, after

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which the banks would in all likelihood receive nothing back on their investments.4 The same summit also forged a plan to increase Europe’s rescue fund for any future countries that went the way of Greece to 1 trillion euros, as well as compelling banks to raise the amount of money they held in store to absorb financial shocks. Taken together, it was a package that promised to finally snuff out the flames of financial contagion that were spreading across Europe while putting a lid on the source of the conflagration: Greece. At the summit’s close, Papandreou personally thanked Merkel and Sarkozy for their efforts. “This agreement gives us time,” he said. “Tens of billions of euros have been lifted from the backs of the Greek people.” Even Merkel departed from her characteristically restrained rhetoric. “I am very aware that the world’s attention was on these talks,” she said at a press conference after 4 a.m. as the summit ended. “We Europeans showed tonight that we reached the right conclusions.” It took one weekend for Europe to demonstrate its inherent capacity to shoot itself in the foot. Greeks were in open rebellion and opposed putting their country any more at the mercy of its international creditors. They wanted nothing do with a policy that promised to inflict yet more deprivation on a population already on its knees. Papandreou, having successfully negotiated for the debt burden to be eased, returned home to be greeted as a traitor. A snap poll in Greece taken after the EU summit floated the idea that the measures agreed should be put to a referendum, with 46 percent saying they would vote against. More than seven in 10 still said they wanted to stay in the euro. With his majority whittled down to 153 seats in the 300-member parliament, Papandreou felt he needed to resolve that contradiction and regain democratic legitimacy. A plebiscite fit the bill, even if for Greece as well as for the rest of Europe the prospect of a referendum created a whole new set of unknown factors. International financial markets, already highly strung after months of bombardment by the crisis centered on Greece, were quick to offer their verdict. On Tuesday, November 1, the day after the referendum plan was announced, Germany’s DAX lost 5 percent, France’s CAC 40 Index dropped 5.4 percent and Italy’s FTSE MIB Index sank 6.8 percent. U.S. stocks were hit and shares in Asia tumbled. National Bank of Greece plunged 15 percent, sending its share price to its lowest since 1992.5 Fitch Ratings said the referendum “dramatically raises the stakes

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for Greece and the eurozone,” increasing the risks of a “forced and disorderly” default. What that meant for the rest of the eurozone was incalculable, but the implications were dire. According to an estimate by Natixis, if Greece left the euro it could cause an additional 16.4 billion euros in net losses to French banks alone, with Sarkozy’s government left to fill the hole.6 Papandreou’s proposal “surprised all of Europe,” the French president said on November 1. “The plan adopted unanimously by the 17 members of the euro area last Thursday is the only possible way to resolve the problem of Greek debt.” In a joint statement issued the same day, he and Merkel said the package of measures agreed in Brussels was “more necessary than ever today.” EU President Herman Van Rompuy and EU Commission President José Barroso raised the pressure on Papandreou to stop the deal from unraveling. “We fully trust that Greece will honor the commitments undertaken in relations to the euro area and the international community,” they said. Italy, the euro area’s third largest economy, was meanwhile coming under threat. That night in Rome, on the eve of the G-20 summit and after a day in which Italy’s government borrowing costs climbed to the highest relative to Germany since before the advent of the euro, Prime Minister Berlusconi called an emergency meeting of his Cabinet. With the stage set for Cannes, Merkel and Sarkozy arranged to meet Papandreou at the film festival center facing the harbor filled with extravagant super-yachts. The Greek premier arrived a few hours after Merkel. This time there was no guard of honor. The EU’s Barroso and Van Rompuy attended the November 2 meeting along with the eurogroup head Juncker, IMF chief Christine Lagarde and the finance ministers of France, Germany and Greece. Papandreou arrived in Cannes bolstered by his Cabinet’s unanimous endorsement for his referendum plan, for all the residual doubts. There was still no word on the question to be put to the people. “The referendum will be a clear mandate and strong message within and outside Greece on our European course and our participation in the euro,” Papandreou told his ministers that morning before leaving for France. Already having to fend off calls for new elections from the opposition New Democracy party led by Antonis Samaras, the Greek premier said the question was not one of his

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government or another government: “The dilemma is yes or no to the loan accord, yes or no to Europe, yes or no to the euro.” Merkel and Sarkozy wouldn’t allow Papandreou the luxury of choice. The meeting, in one of the many rooms off the main conference hall, was explosive. Merkel, who was visibly “very upset,” according to Musca, saw it as time to face up to some unpleasant truths that had been avoided for too long. She and Sarkozy confronted Papandreou and berated him for presenting them with a fait accompli. Yes, the Greek people had made sacrifices, but the country as a whole was not an innocent party in the crisis of confidence sweeping the eurozone. They told him his planned ballot had placed the entire euro area at risk, and Europe’s biggest powers could not let the single currency be wrecked by one country. Suspecting him of trying to wriggle out of the commitments he made one week previously in Brussels, they handed him an ultimatum: hold to the agreement or wave goodbye to 8 billion euros in international rescue funds he needed to pay Greece’s bills. If he must hold a referendum on the outcome of what was decided, then it could be about one thing only: Greece’s future membership of the euro; in or out, they were prepared to let Greece go and risk the consequences. Sarkozy and Merkel dictated the timing and the content of Papandreou’s referendum, and spelled out the consequences of its outcome. The vote had to be brought forward to December to get it out of the way, removing a source of uncertainty as soon as possible. It could address Greece’s future in the euro only and not any aspect of the country’s bailout terms. Furthermore, there would be no money for Greece until the result was known. Sarkozy held a press conference after the meeting and said that not one cent would flow to Greece in the event of a “No” vote. It was all or nothing. Papandreou, presented with no alternative and his referendum eviscerated, accepted their terms. Publicly humiliated, he returned to Athens to face a confidence vote in parliament. The G-20 started the next day, Thursday November 3, with a discussion of Greece. Underscoring the global ramifications of one small country’s travails, a television set was brought into the main meeting room to allow leaders to watch the debate in the Greek parliament broadcast live on BBC World. As he addressed the main chamber in Athens, world leaders and the assembled press of more than 20 nations gathered

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around television screens to watch Papandreou. His majority dwindling further to two, the prime minister made a plea for a government of national unity to overcome the country’s epic problems. Political consensus, with the opposition coming on board to secure outside aid and help the transition through this unprecedented situation, would remove the need to ask the public’s backing for the deal struck in Brussels, he said. Venizelos, his finance minister, was more direct: Greece wasn’t going to hold a referendum. The vote scrapped and his attempt to seek legitimacy for the deal in tatters, Papandreou offered to stand aside to help the formation of a national unity government. He went on to win the confidence ballot by 153 votes to 145 votes after promising his own parliamentary group that he would go. His lastditch gamble had failed. Politically he was a spent force and he resigned the following week on November 11, nine days after Merkel and Sarkozy lost patience with him. Papandreou, who compared Greece’s path out of the crisis to Homer’s classic tale of Odysseus’s 10-year journey back to Ithaca, foundered at sea without reaching home. Merkel, acting with Sarkozy, helped seal his fate. If Greece could trigger the biggest two-day decline in global stocks in almost three years, as Papandreou’s referendum flip-flop had done, then events in Italy had the potential to cause even more carnage. Italy, the third biggest economy in the euro, with domestic output almost 10 times that of Greece, was becoming a worry to Merkel and Sarkozy alike. They’d already confronted Berlusconi on October 23 at a previous EU summit and told him to follow through on his commitments. Asked at a joint press conference what they’d said to Berlusconi then, Merkel and Sarkozy looked at each other for a moment, then laughed. Trust can only be regained by Italy assuming its responsibilities and taking credible steps for the future, Merkel said, dictating to Berlusconi what must be done. “Italy has great strengths but Italy also has a very high overall debt level, and that has to be credibly reduced,” she said. “That, I think, is the expectation on Italy.”7 On the eve of traveling to Cannes, with Italian government borrowing costs soaring, Berlusconi had promised to enact emergency measures in a budget bill to be passed that month including raising the retirement age, easing rules on firing workers, and accelerating state asset sales. Yet having given the

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wrong signals to markets in the past, Berlusconi was unable to give investors the assurances they wanted on Italy’s policy direction to merit an easing of the government’s costs of borrowing. Germany and France were pressing the Italians in private to announce budgetary measures before it was too late. Powerless to change his course and unable to have him fail to meet his commitments, the French and German leaders summoned Berlusconi to a room in the conference center on Thursday morning. As with Papandreou, they gave him an ultimatum: this was not a discussion about voluntary measures. Sarkozy and Merkel told Berlusconi that solving Greece was one thing, dealing with Italy a problem of a different magnitude. Unless he gave an immediate signal demonstrating that he was aware of the gravity of the situation, he was lost. Now that the fire of contagion was in Italy, the whole eurozone was at risk of implosion, they said: Do something about it. When Berlusconi said that he had always done the right thing by Italy, Merkel and Sarkozy told him markets didn’t share that faith. He needed to do something quickly to regain market confidence if he was to give Italy a chance of surviving the crisis. Boxed in, Berlusconi agreed to have the IMF send outside monitors to assess Italy’s budget. In a statement issued the following day at the close of the G-20, Christine Lagarde welcomed “Italy’s decision to invite the IMF to intensify our surveillance and monitoring work, to help support the major steps being taken by the government on both fiscal adjustment and structural reforms.” It was too little too late. Battered by the markets that drove Italy’s borrowing costs to fresh records, Berlusconi announced his resignation on November 10. For Merkel, whose position as Europe’s principal decision maker was cemented six months later when she lost her ally Sarkozy in France’s presidential election, the moment of truth for the euro area was the latest incarnation of financial crisis that had rocked her chancellorship almost since the beginning. Merkel was just 18 months into office when she was confronted with the worst global financial meltdown in living memory. She set about resolving each stage of crisis for which there was no playbook – in the banks, the economy, and as a result of euro countries’ debt loads – and she learned along the way. Catapulted to the forefront of European policy making during the euro trauma,

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it came to define Merkel’s chancellorship even as she struggled for a solution. Some leaders, like Papandreou and Berlusconi, collapse and fall victim to crisis; others like Merkel flourish. Lambasted for delaying, for backtracking, and for refusing to commit more resources to the crisis fight, Merkel showed at Cannes that she can suddenly be decisive, brutally so. The source of her resoluteness lay four months previously in the summer of 2011. Markets were plunging globally with the realization that Europe’s common efforts to help Greece had failed and the bailout program wasn’t working, spelling trouble for the rest of the euro area. An EU summit on July 21 had agreed on the second Greek bailout of 130 billion euros among a package of steps that included expanding the powers of the European rescue fund and easing the terms of emergency bailout loans awarded to Portugal and Ireland. Merkel also quietly dropped plans to enlist banks and other investors in helping to pay for the fallout of crises once a permanent rescue fund was set up in 2013, after criticism from the European Central Bank (ECB) and the U.S. that forcing the private sector to accept losses on their investments would worsen the situation and could tip the euro area over the edge. However, the summit still backed a German-led push for a restructuring of Greek debt, without shoring up Spain and Italy against contagion, sowing the seeds of the next bout of trouble. As early as April 2011, Germany had signaled its willingness to impose losses on Greece bondholders in the face of pledges by Papandreou to avoid such a situation. Werner Hoyer, Germany’s minister for European affairs, said that a so-called haircut on the debt held by investors “would not be a disaster.”8 By broaching a previously taboo subject, Germany was setting itself up for a widening of the crisis for political reasons. The market response was swift: the turmoil spread and started to infect core euro countries, with the interest rates paid by the Spanish, Italian, and even French governments climbing steeply. ECB President Jean-Claude Trichet instructed the central bank to step in and start buying Spanish and Italian government bonds in a bid to impose some calm and stop the situation from spiraling out of control. Until that summer, Europe’s leaders had focused on tackling small, peripheral countries: Greece, Ireland and Portugal, together worth some 6 percent of euro area gross domestic product (GDP). The

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meltdown showed the crisis had moved to the core, marauding Italy and Spain, jointly representing more than 25 percent of the euro area’s output, and lapping at the doors of the region’s linchpin, Germany. Forced to confront the evidence that the entire region was facing an existential threat, Merkel shifted her focus: she decided she had to save the euro and to take Europe with her. As early as May 2010, she had expressed her conviction that “our Europe will overcome the present crisis of our common currency.” Now it was time to act. Up to that point, Merkel insisted there were no innocent victims of the crisis, that countries had brought the market reaction upon themselves, whether through greed, corruption, or ineptitude. As Italy was sucked into the maelstrom despite a budget deficit of 3.9 percent in 2011 – just 0.9 percentage points outside EU limits and lower than France’s9 – she had to question that assessment. Markets were starting to price in a 98 percent chance of a Greek default, yet Merkel concluded it was impossible to calculate the impact of a “disorderly insolvency” on the wider euro area. Merkel told a closed meeting of leaders of her parliamentary group as they gathered in the Reichstag on the last day of August after the summer break that she would not go down in history as the person who wrecked the euro.10 With a lack of drama typical of the chancellor, she announced her decision to the world two weeks later on a regional radio station serving the greater Berlin area. “The top priority is to avoid an uncontrolled insolvency because that wouldn’t just hit Greece,” Merkel said in an rbb Inforadio interview on September 13. “Everything must be done to keep the euro area together politically, because we would very quickly face a domino effect” otherwise.11 The U.S. was quick to recognize the shift in Merkel’s thinking as a turning point for the global economy. Treasury Secretary Timothy Geithner appeared on CNBC the following day and praised Merkel’s comments as an acknowledgment that Europe’s crisis response to date had been “behind the curve” and that more had to be done. “And I think it’s important that you saw the Chancellor of Germany say yesterday – Angela Merkel say yesterday they are absolutely committed, and they have the financial capacity and the economic capacity to do what it takes to hold this thing together,” Geithner said.12 Merkel had until then been prepared to make it easy for Greece to leave the euro, perhaps offering guarantees of an early return to the

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currency under certain conditions, but the decision had to come from Greece. There was no mechanism to expel a country, however wayward, and to do so without the Greek government’s agreement would have spelled meltdown. With the realization that this was a place she could not go, Merkel swung behind Greece. Gone was the chastising language threatening sanctions on deficit “sinners” and in its place was encouragement to meet targets on the road to recovery. “We want a strong Greece in the euro area and Germany is ready to offer all kinds of help that is needed,” Merkel said after meeting with Papandreou in Berlin two weeks later, on September 27, 2011. Having finally acknowledged the stakes, Merkel made a choice to hold the eurozone together. That was why Papandreou’s referendum so incensed her. It also explained Merkel’s reconciliation with his successor, Antonis Samaras, after snubbing him for more than a year and a half. As the fall of 2011 drew closer, she had to rebalance German interests against Europe’s future, pitting her domestic reality against the wider effort to save Europe’s postwar unity. For a chancellor known for her love of weighing the evidence before settling upon her preferred option, it was decision time. French philosopher Bernard-Henri Lévy, interviewed in the German newspaper Frankfurter Allgemeine Zeitung in November 2012, said the fact that Greece and Italy – the cradles of European civilization – were among the countries worst affected by the crisis showed how it had reached “to the very fundament of European existence.” The crisis had overcome Europe’s “memory, everything that makes up its basis and origins, its soul, its grammar,” he said.13 Lévy’s assessment of the debt crisis was dramatic. Yet the fact he pronounced on it at all underscored the extent to which the saga of Greece and its sequels had gone mainstream. As the impact began to be felt by every taxpayer, it went from back page business news to the front pages of the tabloids. The lexicon of the crisis began to seep into the popular culture, with bond yields and spreads used to denote how bad things were. Dispatches from Greece or details of the latest EU summit agreement were topof-the-hour news across Europe, raising the pressure on Merkel, who was cast as making or breaking deals. If the chancellor glanced at Bild, Germany’s biggest-selling daily, she saw headlines such as “So the

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Greeks DO want our money,” or “The Iron Chancellor,” an epithet first attached to Bismarck, the first chancellor of a united Germany. Bild regularly featured the crisis on its front page alongside pictures of topless women, criticizing Greece or railing against joint sales of government bonds across the euro region – a proposal known as euro bonds that would mean Germany underwriting the debts of weaker states. While Germany obsessed about how much it was having to pay for euro rescues, others were preoccupied with how much their governments were paying to service debts. The higher the rate charged by markets, the riskier lending to the government was seen to be. Greece, Portugal, and Ireland were unable to keep functioning as their respective costs breached 7 percent, forcing them to seek outside help. The spread, or divergence from the German bonds that serve as the benchmark, showed how far from the path of fiscal rectitude a country had strayed. In France, “les spreads” became a national obsession; in Italy they echoed political turmoil that helped bring down governments. Italy’s top-selling Corriere della Sera ran a headline on its front page on November 9, 2011, proclaiming “Spread a 500,” as the spread over Germany reached 500 basis points, or 5 percentage points.14 Berlusconi announced his intention to step down as premier the next day. Pope Benedict XVI, a German, used one of his final speeches as pontiff , at the Vatican in January 2013, to urge European leaders to devote the same energy to tackling the growing divergence in wealth as the spread in borrowing costs. With euro countries locked into a single exchange rate, the hitherto obscure business of buying and selling government bonds became both an indicator of the relative economic performance of the 17 countries belonging to the euro and a sign of how imbalanced market perceptions of them had become. Merkel’s response was to call for all euro countries to undertake measures aimed at reducing debt and making Europe more economically competitive; though she never said it in such plain terms, they should become a lot more like Germany. With Europe split into those countries in need of help and those in a position to provide it, Merkel’s combination of austerity and structural reforms gained Germany enemies as the economic mood darkened. Economists such as Nobel Prize winner Paul Krugman held

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19

Germany to blame for exacerbating the crisis by enforcing budget cuts at a time of recession. In his New York Times blog, Krugman compared the process to the medieval practice of bleeding a patient to make them well. Billionaire investor George Soros said Merkel risked generating a revolt across Europe. The Obama administration clashed with Merkel over her refusal to deploy Germany’s economic might to do more to stop the crisis from proliferating. Europeans haven’t responded “as effectively as they needed to,” Obama said during a roundtable discussion at the White House on September 28, 2011. U.S. officials have been more scathing in private, applying constant pressure for Germany to take the lead and calm the crisis, just as they badgered Germany to step up domestic consumption and increase the size of its economic stimulus measures in 2009. They acknowledge that Merkel has been pivotal throughout, however. One senior U.S. official said that Merkel has been the key decision maker at all turning points in the crisis. What anyone attempting to coerce Merkel into more action had to learn to appreciate was the domestic balancing act she had to perform, not only between the public and her three-party coalition, but also taking into account the responses of Germany’s constitutional court and the powerful voice of the central bank, the Bundesbank. The day after Obama’s public comment on the inadequacy of Europe’s crisis response, Merkel faced down her coalition critics to win passage in the lower house, the Bundestag, of a bill allowing an expansion of the euro area rescue fund’s firepower, raising Germany’s share of guarantees to a maximum 211 billion euros from 123 billion euros. She had paved the way for it the previous month by allowing the German parliament veto right over future rescue measures, thus satisfying potential rebels as well as settling any legal doubts of the constitutional court in Karlsruhe. She also used the opportunity to stamp her authority on the coalition, telling dissenters to stop talking down Greece. “What we don’t need is unrest in the financial markets,” she said. “The uncertainties are big enough as it is.” But the domestic concerns remained. The raising of Germany’s guarantees meant that Merkel was unable to agree to a Sarkozy proposal at Cannes to enlist the rest of the world to help Europe’s crisis-fighting efforts. The French had brokered a tentative deal with G-20 nations including China and the U.K. to provide funds that would enable the euro rescue fund to be leveraged to increase

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its size. To go along, Merkel had to win the support of the Bundesbank. Although by then run by Merkel’s former chief economic adviser, Jens Weidmann, the German central bank refused. The French suggested using a credit from the state-owned KfW development bank, but that too was out of the question as parliament would have to vote on any attempt to use the KfW. Coming so soon after lawmakers agreed to raise German liabilities to 211 billion euros, that route too was politically impossible. The French plan was thwarted by Merkel’s unwillingness to risk a domestic defeat and it came to nothing. Where outside observers saw German obstructionism during the crisis, Merkel’s government saw the pressure placed on them to agree to measures that were domestically impossible as posing a threat to the most stable economy in Europe. Political instability in Germany would not help the crisis fight, in the Merkel administration’s view. Nevertheless, as the turmoil spread, Europe’s epiphany was overdue and it fell to Merkel, the pastor’s daughter from the provincial East German town of Templin, to act.

Notes 1. European Commission Autumn projections, November 7, 2012: http:// ec.europa.eu/economy_finance/eu/forecasts/2012_autumn_forecast_en.htm. 2. Juncker interview with Germany’s ZDF television, November 3, 2011, on Luxembourg government website: http://www.gouvernement.lu/salle_presse/ interviews/2011/11-novembre/03-pm/index.html. 3. Interview in Paris, November 30, 2012. 4. “Sarkozy Temper Boils, Banks Yield in Six-Day War Saving the Euro,” Bloomberg News, November 2, 2011: http://www.businessweek.com/news/ 2011–11–02/sarkozy-temper-boils-banks-yield-in-six-day-war-saving-theeuro.html. 5. “Papandreou Grip on Power Weakens,” Bloomberg News, November 14, 2011: http://www.businessweek.com/news/2011–11–14/papandreou-grip-on-powerweakens-as-lawmakers-rebel-on-vote.html. 6. James Amott, “Agricole May Lose EU10.4b on Greek Euro Exit, Natixis Says,” Bloomberg News, November 2, 2011: (not on web). 7. Merkel–Sarkozy press conference: https://www.youtube.com/watch?v=D8Nt EXnc4jY. 8. “Germany Would Back Greece Debt Restructuring, Hoyer Says,” Bloomberg News, April 15, 2011: http://www.bloomberg.com/news/2011–04–15/ger many-would-back-greece-if-it-sought-debt-restructuring-minister-says.html.

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9. Kristian Siedenberg, “EU commission autumn forecasts,” Bloomberg table. 10. “Angela Merkel: A Rational European,” Frankfurter Allgemeine Zeitung, October 13, 2012: http://www.faz.net/aktuell/politik/europaeische-union/ angela-merkel-europaeerin-aus-vernunft-11924570.html. 11. rbb Inforadio interview, September 13, 2011: http://www.bundeskanzlerin .de/Content/DE/Artikel/2011/09/2011–09–13-merkel-rbb-euro.html. 12. Transcript of Geithner interview with CNBC’s Jim Cramer: http://www .cnbc.com/id/44487020/. 13. Frankfurter Allgemeine Zeitung, November 20, 2012: http://www.faz.net/ aktuell/feuilleton/debatten/bernard-henri-levy-im-gespraech-reformenreichen-nicht-aus-um-europa-zu-retten-11965397.html. 14. Dan Liefgreen and Armorel Kenna, “Italians Obsessed by ‘Lo Spread’ as Advance in Bond Yields Makes Headlines,” Bloomberg News, November 14, 2011: http://www.bloomberg.com/news/2011–11–14/italians-obsessed-bylo-spread-as-advance-in-bond-yields-makes-headlines.html.

41


The Road to Recovery How and Why Economic Policy Must Change Andrew Smithers

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2 Why the Recovery Has Been So Weak We are now suffering from a weak and halting recovery. Chart 1 shows that among G5 countries only in Germany and the US has real GDP risen above the level that was achieved in the first quarter of 2008. Both the UK and the US provide examples of how unusual the recession has been, both in terms of the slowness of the recoveries and in the depths of the downturns. It has taken longer to recover to the previous peak in real GDP than on any previous occasion since World War II. Indeed, there are claims that the UK recovered more quickly in the 1930s than it has after the recent recession.1 The US took four years from Q4 2007 to Q4 2011 to recover to its previous peak and the UK after four and half years has still not recovered to its Q1 2008 peak. In both countries the loss of output from peak to trough was the greatest seen in the post-war period, amounting to 6.3% of GDP for the UK and 4.7% for the US.2 1

“A funny way of firing up the locomotive” by Sam Brittan, Financial Times (17th January, 2013). 2 The worst previous post-war recessions were during the first (c.1973–1976) and second oil shocks (c.1979–1983); neither their length nor their duration was as severe in either country as the post-shock recessions.

3 43


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GDP at constant prices Q1 2008 = 100.

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Chart 1. The Weak Recovery of G5 Countries. Sources: National Accounts via Ecowin.

The weak recovery has occurred despite the most aggressive attempt at stimulating the economy, in terms of both fiscal and monetary policy, that has been tried since World War II. Interest rates were kept low in wartime, but then rose and have now fallen back to their lowest post-war level in nominal terms (Chart 2). The pattern is similar, though more nuanced and less marked in real terms. Chart 3 shows that for both the UK and the US interest rates were very low in real terms after the war and after the oil shock, owing to high rates of inflation. With these exceptions, current real interest rates and bond yields are at their lowest postwar levels. Chart 4 shows that the pattern was the same for other G5 countries. Both real and nominal rates are exceptionally low and the fall in real rates is only constrained by the relatively low levels of inflation. As Chart 5 and Chart 6 illustrate, the Japanese, UK and US governments’ deficits have all risen to over 10% of GDP in recent years, while Germany’s budget is currently balanced. France’s deficit

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Yield % p.a. on 3 months T bills and 10-year government bonds.

Why the Recovery Has Been So Weak

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Chart 2. US: Interest Rates & Bond Yields. Sources: Federal Reserve & Reuters via Ecowin.

10.0

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–15.0

Chart 3. US: Real Interest Rates & Bond Yields. Sources: Federal Reserve, Reuters & BLS via Ecowin.

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Nominal short-term interest rates less change in CPI (RPI for UK) over year.

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Chart 4. France, Germany, Japan & UK: Real Short-term Interest Rates. Sources: Reuters & Federal Reserve via Ecowin.

General government net borrowing (+) or lending (-) as % of GDP.

12 10

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Chart 5. France, Germany & Japan: Fiscal Deficits. Source: OECD via Ecowin.

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General government net borrowing (+) or lending (-) as % of GDP.

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Chart 6. UK & US: Fiscal Balances. Source: OECD via Ecowin.

peaked at 7.6% of GDP and is thought to have fallen to 4.5% of GDP in 2012. Large deficits have not therefore been successful in generating strong recovery. Nor has the growth of individual economies been associated with the size of their deficits. Japan, which has the largest current deficit, shares with the UK the wooden spoon for recovery, and Germany with no deficit has achieved the best recovery alongside the US. Neither fiscal nor monetary policy has therefore been successful in creating the growth rates that are generally assumed to be possible. It follows that either the growth potential is less than assumed, the policies are correct but have not been pursued with sufficient vigour or the policies are ill considered. My view is that the policies have been the wrong ones and, although I am not alone in thinking this, my reasons seem very different from those of other economists who share my conclusion. At the centre of the disagreement that I have with those who favour more stimulus is why the economy remains weak. The central issue is whether it is due to short-term, temporary problems, which are

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termed cyclical by economists, or structural ones which last longer and tend to be more intractable. The key difference between my views and the proponents of more stimuli is that I see today’s problems as structural which need to be addressed with different policies, while those who favour continuing the current medicine but upping the dosage assume that the problems are purely cyclical. On the other hand I do not agree with those who see the structural problem as being a lack of output capacity. This in my view is overly pessimistic. There seems to be plenty of unused capacity in terms of both labour and capital equipment; the problem is that there are structural inhibitions to this capacity being used, without creating inflation. We are not being held back by either a simple cyclical weakness in demand or a lack of capacity to grow: we have a new structural problem that we have not encountered before. As I will seek to explain, the key structural inhibition that is preventing the spare capacity which we have in both labour and capital equipment from being fully used is the change in the way company managements behave, and this change has arisen from the change in the way managements are paid. There is abundant evidence that a dramatic change has taken place in the way those that run businesses are paid. Their incentives have been dramatically altered. It should therefore be of no surprise that their behaviour has changed, as this is the usual result of changed incentives. For the economy as a whole, incomes and expenditure must be equal. No one can spend more than their income unless someone else spends less. If one company, individual or sector of the economy spends more than its income, it must find the balance by selling assets or borrowing from somewhere else, and the company, individual or sector that lends the money or buys the asset must spend less than its income. A cash flow deficit in one sector of an economy must therefore be exactly matched by a cash surplus in another. I am not here making a forecast but pointing to a necessary identity and one which it is essential to understand in order to comprehend the nature of the problem that we face in trying to bring government budget deficits under control. Although much that is forecast is not very likely, almost anything in economics is possible, subject only to the essential condition that the figures must add up. This is always important, and often neglected

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by forecasters, but it is particularly informative when a large reduction in fiscal deficits is essential. This is because any reduction in fiscal deficits must be exactly matched by reductions in the combined cash surpluses of the household, business and foreign sectors. When the deficits fall, the cash surpluses of these other sectors of the economy must fall by an identical amount. The OECD estimates that in 2012 the UK and US economies had government budget deficits, which are also known as fiscal deficits, equal to 6.6% and 8.5% of GDP respectively. To prevent a dangerous and unsustainable situation arising in which the ratios of national debts to GDP are on a permanently rising path, these fiscal deficits must be brought down to about 2% or less of GDP. It follows, as a matter or identity, that the surpluses in the household, business and foreign sectors of the economies must fall by around 4.6% of GDP for the UK and 6.5% for the US from the level estimated by the OECD in 2012. One of the major lessons of history is that economies must from time to time adjust to large changes and can do so without disaster, provided that the speed at which they are required to adjust is not too rapid. It will therefore be very important to make sure that there are smooth rather than abrupt declines in the fiscal deficit and thus in the matching declines of other sectors’ cash flows. Unfortunately, ensuring that the adjustment is smooth is also likely to be very difficult. This is partly because the economy is unpredictable and partly because political decisions are often wayward. But it is also because the impact is likely to fall mainly on the business sector, and, if the hit is too sharp, companies are likely to respond by reducing investment and employment, thus causing another recession. The probability that a reduction in the fiscal deficit will fall most heavily on the business sector is shown both by past experience and from considering the contributions that are likely from other sectors. In the past, changes in the fiscal balances of the major Anglophone economies have moved up and down with fluctuations in the business sector’s cash flow, as I illustrate in Chart 7 for the UK and for the US in Chart 8.3 On historical grounds, therefore, the 3 The correlation coefficient between business cash flow and the fiscal deficit is 0.71 for the UK and 0.83 for the US. In each case we measure the relationship for the whole period for which we have data, which are annual from 1987 to 2011 for the UK and quarterly from Q1 1960 to Q3 2012 for the US.

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the road to recove ry 8 Government

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Chart 7. UK: Budget Deficits & Business Cash Surpluses Go Together. Source: ONS (EAOB, NHCQ & YBHA).

Chart 8. US: Budget Deficits & Business Cash Surpluses Go Together. Sources: NIPA Tables 1.1.5 & 5.1.

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Table 1. Business Cash Flow Surpluses (+) or Deficits (−) as % of GDP (Sources: ONS & NIPA) UK 1987 to 2001 2002 to 2011

US −1.65 4.54

1960 to 2001 2002 to 2011

−0.85 3.34

scale of the reductions required in the fiscal deficits means that large compensating falls in the cash surplus of the business sectors will be needed. As Chart 7 and Chart 8 show, companies in both the UK and the US are currently running exceptionally large cash surpluses. It is the existence of these surpluses as well as their size which is unusual. As Table 1 shows, until recently companies have tended to run cash deficits. It is only over the past decade that companies have been producing more cash than they pay out, either to finance their spending on new capital investments or to pay out dividends. The regular cash deficits shown before 2001 are the expected pattern. The business sector normally finances itself partly from equity and partly from debt. The extent to which companies finance their business by debt compared to equity is called their leverage. If, for example, half of companies’ finance comes from borrowing and the rest from equity, the ratio of debt to equity will be 100%, i.e. debt and equity will have equal values. There are limits to the extent that companies can finance themselves with debt. Their leverage rises as the proportion of finance from debt rises, and as this ratio becomes higher so does the risk that lenders will lose money when the economy falls into recession. This puts a limit on the extent to which companies can finance themselves with debt, but this limit is not fixed. If lenders don’t find that they are experiencing losses from bad debts, they assume that current leverage ratios are conservative and are willing to lend on the basis of even higher ratios of debt to equity. But this is a dangerous process, because high leverage increases the risks of a financial crisis and the risks that it will cause a deep recession. Leverage can vary a lot over time, and I will be showing later that business debt had risen to unprecedented heights prior to the financial crisis. It has since fallen a little but remains nearly at record

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levels and it is almost certain that it is still dangerously high. We should therefore wish to see leverage falling and thus see equity providing a higher proportion of companies’ financial requirements than has been the case in recent years. It is easy to see how the growth of the economy can be financed by a mixture of equity and debt. In a long run stable situation the leverage ratio will also be stable. If debt and equity each provide half the capital needed, this will also be the ratio by which new investment is financed. However, the proportion of new investment that needs to be financed with equity will always be a large one. If, for example, over the long-term, investment is financed 60% by debt and 40% by equity, rather than 50% by each, the leverage rises sharply. In the first example debt will equal 100% of equity and in the second it will be 150%. This measure of leverage would thus be 50 percentage points higher than if the proportions financed by debt and equity had remained equal. In practice things can be more complicated, but the broad outline is nonetheless clear. Over time the capital stock must grow if the economy is to expand and, over the long-term, companies must therefore add to their equity capital at a steady rate. This equity capital is equal to the value of companies’ assets less the amount that they have borrowed to finance them and is also known as net worth. Equity rises from operations if companies pay out less than 100% of their after-tax profits as dividends and falls if they pay out more. Equity can also be increased by new issues and will fall if companies buy back their own shares or acquire other companies using cash or debt. Companies either run down their cash or increase their debt when they buy back their own shares, and this often occurs when they acquire other companies. It is possible to finance acquisitions with the whole cost being met by equity through companies using their own shares. In recent years companies have been using debt to finance acquisitions of their own and other companies’ shares to a much greater extent than they have been making new equity issues and they have also, of course, been paying dividends. By adding up the sums of money spent on buybacks, acquisitions and dividends, and deducting any amount raised from new issues, we know the total amount of cash that companies are paying out to shareholders. Continues... 52


Code Red How to Protect Your Savings From the Coming Crisis John Mauldin & Jonathan Tepper 978-1-118-78372-6 • Hardback • 304 pages • November 2013

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Chapter One

The Great Experiment Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. —Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve Bank of the United States

P

resident Lyndon B. Johnson once summed up the general feeling about economists when he asked his advisers, “Did you ever think that making a speech on economics is a lot like pissing down your leg? It seems hot to you, but it never does to anyone else.” Reading a book about monetary policy and central banking can seem equally unexciting. It doesn’t have to be. Central banking and monetary policy may seem technical and boring; but whether we like it or not, the decisions of the Federal Reserve, the Bank of Japan (BoJ), the European Central Bank (ECB), and the 13 54


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Bank of England (BoE) affect us all. Over the next few years they are going to have profound impacts on each of us, touching our lives in every way. They influence the value of the dollar bills in our wallets, the price of the groceries we buy, how much it costs to fill up the gas tank, the wages we earn at work, the interest we get on our savings accounts, and the health of our pension funds. You may not care about monetary policy, but it will have an impact on whether you can retire comfortably, whether you can send your children to college with ease, or whether you will be able to afford your house. It is difficult to overstate how profoundly monetary policy influences our lives. If you care about your quality of life, the possibility of retirement, and the future of your children, you should care about monetary policy. Despite the importance of central bankers in our lives, outside of trading floors on Wall Street and the City of London, most people have no idea what central bankers do or how they do it. Central bankers are like the Wizard of Oz, moving the levers of money behind the scenes, but remaining a mystery to the general public. It is about time to pull the curtains back on monetary policy making. Even though they are separated by oceans, borders, cultures, and languages, all the major central bankers have known each other for decades and share similar beliefs about what monetary policy should do. Three of the world’s most powerful central bankers started their careers at the Massachusetts Institute of Technology (MIT) economics department. Fed chairman Ben Bernanke and ECB president Mario Draghi earned their doctorates there in the late 1970s. Bank of England governor Mervyn King taught there briefly in the 1980s. He even shared an office with Bernanke. Many economists came out of MIT with a belief that government could (and, even more important, should) soften economic downturns. Central banks play a particularly important role, not only by changing interest rates but also by manipulating the public’s expectations of what the central bank might do. We are living through one watershed moment after another in the greatest monetary experiment of all time. We are all guinea pigs in a risky trial run by central bankers: it’s Code Red time. Those of us who are of a certain age remember the great Dallas Cowboys coach Tom Landry. He would stalk the sidelines in his fedora, holding a sheet of paper he would consult many times. On it were the

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plays he would run, worked out well in advance. Third down and long and behind 10 points? He had a play for that. The Code Red policies that central bankers are coming up with more closely resemble Hail Mary passes than they do Landry’s carefully worked out playbook: they are not in any manual, and they are certainly not normal. The head coaches of our financial world are sending in one novel play after another, really mixing things up to see what might work: “Let’s send zero interest rate policy (ZIRP) up the middle while quantitative easing (QE) runs a slant, large-scale asset purchases (LSAPs) goes deep, and negative real interest rates, financial repression, nominal gross domestic product (GDP) targeting, and foreign exchange intervention hold the line.” The acronym alphabet soup of the playmakers is incomprehensible to the average person, but all of these programs are fancy, technical ways to hide very simple truths. In Through the Looking Glass, Humpty Dumpty says, “When I use a word, it means just what I choose it to mean—neither more nor less.” When central bankers give us words to describe their financial policies, they tell us exactly what they want their words to mean, but rarely do they tell us exactly the truth in plain English. They think we can’t handle the truth. The Great Financial Crisis of 2008 marked the turning point from conventional monetary policies to Code Red type unconventional policies. Before the crisis, central bankers were known as boring, conservative people who did everything by the book. They were generally disliked for being party poopers. They would take away the punch bowl just when the party got going. When the economy was overheating, central bankers were supposed to raise interest rates, cool down growth, and tighten monetary policy. Sometimes, doing so caused recessions. Taking away the punch bowl could hardly make everyone happy. In fact, at the start of the 1980s, former chairman Paul Volcker was burnt in effigy by a mob on the steps of the capitol for hiking short-term interest rates to 19 percent as he struggled to fight inflation. Central bankers like Volcker believed in sound money, low inflation, and a strong currency. In the throes of the Great Financial Crisis, however, central bankers went from using interest rates to cool down the party to spiking

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the punch with as many exotic liqueurs as possible. Ben Bernanke, the chairman of the Federal Reserve, was the boldest, most creative, and unconventional of them all. With his Harvard, MIT, and Princeton background, he is undoubtedly one of the savviest central bankers in generations. When Lehman Brothers went bust, he invented dozens of programs that had never existed before to finance banks, money market funds, commercial paper markets, and so on. Bernanke took the Federal Funds rate down almost to zero, and the Fed bought trillions of dollars of government treasuries and mortgage-backed securities. Bernanke promised that the Federal Reserve would act boldly and creatively and would not withdraw the punch bowl until the party was really rolling. Foreign central bankers like Haruhiko Kuroda (BoJ); Mervyn King and his replacement from Canada, Mark Carney (BoE); and Mario Draghi (ECB) have also promised to do whatever it takes to achieve their objectives. We have no doubt that whoever replaces Bernanke will be in the same mold. These are the days of a new breed of central banker who believes in the prescription of ultra-easy money, higher rates of inflation, and a weaker currency to cure today’s ills. Their experimental medicine may have saved the patient in the short term, but it is addictive; withdrawal is ugly; and because long-term side effects are devastating, it can be prescribed only for short-term use. The problem is, they can’t openly admit any of that. Central bankers hope that unconventional policies will do the trick. If everything goes as planned, inflation will quietly eat away at debt, stock markets will go up, house prices will go up, everyone will feel wealthier and spend the newfound wealth, banks will earn lots of money and become solvent, and government debts will shrink as taxes rise and deficits evaporate. And after all is well again, central banks can go back to the good old days of conventional policies. There is no guarantee that will happen, but that’s the game plan. So far, Code Red policies have lifted stock markets, but they have not worked at reviving growth. But Code Red–type policies are like a religion or communism. If they don’t work, it is only proof that they were not tried in sufficient size or with enough vigor. So we’re guaranteed to see a lot more unconventional policies in the coming months and years.

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How I Learned to Stop Worrying and Love Inflation The Great Financial Crisis was a story of a huge mountain of debt that was piled too high, reached criticality, and then collapsed. For decades, families, companies, and governments had accumulated every kind of debt imaginable: credit card bills, student loans, mortgages, corporate and municipal bonds, and so on. Once the mountain rumbled, broke, and started to collapse, the landslides spread everywhere. The epicenter of the crisis was the U.S. subprime mortgage market (in fact, many foreign leaders still think it was fat, suburban, Big Mac–eating Americans who caused the global crisis), but the United States was just a small part of a much bigger problem. Countries such as Ireland, Spain, Iceland, and Latvia also had very large real estate bubbles that burst. Other countries, including Australia, Canada, and China, have housing bubbles that are still in the process of bursting. It’s the same problem everywhere: too much debt that cannot be paid back in full. (We certainly would not minimize the role of the Federal Reserve in failing to supervise the banks and especially subprime debt. By holding interest rates too low for too long and by willfully ignoring the developing bubble in the U.S. housing market, they certainly played a central role.) When a person has too much debt, the sensible thing to do is to spend less and pay down the mortgage or credit card bills. However, what is true for one person isn’t true for the economy as a whole. Economists call this principle the paradox of thrift. Imagine if everyone decided overnight to stop spending beyond what was absolutely necessary, save more, and pay down their debts. That would mean fewer dinners out, fewer visits to Starbucks, fewer Christmas presents, fewer new cars, and so on. You get the picture. The economy as a whole would contract dramatically if everyone spent less in order to pay down debts. But, in fact, that is exactly what happened during the Great Financial Crisis. Economists call this process deleveraging. And the last thing central banks want is for everyone to stop spending money and reduce their debts at the same time. That leads to recessions and depressions. At least that was the theory proposed by John Maynard Keynes, the father of one of the most influential economic schools of thought,

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and it has become the reigning paradigm. It’s all about encouraging consumption and reviving “animal spirits.” If the economy is in the doldrums (recession), it is up to the government to run deficits, even massive ones, in order to “prime the pump.” Put plenty of money into people’s hands so they will go out and spend, encouraging businesses to expand and hire more workers, who will then consume yet more goods, and so on. Wash, rinse, and repeat. Another solution if you have too much debt is to declare bankruptcy. In many countries that can be an effective way of starting over again. You put behind you debts you can’t pay, offer to pay what you can, and start anew. Once again, what is good for the individual isn’t necessarily good for the economy as a whole. Imagine what would happen if millions of people declared bankruptcy at the same time. Banks would all go bust, and the government would probably have to pick up the tab and recapitalize the banks. And then, before long, the government would find itself going bust. The difference between what is right for one person and what is right for society is paradoxical. It is what logicians call the fallacy of composition. What is true for a part is not true for the whole. If you drive to work 10 minutes early, you might avoid traffic. If everyone drives to work 10 minutes early, the traffic jam will happen 10 minutes earlier. Central banks don’t want everyone to be prudent or to go bankrupt at the same time. They would simply prefer everyone to remain calm and carry on spending. If you want to avoid everyone’s ceasing to spend—or, worse yet, everyone’s going bankrupt at the same time—the only way to make the debt go away in real terms is through inflation. Inflation is the Ghostbusters of debt. It wipes debt out over time. For the sake of simplicity, imagine that you owe $100,000. If inflation is 2 percent, it will take about 30 years to cut the value of the loan in half. But if the rate of inflation doubles to 4 percent, it will take just 18 years to halve the value of the loan. And if inflation doubles again to 8 percent, you will halve the loan in 8 years! Inflation is just what the doctor ordered for an economy with too much debt. By ratcheting up inflation, central bankers can erode debt quickly and quietly. But while inflation is the friend of debtors, it is the enemy of savers; so for central bankers to come out and say they’re

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in favor of inflation would be like the pope’s announcing one day that he’s not Catholic. That isn’t going to happen. Inflation is a subject that divides economists because it means different things to different people. Not all inflation is bad. Inflation is generally considered to be problematic when the broad price level of most goods and services starts to go up because too much money is chasing too few goods. The increase in the price of a haircut is bad inflation. The method of cutting hair is no different than it was in the 1930s or the 1950s, yet it is vastly more expensive to get your hair cut today. (I [ John] pay 200 times more for a haircut today than I did when I was a kid.) However, an increase in the price of a Picasso or de Kooning is considered to be normal, or “good,” inflation. The higher prices are merely a reflection of more wealthy people in the world chasing fine art. They reflect the scarcity of the goods for sale and the laws of supply and demand at work. And who complains about the asset inflation of a rising stock market or rising home values? Then there is good deflation and bad deflation. The deflation of falling telegraph, telephone, or Internet prices is viewed as good. Better technology means that prices fall because we can do the same things more cheaply or even nearly for free. For example, in Money, Markets & Sovereignty, Benn Steil and Manuel Hinds describe the second phase of the Industrial Revolution in the United States between 1870 and 1896. Prices fell by 32 percent over the period, but real income soared 110 percent amid robust economic growth, expanded trade, and enormous innovation in telecommunications and other industries. The bad kind of deflation is different. When demand drops because people have too much debt and not enough money to spend, prices fall, too, though the cost of production does not. Jobs dry up, leaving people with even less to spend. That is the kind of deflation central bankers fear today.

Alphabet Soup: ZIRP, QE, LSAP Let’s look at how central bankers attempt to create inflation and how they help households, companies, and governments burdened with too much debt. We’ll go through the main acronyms and technical terms and explain what they mean and how they affect you.

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The main way monetary authorities have an impact on the economy is by setting interest rates. Interest rates determine the price at which people will borrow and lend. In the old days, when the economy was growing quickly, central banks would raise rates. When the economy was slowing, they’d cut rates, which meant that financing got cheaper, credit was easier, and money was looser. The reason the Fed cut interest rates was to stimulate the economy. Lower rates mean lower mortgage, credit card, and car payments. They give businesses access to cheaper capital and hopefully spur profits and thus hiring. This puts more money into the hands of consumers. As an example, U.S. 30-year mortgage rates recently hit a record low of 3.66 percent, down from 4.5 percent the same time last year. A number of mortgage holders will refinance, given the much lower rates, increasing their disposable income. That almost makes us want to buy a house or two. Who can complain about a free lunch? Cutting rates can only go so far until you hit zero. Then you’re stuck with a floor. In fact, central banks cut rates during the financial crisis, and then left them near zero and have not raised them since. Leaving rates at or near zero is what central banks refer to as zero interest rate policy (ZIRP). Currently, the United States, United Kingdom, Japan, Switzerland, and, arguably, the Euro area are all engaging in ZIRP.

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In a ZIRP world, debtors are overjoyed and savers are screwed. Imagine borrowing at 5 or 10 percent and then suddenly seeing your borrowing costs fall to a little above zero. No matter how much debt you had before, paying very little interest every month is a lifesaver. Low borrowing costs make it easier for struggling businesses to roll over their debt and reduce the real value of debt payments. If you reduce the coupon payment on a loan, that is economically the same thing as forgiving part of the principal amount, but this forgiveness is hidden. The low rates effectively allow “zombie” households and businesses to limp along without going bankrupt. Near-zero interest rates are, however, terrible for savers, investors, and lenders. Imagine you’re a retiree, and you’ve been responsible and saved all your life; you’ve put money in the bank that you expect to pay you interest every month. You probably bought some bonds as well so you could collect coupons every quarter. In a ZIRP world, you would be getting very little every month from interest and coupon payments. You would live your retirement years with far less income than you had planned for, or you would need to work far longer in order to save more. This is happening to retirees all over the world—it’s why more and more people over 60 are still working. The Federal Reserve and central bankers are not particularly worried about savers. Most Americans are struggling with debt. In an indebted society, helping debtors beats helping savers. Inflation is the opposite of a gift that keeps on giving. Higher inflation allows the Federal Reserve and other central banks to take real interest rates below zero. Nominal interest rates are the actual interest rate you get. Real interest rates are nominal rates minus the inflation rate. If your bank offers you 2 percent on your bank account, the nominal rate is 2 percent. So far, so simple. If inflation is 2 percent, then the real interest rate is 0 (2 − 2 = 0). The interest rate is only just keeping up with inflation. If inflation is 4 percent, then the interest you are getting on your bank account isn’t even keeping pace with inflation. Your real interest rate would be negative 2 (2 − 4 = −2). As you can see, with rates near zero, as long as inflation is positive, central banks can create negative real rates. Even though nominal rates can be trapped at zero, real interest rates can go below zero.

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When real rates are negative, cash is trash. Negative real rates act like a tax on savings. Inflation eats away at your money, and is in effect a tax by the (unelected!) central bankers on your hard-earned money. Leaving money in the bank when real rates are negative guarantees that you will lose purchasing power. Negative real rates force savers and investors to seek out riskier and riskier investments merely to tread water. It almost guarantees people don’t save and stop spending. In fact, Bernanke openly acknowledges that his low interest-rate policy is designed to get savers and investors to take more chances with riskier investments. The fact that this is precisely the wrong thing for retirees and savers seems to be lost in their pursuit of market and economic gains. Simply by opening their mouths, central bankers can affect not only today’s interest rate, but tomorrow’s expected interest rate as well. If Bernanke (and his successors) or Mario Draghi of the ECB promise to keep interest rates near zero until kingdom come, investors will generally take them at their word. By promising to keep rates low, central banks have crushed bond yields. The bond yield curve tells the story. The yield curve is the structure of interest rates for bonds for today, tomorrow, and the day after tomorrow. By plotting a line for each bond maturity, you can see what expected rates are out into the future: 2 years, 5 years, 10 years, and 30 years. The U.S. government can now issue 10-year debt for less than 2 percent yield. This is below the rate of inflation. It implies the Fed has been successful at keeping rates below inflation all the way out to 10 years. Lots of big economists such as Paul Krugman, Ben Bernanke, Gauti Eggertsson, and Michael Woodford, have provided the intellectual underpinnings that justify Code Red policies (the list of names is actually quite long). They argued that if unconventional monetary policy can raise expected inflation, this strategy can push down real interest rates even though nominal rates cannot fall any further (i.e., they can’t fall below zero). Read their research and bear that in mind when these same economists say they don’t want to create inflation. Government bonds used to offer a risk-free rate of return. You took no risk in buying them, and you were guaranteed a return. Jim Grant, the astute financial analyst, has noted that bonds have rallied so much, and the yields on government bonds are so low, that they now offer investors return-free risk: you’re now guaranteed a loss buying

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government bonds. Coupons are so low that investors are not even being compensated at the rate of inflation. It is hard to see how rates can go much lower or how more fools can be found to buy the bonds. The only people who buy British, Japanese, German, or American government bonds today in any size are institutions that are legally forced to do so, like insurance companies and pension funds. From a central banker’s point of view, leaving interest rates near zero is useful, but it has given them little direct influence over the economy. They can control rising inflation and expectations of higher prices only indirectly. However, central banks still have more bullets in the chamber they can use.

Quantitative Easing, a.k.a. Money Printing In addition to manipulating interest rates, central banks have the ability to increase the money supply through quantitative easing (QE). Despite all the syllables, that’s just a fancy way to say money printing. When the Fed wants to print new money and expand the money supply, it goes out and buys government bonds from banks that it has designated as “primary dealers.” The Fed takes delivery of the securities and pays the dealers with newly printed money. The money goes into the dealers’ bank accounts, where it can then support lending and money creation by the banking system. Likewise, when the Fed wants to reduce the money supply, it sells bonds back to the banks. The bonds go to the dealers, and the money paid to the Fed simply disappears. (As you can see, both “printing” money and making money disappear happen electronically and instantly. No actual printing of currency is involved. No trees are harmed in the process.) Banks absolutely love QE—it is a gift to them, and it’s one that circumvents the congressional appropriations process. To pay for QE, the Fed credits banks with electronic deposits that are reserve balances at the Federal Reserve. These reserve balances have ballooned to $1.5 trillion, from a mere $8 billion in late 2008. The Fed now pays 0.25 percent interest on reserves it holds, which amounts to nearly $4 billion a year in the banks’ coffers. If interest rates rise to 3 percent, and the Federal Reserve then raises the rate it pays on reserves

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correspondingly, the interest payment will rise from $4 billion to $45 billion a year—an even larger gift! And that is one of the reasons why people are so worried about what will happen if the Fed ever goes back to a normal policy regime.Will the primary dealers lose their interest bennies? Will the Fed actually raise reserve rates? Or will the Fed reduce the money supply, taking away profits of the banks? There is a reason the markets are worried, and it has to do with profits.Their profits. Stay tuned. The Fed has done over $1.5 trillion of money printing via QE. It is set to do a lot more. See Figure 1.2 for the projected growth of the Fed’s balance sheet. It resembles a Nasdaq stock in 1999, shooting to the moon. You would think that $1.5 trillion might be enough, but many respected economists and writers such as Paul Krugman and Martin Wolf are calling for even more QE. When you hear pundits calling for even more QE, you can almost conjure reruns of old Star Trek episodes, with Captain Kirk—make that Captain Ben—shouting, “Dammit, Scotty, you’ve got to give me more QE!” as the Fed tries to escape a black hole of high debt and low growth. Every time a central bank prints money, it creates winners and losers. So far, the biggest beneficiaries of money printing are governments themselves. This should come as no surprise. (To paraphrase Captain Renault in Casablanca, “I’m shocked, shocked to find that money printing is going on in here!”) Central banks everywhere are printing

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Projected Growth of the Federal Reserve’s Balance Sheet

Source: Variant Perception, Bloomberg.

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money to finance very large government deficits. In fact, in 2011, the Federal Reserve financed around three quarters of the U.S. deficit; in 2012, it financed over half of it; and in 2013, it will finance most of it. Why borrow money from real savers when the central bank will print it for you? The problem for savers and investors is that all the major central banks are in on the act. Take a look at Figure 1.3 and you can see that it isn’t just the Fed. It is the BoJ, the BoE, the Swiss National Bank, and even the ECB that have expanded their balance sheets. In the case of Japan and England, the central banks are buying bonds outright. The Europeans are not buying bonds directly, but they’ve provided unlimited financing for private banks to do so. And the Swiss have been buying loads of everyone else’s bonds to keep their currency from appreciating. It’s a lollapalooza of money creation. Since printing the money to buy government bonds costs nothing (given that central bank money is just bytes on a computer somewhere), governments get money for nothing and their checks for free. The central bank buys government bonds in the open market rather than from the government directly, and the pretense of an arm’slength transaction between government and central bank maintains

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Source: Variant Perception, Bloomberg.

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the illusion of central bank independence, with all parties claiming a separation of monetary and fiscal policy. But that’s just for show. By essentially issuing bonds to itself, the government appears to raise revenue miraculously, without burdening anyone else. Yet free money is like a unicorn that leaves trails of tasty chocolate droppings wherever it goes: it exists only in the realms of fantasy. (You or I might simply say, “There are no free lunches”; but as John Maynard Keynes put it, “Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.”) Since there can actually be no such thing as a government raising revenue at no cost, simple logic tells us that someone has to pay. It is impossible to know in advance who will pay for a central bank’s “free lunch,” only that someone, somewhere will eventually pay. So governments are using quantitative easing to raise revenues without even knowing upon whom the burden will fall (let alone telling them). Compare this to raising revenue the normal way, by taxation. It is possible to know who raised the tax, when it was levied, when it is payable, and how much has to be paid. The burden of money printing, however, falls on unsuspecting victims. These are generally creditors, savers, and investors, but the costs are even more widely felt. It is easy for your local politician to deny culpability—the central bank is by design out of his control. (Well, except in Japan these days. Things like central bank independence can change when survival is at stake.) Extremely high government spending would be difficult without central bank financing. As the book goes to press, for every dollar that the U.S. federal government spends, it borrows 40 cents (and that has been the case for some time). To put this in everyday terms, in 2012 the median American household income was $50,054. If a normal American family ran its budget like the U.S. government, it would borrow about $20,000 a year to pay for expenses. Most households would love to print money to finance their spending. By printing money, the Federal Reserve lends a helping hand to ease spending. (If the Federal Reserve is reading this, any money printing sent our way would be much appreciated. Please call for our bank account details. We promise to spend any such money immediately and thus do our part to drive up consumer spending.)

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The biggest winners from the Fed’s policies have been stockholders. The job of all central bankers is to keep prices stable. In the case of the Fed, it also has the job of promoting full employment in the economy. The two missions are referred to as the “Dual Mandate.” However, in a Code Red world, the central banks have created a third mandate for themselves: make stock prices go up through large-scale asset purchase (LSAP) programs. Bernanke spoke directly about this in a speech in January 2011: Policies have contributed to a stronger stock market just as they did in March 2009, when we did the last iteration of this. The S&P 500 is up 20 percent-plus and the Russell 2000, which is about small cap stocks, is up 30 percent-plus. He returned to the theme in a speech in 2012. LSAPs also appear to have boosted stock prices, presumably both by lowering discount rates and by improving the economic outlook; it is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC’s decision to greatly expand securities purchases. This effect is potentially important because stock values affect both consumption and investment decisions. These remarks are vintage Bernanke. If you’re an investor or speculator, the message is loud and clear: Buy stocks. We’ve got your back. (But let’s see who takes the blame when the stock market falls next time. Just saying . . .) The reason the Fed wants stock prices to go up is that when stocks go up, investors are happy and likely to spend more money. It is trickledown monetary policy. QE, ZIRP, and LSAPs to the tune of $85 billion of purchases a month are pumping up the stock market, all with the hope that rich people will spend those gains, and that money will trickle down to the rest of the country. So far, no dice. (As we write this, new jobs created per month in the United States are around 150,000, so it takes about $500,000 of QE to create one job. Bravo to the Fed!! It would be far easier to simply write the unemployed checks for $100,000. That would be 80 percent cheaper.)

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The problem is that there is no clear link between developments in financial markets and the real economy. Research now points to the problem: the “wealth effect� from a rise in the stock market is quite small. Higher stock market prices tend to benefit only the few who were already wealthy. The same economists who despise supply-side economics are madly infatuated with supply-side monetary policy. Go figure. Trickle-down monetary policy indeed! Most Americans own stocks, but only the wealthiest 10 percent of the population own significant amounts of stocks. Their retirement accounts are worth an average $277,000. But middle-income families have just $23,000 in their accounts, and the poor have nothing at all. The rich were almost all employed before quantitative easing anyway. Afterwards, they still have jobs and are richer. As for the poor, they still have very high unemployment and have not benefited in the slightest from a higher stock market.

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Debasing Your Currency In a world of zero interest rates, negative real rates and quantitative easing, money has less and less value. Central bankers are perfectly aware of this, and they’ve discussed it in public. In fact, devaluing the dollar is a very explicit goal. In a speech in 2002 Ben Bernanke admitted that creating money electronically would immediately devalue the dollar. As he argued: Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. The Obama administration is thrilled with a weaker dollar. Christina Romer, former chair of the Council of Economic Advisers, also noted that, “Quantitative easing also works through exchange rates.� She argued that the Fed could engage in much more aggressive QE to further lower the dollar, if needed. We will return later to the point that this makes it hard to object when Japan does the same thing but just twice as intensively! While devaluing the dollar might seem like an insane idea to a normal person, it is exactly what some central banks want. Weakening your currency is a tried and tested strategy that countries have used throughout the years. Central bankers who weaken their currencies are like drag racers that inject nitrous oxide into their engines. It is like cheating and can give an economy a little extra push in the race for economic growth. The fact that is bad for the long-term survival of their engines is lost in the drive to win the race today. Many countries rely on exports or would like to export more to grow. A weaker currency makes goods and services more appealing

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to foreigners. For example, a few years ago, when the pound had an exchange rate of $2.10 against the dollar, lots of British women traveled to New York for the weekend to buy handbags and eat out. But when the pound bought only $1.35 worth of goods, no one hopped from London to the United States to go shopping. On a very large scale, the same happens. For a U.S. auto maker, selling cars to foreigners gets a lot easier if the dollar is weak against foreign currencies. When a currency appreciates, exports can be hit very hard. It’s tougher to sell computers, cars, and ships to foreigners, and so most countries and their businesses want a weak currency. It is easier for a business to sell products when their currency is dropping than it is to become more productive. Politicians may say they want a strong dollar or a strong euro, but in practice the opposite is true. (Watch what they do, not what they say.) Devaluing your currency sounds wonderful in theory. In practice, it doesn’t always work out as planned. Central bankers, like drag racers, can inject nitrous oxide into their engines to get a little more horsepower. If you are the only one doing it, you’ll have an edge. The problem is that if everyone is doing it, no one has an advantage. And eventually, everyone burns out their engines and no one wins. Despite the initial optimism they may inspire, in the long run currency crises can only lead to stagnation, inflation, falling standards of living, and poor growth.

Navigating a Code Red World Whenever central bankers spike the punchbowl through money printing or currency devaluations, investors are happy. Every QE announcement has made stocks go up. Every major currency sell-off, whether it is the dollar or, lately, the Japanese yen, has lifted stock markets and commodities like oil, copper, wheat, and corn in the terms of the currency being trashed—er, we mean devalued. The policy of very low interest rates and money printing appears to have worked, up to this point. Most stock markets have doubled from the lows they hit after Lehman Brothers went bankrupt. The euphoria of investors should come as no surprise. When Nixon took the dollar off the gold standard

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in 1971, stocks skyrocketed. But investors should recall that the joy was short-lived. As it turned out, the 1970s were one of the worst decades for investing in stocks or bonds. Commodities did well for a while and then crashed. Investing was treacherous. The near future will likely be equally tumultuous, marked by bubbles, booms, and busts; and investors will need to be prepared. For many investors, the last few years have been a stormy voyage. It is easy to feel like a medieval explorer sailing through uncharted waters into terra incognita beyond the edge of the map. In a memorable (and relevant!) scene from Blackadder, one of our favorite comedies, Lord Melchett hands Blackadder a map and says, “Farewell, Blackadder. The foremost cartographers of the land have prepared this for you; it’s a map of the area that you’ll be traversing.” When Blackadder opens it, he sees the map is blank. Lord Melchett smiles and adds, “They’ll be very grateful if you could just fill it in as you go along. Bye-bye.” Luckily, you do not need to be without a map, or indeed to fill in an empty map as you go along. Code Red will show you how to navigate the treacherous currents ahead.

Key Lessons from the Chapter In this chapter we learned: • Before the Great Financial Crisis, central bankers used conventional monetary policy. Now they are experimenting with nonconventional “Code Red” policies like quantitative easing, zero interest rates, large-scale asset purchases, and currency debasement. These policies will lead to inflation in the long run. • If you have borrowed too much, it is good to spend less and save. Central bankers, however, want everyone to keep borrowing and spending. Their policies are designed to encourage borrowing and speculation. • The way to get people to spend their money instead of save is to create negative real interest rates on cash. Inflation in most countries is higher than interest rates, so cash is trash.

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• Politicians and central bankers want to encourage exports, so they are trying to devalue their currencies and make goods and services cheaper for foreigners. Unfortunately, not everyone can devalue their currency at the same time. • Currency wars have happened before in the 1930s and 1970s. They rarely end well for anyone, but governments pursue currency wars anyway. • Let’s review some Code Red terms: • ZIRPs—zero interest rate policies. Many central banks have cut interest rates to zero and can’t cut them anymore. The central banks have promised to keep them near zero for years. • LSAP—large-scale asset purchase program. This is when a central bank prints money to buy bonds, mortgage securities or stocks. • QE—quantitative easing. This is when central banks expand the size of their balance sheet to influence the economy rather than through raising or lowering interest rates. • Currency wars—is a policy to deliberately weaken your own currency. This happens when central banks use QE and ZIRP to reduce the attractiveness of holding cash. Central banks also can “talk down” their currency and say they want it to go lower.

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CHAPTER

1

A Highly Personal Endeavor What Do You Want to Own? Man the living creature, the creating individual, is always more important than any established style or system. —Bruce Lee

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he stock market is a curious place because everyone participating in it is loosely interested in the same thing—making money. Still, there is no uniform path to achieving this rather uniform goal. You may be only a few mouse clicks away from purchasing the popular book The Warren Buffett Way,1 but only one man has ever truly followed the path of Warren Buffett. In investing, it is hard enough to succeed as an original; as a copycat, it is virtually impossible. Each of us must carve out a personal way to investment success, even if you are a professional investor. That said, great investors like Ben Graham, Seth Klarman, and Warren Buffett have much to teach us, and we have much to gain by learning from them. One of the masters’ key teachings is as important as it is simple: A share of stock represents a share in the ownership of a business. A stock exchange simply provides a convenient means of exchanging your ownership for cash. Without an exchange, your ownership of a business would not change. The ability to sell your stake would be negatively affected, but you

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would still be able to do it, just as you can sell your car or house if you decide to do so. Unfortunately, when we actually start investing, we are inevitably bombarded with distractions that make it easy to forget the essence of stock ownership. These titillations include the fast-moving ticker tape on CNBC, the seemingly omniscient talking heads, the polished corporate press releases, stock price charts that are consolidating or breaking out, analyst estimates being beaten, and stock prices hitting new highs. It feels a little like living in the world of Curious George, the lovable monkey for whom it is “easy to forget” the well-intentioned advice of his friend. My son loves Curious George stories, because as surely as George gets into trouble, he finds a way out of trouble. The latter doesn’t always hold true for investors in the stock market.

Give Your Money to Warren Buffett, or Invest It Yourself? I still remember the day I had saved the princely sum of $100,000. I had worked as a research analyst for San Francisco investment bank Thomas Weisel Partners for a couple of years and in 2003 had managed to put aside what I considered to be an amount that made me a free man. Freedom, I reasoned, was only possible if one did not have to work to survive; otherwise, one was forced into a form of servitude that involved trading time for food and shelter. With the money saved, I could quit my job, move to a place like Thailand, and live on interest income. While I wisely chose not to exercise my freedom option, I still had to find something to do with the money. I dismissed an investment in mutual funds quite quickly because I was familiar with findings that the vast majority of mutual funds underperformed the market indices on an after-fee basis.2 I also became aware of the oft-neglected but crucial fact that investors tended to add capital to funds after a period of good performance and withdraw capital after a period of bad performance. This caused investors’ actual results to lag significantly behind the funds’ reported results. Fund prospectuses show time-weighted returns, but investors in those funds reap the typically lower capital-weighted returns. A classic example of this phenomenon is the Munder NetNet Fund, an Internet fund that lost investors billions

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of dollars from 1997 through 2002. Despite the losses, the fund reported a positive compounded annual return of 2.15 percent for the period. The reason? The fund managed little money when it was doing well in the late 1990s. Then, just as billions in new capital poured in, the fund embarked on a debilitating three-year losing streak.3 Although I had felt immune to the temptation to buy after a strong run in the market and to sell after a sharp decline, I thought this temptation would be easier to resist if I knew exactly what I owned and why I owned it. Owning shares in a mutual fund meant trusting the fund manager to pick the right investments. Trust tends to erode after a period of losses. Mutual funds and lower-cost index funds should not be entirely dismissed, however, as they offer an acceptable alternative for those wishing to delegate investment decision making to someone else. Value mutual funds such as Bruce Berkowitz’s Fairholme Fund or Mason Hawkins’s Longleaf Funds are legitimate choices for many individual investors. High-net-worth investors and institutions enjoy the additional option of investing in hedge funds, but few of those funds deserve their typically steep management and performance fees. Warren Buffett critiqued the hedge fund fee structure in his 2006 letter to shareholders: “It’s a lopsided system whereby 2 percent of your principal is paid each year to the manager even if he accomplishes nothing—or, for that matter, loses you a bundle—and, additionally, 20 percent of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10 percent in a year will keep 3.6 percentage points—two points off the top plus 20 percent of the residual eight points—leaving only 6.4 percentage points for his investors.”4 A small minority of value-oriented hedge fund managers have chosen to side with Buffett on the fee issue, offering investors a structure similar to that of the limited partnerships Buffett managed in the 1960s. Buffett charged no management fee and a performance fee only on returns in excess of an annual hurdle rate. The pioneers in this small but growing movement include Guy Spier of Zurich, Switzerland-based Aquamarine Capital Management and Mohnish Pabrai of Irvine, California-based Pabrai Investment Funds. These types of funds bestow a decisive advantage, ceteris paribus, on long-term investors. Table 1.1 shows the advantages of an investorfriendly fee structure.

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TABLE 1.1 Effect of Fees on the Future Wealth of a Hedge Fund Investor Typical Hedge Fund Fee Structure: “2 and 20”

Buffett PartnershipStyle Fee Structure

Management fee: 2%

Management fee: 0%

Performance fee: 20%

Performance fee: 20%

Annual hurdle rate: 0%

Annual hurdle rate: 6%

Assumed gross return

5.0%

10.0%

5.0%

10.0%

Resulting net return

2.4%

6.4%

5.0%

9.2%

Gross value of $1 million . . . after 10 years

$1,628,895

. . . after 20 years

2,653,298

$2,593,742 $1,628,895 $2,593,742 6,727,500

. . . after 30 years

4,321,942

17,449,402

2,653,298

6,727,500

4,321,942 17,449,402

Net value of $1 million . . . after 10 years

$1,267,651

. . . after 20 years

1,606,938

$1,859,586 $1,628,895 $2,411,162 3,458,060

2,653,298

. . . after 30 years

2,037,036

6,430,561

4,321,942 14,017,777

. . . after 10 years

$361,244

$734,156

. . . after 20 years

1,046,360

3,269,440

0

913,798

. . . after 30 years

2,284,906

11,018,842

0

3,431,625

5,813,702

Value lost due to fees $0

$182,580

I also considered investing my savings in one of a handful of public companies that operate as low-cost yet high-quality investment vehicles. Berkshire Hathaway pays Warren Buffett an annual salary of $100,000 for arguably the finest capital allocation skills in the world. Buffett receives no bonus, no stock options, and no restricted stock, let alone hedge-fund-style performance fees.5 It certainly seems like investors considering an investment in a highly prized hedge fund should first convince themselves that their prospective fund manager can beat Buffett. Doing this on a prefee basis is hard enough; on an after-fee basis, the odds diminish considerably. Of course, buying a share of Berkshire is not quite

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associated with the same level of privilege and exclusivity as being accepted into a secretive hedge fund. Berkshire is not the only public holding company with shareholder-friendly and astute management. Alternatives include Brookfield Asset Management, Fairfax Financial, Leucadia National, Loews Companies, Markel Corporation, and White Mountains Insurance. While these companies meet Buffett-style compensation criteria, some public investment vehicles have married hedge-fundstyle compensation with a value investment approach. Examples include Greenlight Capital Re and Biglari Holdings. These hedge funds in disguise may ultimately deliver satisfactory performance to their common shareholders, but they are unlikely to exceed the long-term after-fee returns of a company like Markel, which marries superior investment management with low implied fees. In light of the exceptional long-term investment results and low fees of companies like Berkshire and Markel, it may be irrational for any long-term investor to manage his or her own portfolio of stocks. Professional fund managers have a slight conflict of interest in this regard. Their livelihood depends rather directly on convincing their clients that the past performance of Berkshire or Markel is no indication of future results. Luckily for them, securities regulators play along with this notion, thereby doing their part in encouraging a constant flow of new entrants into the lucrative fund management business. Rest assured, we won’t judge too harshly those who choose to manage their own equity investments. After all, that is precisely what I did with my savings in 2003 and have done ever since. You could say that underlying my decision has been remarkable folly, but here are a few justifications for the do-it-yourself approach: First, investment holding companies like Berkshire and Markel are generally not available for purchase at net asset value, implying that some recognition of skill is already reflected in their market price. While over time the returns to shareholders will converge with internally generated returns on capital, the gap is accentuated in the case of shorter holding periods or large initial premiums paid over net asset value. Even for a company like Berkshire, there is a market price at which an investment becomes no longer attractive. In addition, one of the trappings of investment success is growth of assets under management. Few fund managers limit their assets,

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and this is even rarer among public vehicles. Buffett started investing less than $1 million six decades ago. Today he oversees a company with more than $200 billion in market value. If Buffett wanted to invest $2 billion, a mere 1 percent of Berkshire’s quoted value, into one company, he could not choose a company with a market value of $200 million. He would likely need to find a company quoted at $20 billion, unless he negotiated an acquisition of the entire business. Buffett is one of few large capital allocators who readily admit that size hurts performance. Many others evolve their view, perhaps not surprisingly, as their assets under management grow. Arguments include greater access to management, an ability to structure private deals, and the spreading of costs over a large asset base. Trust Buffett that these advantages pale in comparison with the disadvantage of a diminished set of available investments. If you manage $1 million or even $100 million, investing in companies that are too small for the superinvestors offers an opportunity for outperformance. Buffett agrees: “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”6 The corollary: When small investors commit capital to megacaps such as Exxon Mobil or Apple, they willingly surrender a key structural advantage: the ability to invest in small companies. Echoing Buffett’s sentiments on the unique advantages of a small investable asset base, Eric Khrom, managing partner of Khrom Capital Management, describes the business rationale he articulated to his partners early on: “The fact that we are starting off so small will allow me to fish in very small pond where the big fishermen can’t go. So although I’m a one man shop, you don’t have to picture me competing with shops that are much larger than me, because they can’t look at the things I look at anyway. We will be looking at the much smaller micro caps, where there are a lot of inefficiencies. . . .”7 The last argument for choosing our own equity investments leads to the concept of capital allocation. Contrary to the increasingly popular view that the stock market is little more than a glorified casino, the market is supposed to foster the allocation of capital

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to productive uses in a capitalist economy. Businesses that add value to their customers while earning acceptable returns on invested capital should be able to raise capital for expansion, and businesses that earn insufficient returns on capital should fail to attract funding. A properly functioning market thereby assists the process of wealth creation, accelerating the growth in savings, investment, and GDP. If the role of the market is to allocate capital to productive uses, it becomes clear that a few dozen top investors cannot do the job by themselves. There are simply too many businesses to be evaluated. By doing the work the superinvestors must forgo due to limited bandwidth, we put ourselves in a position to earn the just reward of good investment performance. This idea of capital allocation ties in with the previous point regarding our ability to invest in companies that are too small for the superinvestors. We may safely assume that Buffett and the others will allocate capital to mega-caps such as Coca-Cola, if those companies deserve the money. On the other hand, companies such as Strayer Education and Harvest Natural Resources may be left without capital even if they can put it to productive use. Smaller investors can fill this void and make money, provided that they make the right capital allocation judgments.

Cast Yourself in the Role of Capital Allocator It is little surprise that the world’s richest investor is a capital allocator rather than a trend follower, thematic investor, or day trader. Buffett is famous for his buy-and-hold strategy, which has been the hallmark of Berkshire’s portfolio investments and outright purchases of businesses. Buffett looks to the underlying businesses rather than stock certificates to deliver superior compounding of capital over the long term. Buying businesses cheaply has not generated his long-term returns—it has merely accentuated them. Buffett raised eyebrows in the investment community many years ago when he bought Coca-Cola at a mid-teens multiple of earnings. Most value investors could not understand why Buffett considered it a bargain purchase. Buffett was allocating capital to a superior business at a fair price. He knew that Coca-Cola would compound the capital employed in the business at a high rate for a long time to come. Buffett did not need P/E multiple expansion to make the investment in Coca-Cola pay off.

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Similarly, famed value investor Joel Greenblatt paid roughly 20 times earnings for Moody’s when it went public in 2000. Greenblatt was allocating capital to a superior business, one that could grow earnings at a high rate without requiring additional capital, thereby freeing up large amounts of cash for share repurchases. Despite trading at a relatively high earnings multiple at the time of the initial public offering (IPO), Moody’s shares more than quintupled in the subsequent six years. Of course, the company ran into major trouble when the U.S. housing bubble burst a few years ago. Despite the steep decline, Moody’s traded at $48 per share in early 2013, up from a comparable price of $12.65 per share the day it was spun off from Dun & Bradstreet in October 2000.

Role versus Objective: A Subtle but Important Distinction Our role in the stock market may at first glance seem like a trivial issue. It is hardly a secret that rational investors seek to maximize risk-adjusted after-tax returns on invested capital. What is our role, therefore, if not to make the most money by identifying investments that will increase in price? This question is misplaced because it confuses objective (making money) and role. We typically view our role in the market as insignificant. While most investors do have a negligible impact on the overall market, the accompanying small fish mind-set does not lend itself to successful investing. Even when I invested a tiny amount of money, I found it helpful to adopt the mind-set of chief capital allocator. I imagined my role as distributing the world’s financial capital to activities that would generate the highest returns on capital. Consider the following subtle difference in how investors may perceive their portfolios in relation to the available investment opportunities. Many of us inappropriately consider the scale of our portfolio ahead of the scale of potential investments. To illustrate this, imagine we wanted to invest $100,000 in one of the stocks in Table 1.2 in late 2001. When selecting a company from this list, we might analyze financial statements and consider various valuation measures. But even before embarking on a detailed analysis, some of us may think, “I have $100,000 to invest, which will buy me a tiny stake in one the above companies. It looks like I can buy a few thousand

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A Highly Personal Endeavor TABLE 1.2 “Mind-Set A”—Selected Investment Opportunities, November 20018 Ticker

Company

AET

Aetna

DAL

Delta Air Lines

Stock Price

Market Value

$100,000 Buys . . .

$30.52

$4.4 billion

3,277 shares

29.31

3.6 billion

3,412 shares

F

Ford Motor

17.88

32.4 billion

5,593 shares

GM

General Motors

47.69

26.5 billion

2,097 shares

LMT

Lockheed Martin

45.01

19.8 billion

2,222 shares

NYT

New York Times

45.15

6.8 billion

2,215 shares

TIF

Tiffany & Co.

29.17

4.3 billion

3,428 shares

TM

Toyota Motor

53.71

99.0 billion

1,862 shares

shares of any of these stocks” (“mind-set a”). Without realizing it, we are committing the fallacy of considering the scale of our portfolio ahead of the scale of potential investments. On the flip side, if we adopted an asset allocator’s mind-set, we might ask, “If I could buy one of the above companies, which would I choose?” This question focuses attention on the relative scale of the potential investments rather than the size of our portfolio. By applying this mind-set even before embarking on in-depth analysis of the various companies, we might make the observation shown in Table 1.3. Toyota alone was valued more highly than all the companies on the left combined (based on market value rather than enterprise value, which in this case would have been a more appropriate measure). The investor with mind-set b might wonder: “Would I rather own Toyota or Aetna, Delta, Ford, GM, Lockheed Martin, the New York Times, and Tiffany combined?” While after careful analysis the answer might indeed be Toyota, it is obvious that we would need well-founded reasons for that choice. Had we kept a small fish mentality, however, we might have completely missed this issue of relative scale and invested in Toyota, ignorant of the severity of the implied relative value bet. In Table 1.4, we revisit the previous comparison as of late 2004. As a comparison of the market values shows, Toyota outperformed a portfolio of the companies on the left over the three-year

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TABLE 1.3 “Mind-Set B”—Selected Investment Opportunities, November 2001 Ticker Company

Market Value Ticker Company Market Value

AET

Aetna

$4.4 billion

DAL

Delta Air Lines

F

Ford Motor

32.4 billion

GM

General Motors

26.5 billion

LMT

Lockheed Martin

19.8 billion

NYT

New York Times

6.8 billion

TIF

Tiffany & Co.

4.3 billion

TM

Toyota Motor

$99.0 billion

3.6 billion

$97.8 billion

$99.0 billion

TABLE 1.4 “Mind-Set B”—Selected Investment Opportunities, October 2004 9 Ticker Company

Market Value Ticker Company Market Value

AET

Aetna

$12.8 billion

DAL

Delta Air Lines

F

Ford Motor

23.7 billion

GM

General Motors

21.4 billion

LMT

Lockheed Martin

23.8 billion

NYT

New York Times

5.7 billion

TIF

Tiffany & Co.

4.1 billion

TM

Toyota Motor

$125.3 billion

0.4 billion

$91.9 billion

$125.3 billion

period ending in late 2004.10 While this may come as a surprise, it simply means that mind-set b is not a sufficient condition for investment success: Good decision making requires thorough analysis of underlying fundamentals. (Giving the previous table another thought, it is interesting that, in theory, by selling short all of Toyota in late 2004, we could have bought not only the companies on the left but also 93 percent of McDonald’s.)

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The Buck Stops Here Once I had put aside my small fish mentality and embraced a capital allocator’s mind-set, I started making better investment decisions. I found it easier to conclude, for example, that auto companies might not make good investments despite their recognized brands, large sales, and low P/E ratios. The capital allocator mindset helped me realize I did not have to pick a winner in the auto industry when many companies outside the auto industry had better business models and were available at reasonable prices. The new mind-set also raised the hurdle for investments in unprofitable companies because I knew intuitively that I would be forgoing current profits and the reinvestment of those profits in expectation of a future windfall. This seemed a rather speculative proposition. Many market participants, especially growth investors, exhibit a high tolerance for money-losing companies. An even more common trait is a willingness to ignore nonrecurring charges, even though such expenses reduce book value in the same way as recurring expenses. While no one would buy shares in a moneylosing company unless he or she believed in a profitable future or in a favorable sale or liquidation, it seems that many investors’ tolerance for losses is exaggerated by the subconscious reassurance that their investment amount is limited and they cannot be forced to commit more capital to a company even if it continues to lose money. Though our exposure is indeed legally limited to the initial investment, any impression that someone else will take care of a company’s losses is an illusion: ■

If other investors end up funding the losses of a company we own, they will either (1) dilute our interest or (2), if they lend money to the company, increase its interest expense and leverage. Both scenarios are blows to our prospects for a decent return on investment. If the company is able to fund losses with the liquidity available on the balance sheet, our percentage stake will not get diluted, but book value per share will decline. As Figure 1.1 shows, the impact of losses, whether recurring or not, on book value is perverse because, for example, a 20 percent drop in book value requires a 25 percent subsequent increase just to offset the decline.

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Subsequent gain required in order to break even

The Manual of Ideas

250% 200% 150% 100% 50% 0% –70%

–60%

–50%

–40%

–30%

–20%

–10%

Magnitude of initial decline

FIGURE 1.1

The Perverse Impact of Losses—Subsequent Gain Required

to Break Even

Source: The Manual of Ideas.

Perhaps most important, the capital allocator mind-set enabled me to draw a sharp distinction between value and price, echoing Ben Graham’s teaching, “Price is what you pay; value is what you get.”11 If I directed the allocation of the world’s capital, I would not be able to rely on the market to bail me out of bad decisions. The greater fool theory of someone buying my shares at a higher price breaks down if the buck stops with me. Successful long-term investors believe their return will come from the investee company’s return on equity rather than from sales of stock. This mind-set produces a very different process of estimating value than if we rely on the market to establish value and then try to gauge whether a company is likely to beat or miss quarterly earnings estimates. Acting as a capital allocator rather than a speculator or trader required tremendous discipline at first, as I sometimes felt the temptation to outsmart other investors by betting that an earnings report would beat consensus estimates or an acquisition rumor would prove correct. Trading on such tenuous propositions required tacit agreement with the market’s underlying valuation of a business, as I would have been betting on an incremental change in the stock price and not necessarily buying a fundamentally undervalued business. I learned that self-restraint was crucial, as buying an overvalued company in expectation of positive news could backfire. There is simply no way to know how an overvalued stock will react to an apparent earnings beat. Investors may be

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impressed by the strong earnings but disappointed by future guidance. The market may also have already priced in an earnings beat, with investors having bought the rumor, only to sell the news. Asset allocator Jeremy Grantham, chief investment strategist of GMO, agrees that investors have a hard time restraining themselves from playing the market: “Most professionals, including many of the best, prefer to engage in Keynes’s ‘beauty contest,’ trying to guess what other investors will think in the future and ‘beating them to the draw’ rather than behaving like effective components of an efficient market; spending their time and talent seeking long-term values.”12 A money manager volunteered his outlook for energy investing in the Wall Street Journal in late 2005: “I think the sector is probably a little overvalued, but I wouldn’t be surprised to see a run for energy stocks as we get to year-end.  .  . . People who are behind will go there to catch up.”13 The manager could not have been referring to investors who view themselves as capital allocators.

The Scale of Investments: How Much Is a Billion Dollars, Really? In a world in which the valuations of many firms stretch into the billions or even hundreds of billions of dollars, developing intuition for the scale of such mind-boggling figures is critical. In late 2004, I came across Sirius Satellite Radio, which was valued at more than $8 billion, having reported revenue of $19 million and a net loss of $169 million in the previous quarter. Was $8 billion too much to pay for a company with little revenue and a net loss of more than eight times revenue? Since no traditional valuation measure could be used to arrive at an $8 billion valuation, why should the company not be worth $4 billion, or $16 billion? When a valuation appears to get out of hand, it helps to ask what else an equivalent sum of money would buy. At $50 per barrel of crude oil, $8 billion would have been enough to meet the oil demand of India for almost three months. Or assuming U.S. per capita GDP of $37,800, it would have taken the lifetime GDP of 4,200 Americans to equal $8 billion. It would have taken the lifetime savings of a multiple of 4,200 Americans to buy Sirius. Does it make sense that possibly tens of thousands of Americans would have had to spend their lives working and saving just so they could buy a money-losing company? While this question did not tell me how much Sirius was

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worth, it alerted me to a situation in which the company’s per-share value might have deviated from the market price. Mohnish Pabrai makes an eloquent case against investing in companies that become too large.14 He compares companies to mammals, echoing Charlie Munger’s latticework approach. According to Pabrai, nature seems to have imposed a size limit on mammals and companies alike. There have never been mammals much larger than an elephant, perhaps because mammals are warm-blooded and need energy to survive. It gets progressively more difficult for the heart to circulate blood to the extremities as a mammal grows bigger. Similarly, the top management of a large and growing corporation becomes progressively more removed from the multiplying touch points with customers, suppliers, and partners. This reduces management effectiveness, eventually causing scale to become a disadvantage and providing competitors with an opportunity to beat the incumbent. Pabrai observed nearly 10 years ago that no company on the Fortune 500 list of the most valuable corporations had net income much in excess of $15 billion (this changed in 2005 when Exxon Mobil posted record profits due to rising oil prices). It seems that any company successful enough to make much more than a billion dollars per month triggers a particularly fierce competitive response and sometimes piques the interest of trustbusters.

Owner Mentality You have to give Wall Street credit. It was not easy to start with the simple concept of business ownership and end up in a world of quarterly earnings guidance, credit default swaps, and highfrequency trading. Wall Street was supposed to foster the allocation of capital to productive uses while minimizing frictional costs and enabling other industries to deliver the goods and services demanded by consumers. In the case of Wall Street and the broader economy, the tail really has come to wag the dog. You have probably heard a wide range of reasons for buying a stock over the years: “This company has a great management team.” “I love its products.” “It will take over the world.” Those three examples are among the more palatable justifications, even if they contain no mention of the price paid for the business. Other arguments include: “This company operates in an industry with huge

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growth potential.” “This company is just one of many I’m buying because I think the market will go up.” “This is a small-cap stock, and today is December 31st—I’m betting on the ‘January effect.’” “This company is a great acquisition candidate.” “A taxi driver gave me a hot tip from a man he drove to 11 Wall Street.” “This company’s name starts with ‘China.’” While it may be in the interest of bankers and brokers to complicate matters to boost demand for financial guidance and trading, those of us concerned primarily with investment performance might do best to follow the advice of Henry David Thoreau in Walden: “Simplify, simplify.” But how do we simplify the complicated and treacherous game investing has become? The only way to do it reliably may be to focus on what a share of stock actually gives us, legally speaking. If the stock market shut down tomorrow, how would we estimate the value of the stock we own? We might try to figure out the financial profile of the business in which we are part owners. How much cash could this business pay out this year, and is this amount more likely to increase or decrease over time? Somewhat counter-intuitively, the recipe for evaluating a business purchase is the same whether the stock market is open or closed. A functioning market offers one unique source of value, however: It occasionally provides an opportunity to buy a business at well below fair value. Those who take advantage of this opportunity may want to write a few thank-you notes to those on Wall Street who put career risk ahead of investment risk and put duty to their own pocketbooks ahead of fiduciary duty. On second thought, “a few” notes may not be enough.

Adopting the Right Mind-Set Thinking like a capital allocator goes hand in hand with thinking like an owner. Investors who view themselves as owners rather than traders look to the business rather than the market for their return on investment. They do not expect others to bail them out of bad decisions. Investment professionalization has had unintended consequences, as the ultimate owners of capital (households and endowments) have become increasingly detached from security selection. Short-term-oriented security holders, such as mutual funds and hedge funds, have displaced long-term owners. The results have been a greater tendency to choose portfolios that reduce occupational risk

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rather than investment risk, increased trading mentality, and less participation in company affairs. As Vanguard founder John Bogle pointed out, “The old own-a-stock industry could hardly afford to take for granted effective corporate governance in the interest of shareholders; the new rent-a-stock industry has little reason to care.” The incentive structure of the asset management industry discourages fund managers from standing up to corporate executives, as funds prize access for business and social reasons. When Deutsche Asset Management, a large Hewlett-Packard shareholder in 2002, voted for the contentious HP-Compaq merger, it may have been due to pressure from HP executives. According to a report, “Merger opponent Walter Hewlett has sued HP, saying its management threatened to lock Deutsche Bank, Deutsche Asset Management’s parent company, out of future HP investment-banking business if it had voted against [the deal]. Because of that pressure . . . Deutsche Bank, which previously had indicated it would vote against the deal, at the last minute switched its votes in favor of it. . . .” Disintermediation of ownership has placed massive amounts of stock in the hands of mutual funds, weakening corporate governance, sustaining excessive executive pay, and tolerating imperialistic mergers and acquisitions. In hindsight, was there a way to profit from knowing that Deutsche’s vote for the HP-Compaq deal might be influenced by factors other than its merits to HP shareholders? Perhaps we could have used a cynical view of Deutsche’s incentives as a reason to invest in Compaq, which traded at a wider-than-typical merger arbitrage spread, reflecting investors’ belief that the unsound merger might be called off. The bigger lesson may be to avoid giving money to entities that have less than their clients’ or shareholders’ best interests in mind. It is hard to overstate how important owner mentality is when investing in stocks. Management works for the shareholders, not the other way around. There is no law that prevents owners from asserting their rights, regardless of whether they own one share of stock or a million. Of course, there are practical limits to influencing management as a small shareholder, but we need to think big to succeed. If our analysis shows a company would be a great investment if only we could get management to pay a special dividend, repurchase stock, spin off a division, or remove an underperforming CEO, chances are good that someone with the power to effect such a change (read: a large shareholder or hedge fund)

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agrees with us. I am surprised by how often I have invested in companies that ended up announcing seemingly unexpected actions to unlock shareholder value. The only way to find such companies consistently is to think about what changes we would make if we had the power and how much value such changes would create. If the latter is sufficiently high, we may get rewarded, even though someone else will do the hard work.

Stock Selection Framework In this book, we examine equity idea generation in nine categories, each of which requires a slightly different approach to idea generation and evaluation. However, it also makes sense to think about an overarching approach to choosing equity investments. In this regard, we consider a stock selection framework that is (1) flexible enough to allow for analysis of any stock, regardless of company size or industry, yet (2) concrete enough to be useful in making informed investment decisions. To achieve both objectives, the framework needs to go far beyond the basic dividend-discount model of equity value, which fails miserably at the second objective. Perhaps it is precisely the lack of real-world applicability of that basic model that compels so many investors to select stocks based on such subjective criteria as first-mover advantage and technology leadership without understanding how those criteria fit into a more holistic view of stock valuation. Notwithstanding the complexity inherent in a universal stock selection framework, developing a holistic approach to stock selection is an eminently achievable task. After all, the stock market itself is a holistic framework that ranks all companies along the same dimension—market value. Biotech companies are not valued in biotech dollars that are not convertible into construction dollars. On the contrary, because market value is a variable that is defined in the same way for every public company, investors know exactly what percentage of a biotech firm they could own in exchange for a piece of a construction company. Similarly, biotech investors do not commit capital because they like the sound of biotech companies’ names or because they are fascinated with furthering DNA research. They invest for the same reason as all other investors: to make a buck. Consequently, we ought to have a model that boils all companies

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down to the same dimension—equity value. By comparing that value with market value, we can make informed investment decisions. Figure 1.2 outlines an approach that may be able to handle, at least in principle, the vast array of equity investment opportunities available in the public markets. Although the following framework may not be practicable for most small investors, it does illustrate how we may think about security selection if we adopt the mindset of chief capital allocator. The stock selection framework begins by asking whether the net assets are available for purchase for less than replacement cost. If this is not the case, we exclude the company from consideration because it might be cheaper to re-create the equity in the private market. If the equity is available for less than replacement cost, then we consider whether it is so cheap that liquidation would yield an incremental return. If this is the case, we may consider liquidating the equity. In the vast majority of cases, an equity will trade far above liquidation value, in which case we turn our attention to earning power. Once we focus on the earning power of a going concern, the key consideration becomes whether the business will throw off sufficient income to allow us to earn a satisfactory return on investment. Many related considerations enter the picture here, including the relationship between net income and free cash flow, the ability of the business to reinvest capital at attractive rates of return, and the nature of management’s capital allocation policies.

Key Takeaways Here are our top 10 takeaways from this chapter: 1. In investing, it is hard enough to succeed as an original; as a copycat, it is virtually impossible. Each of us must carve out a personal way to investment success, even if you are a professional investor. 2. One of the masters’ key teachings is as important as it is simple: A share of stock represents a share in the ownership of a business. 3. Investors tend to add capital to investment funds after a period of good performance and withdraw capital after a period of

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XYZ Stock

No

Is (Normalized EBIT) / (Capital Employed) > (Required Return)?*

i.e.:

Yes

No

Potential investment opportunity

Yes

Potential opportunity to acquire and liquidate

Yes

Can control of the company be acquired for less than liquidation value?

Is the company about to be liquidated or reorganized? No

Yes

Eliminate XYZ from consideration

No

Is (Normalized EBIT) / (Enterprise Value) > (Required Return)?*

i.e.:

Does normalized EBIT provide an attractive yield on current enterprise value?

Does normalized EBIT provide an attractive return on capital employed?**

No

Is (Book Equity - Liquidation Impairments - Market Capitalization) > $0 ?

i.e.:

Earnings Power Analysis I (earning yield)

Eliminate XYZ from consideration

Yes

Asset Value Analysis II (lower boundary: liquidation value) No Is XYZ quoted for less than its liquidation value?

Yes

Earnings Power Analysis II (return on capital)

Is (Enterprise Value) / (Replacement Cost) > 1?

i.e.:

Is XYZ quoted more highly than it would cost to create the substantially same company?

Eliminate XYZ from consideration

Source: The Manual of Ideas.

FIGURE 1.2 Illustrative Stock Selection Framework

*Required return depends on conviction regarding normalized EBIT and other factors. **Additional considerations: Can capital be reinvested at the normalized return on capital? Are above-average returns on capital sustainable?

Potential investment opportunity

Idea Generation • Quantitative stock screening • Research of all companies in certain market cap range • SEC filings • News publications

Asset Value Analysis I (upper boundary: replacement value)


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4.

5.

6.

7.

8.

9.

10.

The Manual of Ideas

bad performance, causing their actual results to lag behind the funds’ reported results. Those considering an investment in a hedge fund may first wish to convince themselves that their prospective fund manager can beat Warren Buffett. Doing this on a prefee basis is hard enough; on an after-fee basis, the odds diminish considerably. It is little surprise that the world’s richest investor is a capital allocator rather than a trend follower, thematic investor, or day trader. Buffett looks to the underlying businesses rather than the stock certificates to deliver superior compounding of capital over the long term. While most of us have a negligible impact on the stock market, the accompanying small fish mind-set does not lend itself to successful investing. Instead, we benefit from casting ourselves in the role of the world’s chief capital allocator. Although our exposure to the losses of the companies in which we invest is legally limited to our initial investment, any impression that someone else will take care of a company’s losses is an illusion. Losses have a perverse impact on long-term capital appreciation, as a greater percentage gain is required to get us back to even. For example, a 20 percent drop in book value requires a 25 percent subsequent increase to offset the decline. Mohnish Pabrai makes an eloquent case against investing in companies that become too large, echoing Charlie Munger’s latticework approach. According to Pabrai, nature seems to have imposed a size limit on mammals and companies alike. Thinking like a capital allocator goes hand in hand with thinking like an owner. Investors who view themselves as owners rather than traders look to the business rather than the market for their return on investment.

Notes 1. See Hagstrom (2005). 2. Multiple studies have been published on mutual fund performance, including Brown and Goetzmann (1995), Malkiel (1995), Carhart (1997), and Khorana and Nelling (1997). Carhart concludes: “The results do not support the existence of skilled or informed mutual

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3. 4. 5. 6. 7. 8. 9. 10.

11. 12. 13. 14.

fund portfolio managers.” Malkiel finds: “In the aggregate, funds have underperformed benchmark portfolios both after management expenses and even gross of expenses.” See Ferri (2003). See Buffett (2007). See Berkshire Hathaway (2010). See Stone (1999). The Manual of Ideas interview with Eric Khrom, New York, 2012. Source of price and market value information: Yahoo! Finance, http:// finance.yahoo.com, accessed November 23, 2001. Source of price and market value information: Yahoo! Finance, http:// finance.yahoo.com, accessed October 22, 2004. A more accurate gauge of Toyota’s outperformance would be an analysis based on stock price (including paid dividends) rather than market value, which can be affected by events such as mergers and acquisitions that do not necessarily improve the per-share return to an investor. See Buffett (2009). See Grantham (2005). See McDonald (2005). See Pabrai (2002–2004).

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The Dao of Capital Austrian Investing in a Distorted World Mark Spitznagel 978-1-118-34703-4 • Hardback • 368 pages • October 2013

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Chapter One The Daoist Sage Klipp’s Paradox

Y

ou’ve got to love to lose money, hate to make money, love to lose money, hate to make money. . . . But we are human beings, we love to make money, hate to lose money. So we must overcome that humanness about us.” This is “Klipp’s Paradox”—repeated countless times by a sage old Chicago grain trader named Everett Klipp, and through which I first happened upon an archetypal investment approach, one that I would quickly make my own. This is the roundabout approach (what we will later call shi and Umweg, and ultimately Austrian Investing), indeed central to the very message of this book: Rather than pursue the direct route of immediate gain, we will seek the difficult and roundabout route of immediate loss, an intermediate step which begets an advantage for greater potential gain. This is the age-old strategy of the military general and of the entrepreneur—of the destroyer and of the very creator of civilizations. It is, in fact, the logic of organic efficacious growth in our world. But when it is hastened or forced, it is ruined. Because of its difficulty it will remain the circuitous road least traveled, so contrary to our wiring, to our perception of time (and virtually impossible on Wall Street). And this is why it is ultimately so

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effective.Yet, it is well within the capability of investors who are willing to change their thinking, to overcome that humanness about them, and follow The Dao of Capital. How do we resolve this paradox? How is it that the detour could be somehow more effective than the direct route, that going right could be somehow the most effective way to go left? Is this merely meant to confuse; empty words meant to sound wise? Or does it conceal some universal truth? The answers demand a deep reconsideration of time and how we perceive it. We must change dimensions, from the immediate to the intermediate, from the atemporal to the intertemporal. It requires a resolute, forward-looking orientation away from what is happening now, what can be seen, to what is to come, what cannot yet be seen. I will call this new perspective our depth of field (using the optics term in the temporal rather than the spatial), our ability to sharply perceive a long span of forward moments. This is not about a shift in thinking from the short term to the long term, as some might suppose. Long term is something of a cliché, and often even internally inconsistent: Acting for the long term generally entails an immediate commitment, based on an immediate view of the available opportunity set, and waiting an extended period of time for the result—often without due consideration to or differentiation between intertemporal opportunities that may emerge during that extended period of time. (Moreover, saying that one is acting long term is very often a rationalization used to justify something that is currently not working out as planned.) Long term is telescopic, short term is myopic; depth of field retains focus between the two. So let’s not think long term or short term. As Klipp’s Paradox requires, let’s think of time entirely differently, as intertemporal, comprised of a series of coordinated “now” moments, each providing for the next, one after the other, like a great piece of music, or beads on a string. We can further peel away Klipp’s Paradox to reveal a deeper paradox, at the very core of much of humanity’s most seminal thought. Although Klipp did not know it, his paradox reached back in time more than two and a half millennia to a far distant age and culture, as the essential theme of the Laozi (known later as the Daodejing, but I will refer to it by its original title, after its purported author), an

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ancient political and military treatise, and the original text and summa of the Chinese philosophy of Daoism. To the Laozi, the best path to anything lay through its opposite: One gains by losing and loses by gaining; victory comes not from waging the one decisive battle, but from the roundabout approach of waiting and preparing now in order to gain a greater advantage later.The Laozi professes a fundamental and universal process of succession and alternation between poles, between imbalance and balance; within every condition lies its opposite. “This is what is called the subtle within what is evident. The soft and weak vanquish the hard and strong.”1 To both Klipp and the Laozi, time is not exogenous, but is an endogenous, primary factor of things—and patience the most precious treasure. Indeed, Klipp was the Daoist sage, with a simple archetypal message that encapsulated how he survived and thrived for more than five decades in the perilous futures markets of the Chicago Board of Trade.

THE OLD MASTER Daoism emerged in ancient China during a time of heavy conflict and upheaval, nearly two centuries of warfare, from 403 to 221 BCE, known as the Warring States Period, when the central Chinese plains became killing fields awash in blood and tears. This was also a time of advancement in military techniques, strategy, and technology, such as efficient troop formations and the introduction of the cavalry and the standardissue crossbow. With these new tools, armies breached walled cities and stormed over borders. War and death became a way of life; entire cities were often wiped out even after surrender,2 and mothers who gave birth to sons never expected them to reach adulthood.3 The Warring States Period was also a formative phase in ancient Chinese civilization, when philosophical diversity flourished, what the Daoist scholar Zhuangzi termed “the doctrines of the hundred schools”; from this fertile age sprung illustrious Daoist texts such as the Laozi and the Sunzi, the former the most recognized from ancient China and one of the best known throughout the world today. Its attributed author, translated as “Master Lao” or “The Old Master,” may or may not have

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even existed, and may have been one person or even a succession of contributors over time. According to tradition, Laozi was the keeper of archival records for the ruling dynasty in the sixth century BCE, although some scholars and sinologists maintain that the Old Master emanated from the fourth century BCE. We know from legend that he was considered to have been a senior contemporary of Kongzi (Confucius), who lived from 551 to 479 BCE, and who was said to have consulted Laozi and (despite being ridiculed by Laozi as arrogant) praised him as “a dragon riding on the winds and clouds.”4 Furthermore, written forms of the Laozi, which scribes put down on bamboo scrolls (mostly for military strategists who advised feuding warlords), are likely to have been derivatives of an earlier oral tradition (as most of it is rhymed). Whether truth or legend, flesh and bones or quintessential myth, one person or many over time, the Old Master relinquished an enduring, timeless, and universal wisdom. To most people, it seems, the Laozi is an overwhelmingly religious and even mystical text, and this interpretive bias has perhaps done it a disservice; in fact, the term “Laoism” has been used historically to distinguish the philosophical Laozi from the later religious Daoism. Recently, new and important translations have emerged, following the unearthing of archeological finds at Mawangdui in 1973 and Guodian in 1993 (which amounted to strips of silk and fragments of bamboo scrolls), providing evidence of its origins as a philosophical text5—not mystical, but imminently practical. And this practicality relates particularly to strategies of conflict (specifically political and military, the themes of its day), a way of gaining advantage without coercion or the always decisive head-on clash of opposing forces. The Dao of Capital stays true to these roots. The Laozi, composed of only 5,000 Chinese characters and 81 chapters as short as verses, outlines the Dao—the way, path, method or “mode of doing a thing,”6 or process toward harmony with the nature of things, with awareness of every step along the way. Sinologists Roger Ames and David Hall describe the Dao as “way-making,” “processional” (what they call the “gerundive”), an intertemporal “focal awareness and field awareness”—a depth of field—by which we exploit the potential that lies within configurations, circumstances, and systems.7

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The central concept permeating the Laozi is referred therein as wuwei, which translates literally as “not doing,” but means so much more; rather than passivity, a common misperception, wuwei means noncoercive action—and here we see the overwhelming laissez-faire, libertarian, even anarchistic origins in the Laozi, thought by some to be the very first in world history8 (as in “One should govern a country as one would fry a small fish; leave them alone and do not meddle with their affairs”9—a cardinal Laozi political credo most notably invoked in a State of the Union address by President Ronald Reagan). The Laozi also has been deemed a distinctive form of teleology, one that emphasizes the individual’s self-development free from the intervention of any external force. This leads to the paradox of what has come to be known as wei wuwei (literally “doing/not doing,” or better yet “doing by not doing,” or “do without ado”10). “One loses and again loses / To the point that one does everything noncoercively (wuwei). / One does things noncoercively / And yet nothing goes undone.”11 In wuwei is the importance of waiting on an objective process, of suffering through loss for intertemporal opportunities. From the Laozi, “Who can wait quietly while the mud settles? Who can remain still until the moment of action?”12 It appears as a lesson in humility and tolerance, but, as we wait, we willingly sacrifice the first step for a greater later step. In its highest form, the whole point of waiting is to gain an advantage. Therefore, the apparent humility implied in the process is really a false humility that cloaks the art of manipulation; as French sinologist François Jullien noted, “the sage merges with the manipulator,” who, in Daoist terms, “humbles himself to be in a better position to rise; if he withdraws, he does so to be all the more certainly pulled forward; if he ostensibly drains away his ‘self,’ he does so to impose that ‘self ’ all the more imperiously in the future.”13 This is the efficacy of circumvention camouflaged as suppleness. And in this temporal configuration is, in the words of Ames and Hall, the Laozi’s “correlative relationship among antinomies”:14 With false humility we deliberately become soft and weak now in order to be hard and strong later—the very reason that, in the Laozi, “Those who are good at vanquishing their enemies do not join issue.”15 In this sense, the Laozi can simply be seen as a manual on gaining advantage through indirection, or turning the force of an opponent against him, through “excess leading to its opposite.”16

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THE SOFT AND WEAK VANQUISH THE HARD AND STRONG Perhaps the most tangible representation of wuwei can be seen in the interplay of softness and hardness in the Chinese martial art taijiquan— not surprising as it is a direct derivative of the Laozi. According to legend, taijiquan was created by a thirteenth-century Daoist priest, Zhangsanfeng. Cloistered on Wudang Mountain, he observed a clash between a magpie and a serpent, and suddenly fully grasped the Daoist truth of softness overcoming hardness.17 The serpent moved with— indeed, complemented—the magpie, and thus avoided its repeated decisive attacks, allowing the snake to wait for and finally exploit an opening, an imbalance, with a lethal bite to the bird. In this sequential patience, retreating in order to eventually strike, was the Laozi’s profound and unconventional military art: There is a saying among soldiers: I dare not make the first move but would rather play the guest; I dare not advance an inch but would rather withdraw a foot. This is called marching without appearing to move, Rolling up your sleeves without showing your arm, Capturing the enemy without attacking, Being armed without weapons.18

Like Daoism itself, taijiquan has drifted into the more mystical and new age, but its roots remain in its martial application; this is clear today in the powerful blows of the original Chen style taijiquan form, as still practiced in Chen Village (located in Henan province in central China). According to Chen Xin (among the lineage of the eponymous Chen clan) in his seminal Canon of Chen Family Taijiquan, a deceptive rotational and circular force—known as “silk reeling”—is “the main objective of Taijiquan moves, which work on the centrifugal principles of a ‘roundabout’.”19 The rotation is between retreating and advancing, between soft and hard. (When performed by a master, such as my teachers Qichen Guo and Jwing-Ming Yang, of whose qinna maneuvers I have oft found myself on the wrong end, it is most unsettling, almost deplorable in its artful deceitfulness.)

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Taijiquan is a physical manifestation of the importance of waiting and exploiting another’s urgency through softness in a clash. This is most apparent in the two-person taijiquan competitive exercise known as tuishou, or “push hands,” in which two opponents engage in what looks to the casual observer like a choreographed series of synchronized movements. In actuality tuishou is a cunning contest with highly constrained rules, in which each tries to throw the other to the ground (or outside a boundary) during a sequence of subtle alternating feints and attacks. The real force is not in the pushing, but in the yielding. (In tuishou is an ideal roundabout and investing metaphor, one that I will return to again and again.) The “Song of Push Hands,” in its oral transfer of the art over centuries in Chen Village, instructs the competitor to “guide [the opponent’s] power into emptiness, then immediately attack.”20 To guide or lure the opponent into emptiness and thus destroy his balance is the very

Tuishou: Zouhua and Niansui

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indirect objective—to gain the position of advantage—to be followed by the direct objective of attack. This is the essential tuishou sequence of yielding, neutralizing, and sticking. Yielding and neutralizing—zou or zouhua, “leading by walking away”—is the sneaky retreating rout, followed by converting and redirecting a force to advantage; that advantage is exploited by sticking and following—nian or niansui—and thus eventually advancing back in a decisive counterattack. (Taken together, as we will see in Chapter 3, this sequence describes shi, the strategy of wuwei.) The competition is a subtle interplay of delusive complementary— not opposing—forces between opponents, between hard and soft, each seeking the shrewd strategy of patiently attacking the balance rather than the force, of going right in order to ultimately go decisively left. This is also the insidious strategy of guerilla warfare. While used effectively, for instance, by the scrappy American colonists against the British in the eighteenth century, it was later used deftly against the mighty United States by the far weaker and smaller Vietcong in the twentieth century, the very same alternating intertemporal softness and hardness: When the U.S. troops surged, the Vietcong retreated in a rout into the mountains (zouhua), drawing the U.S. troops out until overextended; then the Vietcong counterattacked, following the U.S. troops (nian) in a destructive counterrout. The great frustration—the unfairness—is that the harder you push, the harder you fall. Chairman Mao knew these words from the Laozi: “If a small country submits to a great country / It can conquer the great country. Therefore those who would conquer must yield / And those who conquer do so because they yield.”21(We will encounter this again with the guerilla warriors of the north in the Epilogue.) In the wuwei of taijiquan, the advantage comes not from applying force but from circular yielding, from directing the course of events rather than forcing them; from the Laozi, “Hence an unyielding army is destroyed. An unyielding tree breaks.”22 The patience of the intermediate steps of loss and advantage defeats the impatience of the immediate gain; the direct force is defeated by the counterforce. Thus there are always two games being played in time, one now and one later, against two different opponents. As the great tuishou practitioner Zheng Manqing observed, one must first “learn to invest in loss” by leading “an opponent’s force away so that it is useless,” and which will “polarize into

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its opposite and be transformed into the greatest profit.”23 In taijiquan is the essence of The Dao of Capital. So much of waiting and ignoring present circumstances, of willingness to be in an uncomfortable place, is understanding the sequential instead of only seeing the immediate. There is a definite brand of epistemology at the root of the Laozi. To the Laozi, much of the exterior world is but exterior diversion, much perception is a distraction from a hidden reality—though one which requires diligent attention. It states this most succinctly in “Venture not beyond your doors to know the world / Peer not outside your window to know the way-making. . . . The farther one goes / The less one knows.”24 Paul Carus, in his definitive 1913 The Canon of Reason and Virtue: Being Lao-tze’s Tao Teh King, went so far as to relate this epistemology of the Laozi to eighteenth-century German philosopher Immanuel Kant: The Laozi “endorses Kant’s doctrine of the a priori, which means that certain truths can be stated a priori, viz., even before we make an actual experience. It is not the globe trotter who knows mankind, but the thinker. In order to know the sun’s chemical composition we need not go to the sun; we can analyze the sun’s light by spectrum analysis. We need not stretch a tape line to the moon to measure its distance from the earth, we can calculate it by the methods of an a priori science (trigonometry).”25 Indeed, there is an almost antiempirical vein to the Laozi, a stand against the positivist view of knowledge as exclusively flowing from sense perceptions. As Jacob Needleman interprets the Laozi, “We see only things, entities, events; we do not directly experience the forces and laws that govern nature.”26 Similarly, Ellen Chen says the Laozi “is not pro-science in spirit,” “repudiating the knowledge of the many as not conducive to the knowledge of the one”27  (thus invalidating induction). Truth is learned from understanding basic natural and logical constructions, a tree that bends to the force of a wind, pent-up water that eventually destroys all in its path, the interplay between snake and bird. There is much deception in appearance, the tyranny of the senses, of empirical data—wisdom that gains particular context and meaning in investing.

INTO THE PIT My exposure to investing came quite by accident. As a 16-year-old (whose only previous experience with markets was through a share in

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the Rochester Red Wings minor league baseball team, passed down proudly for three generations) I tagged along with my father when he paid a visit to his good friend (and corn futures trader, whatever that was) Everett Klipp at the Chicago Board of Trade. I stood in the visitors’ gallery overlooking the grain trading pits, gaining a bird’seye view over a kaleidoscope of bright trading jackets, flailing arms, and lurching bodies. I was expecting some kind of swanky casino (perhaps out of a James Bond film), but this was different than that. I was mesmerized. It reminded me of watching a flock of birds, a cloud of countless individual parts appearing as a single fuzzy organism, seemingly resting, hovering in midair, until something unseen starts to ripple through it like a pulse of energy, causing a sudden jolting turn in a burst of speed. The flock swoops and dives, rests, and then rises again, with a mechanical yet organic coordination and precision, while the outside observer can only marvel at its driver. In the pit was the same mystery, with pauses interrupted by sudden cascades of noise and energy driven by something imperceptible. It was a financial Sturm und Drang, but within it was an unmistakable, intricate communication and synchronization. In an instant, I scrapped my hard-won Juilliard plans (needless to say, my mother was horrified) and wanted nothing more than to be a pit trader. After that fateful trip, I became obsessed with the grain futures markets. Price charts soon lined my bedroom walls and I constructed a potted corn and soybean plant laboratory (with seedlings lifted from local farms in the dark of night) for monitoring rainfall and crop progress. From then on, whenever I would see Klipp I always peppered him with questions (often with handy graphs and USDA reports in tow) on price trends, world grain supplies, Soviet demand, Midwest weather patterns—basically on where the markets were headed. His response was always a variation on: “The market is a completely subjective thing, it can do anything. And it is always right, yet always wrong!” His abject disdain for data and information left me bemused, even skeptical of this stubborn old Chicago grain man with the gravelly voice, ever speaking in fortune-cookie prose. How could he have done so well as a speculator without knowing—or even caring—where the market was heading? How could it be that “guys who know where the market is heading are no longer at the Board of Trade. They are either retired or broke. And I can’t think of any that are retired.” Classic Klipp.

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If trading wasn’t about predicting price movements, then what was it all about? After all, profiting was buying (or selling) at one price and then eventually selling (or buying) it back at a higher (or lower) price. How could this be done without any ability to forecast? The answer, which took this teenager some time to understand, was that the edge to pit trading was in the order flow—the succession of mini-routs, as I always called them—and in the discipline; it was in a patient response to someone else’s impatience, someone else’s urgency. The edge was a process—an intertemporal process—an intermediate step to gain an advantage, rather than any direct analytical acumen or information. And its monetization—its roundabout production—required time. The bond pit was where the real action was (and where the average trader’s age was perhaps twenty to thirty years below that in the corn pit). When it came time to ask Klipp what to study in college to best prepare me for a career in the bond pit, he advised, “Anything that won’t make you think you know too much” (alas, my economics major would have to remain a dirty secret). During summers and over holiday breaks from college (where I can recall always carrying around a copy of the book The Treasury Bond Basis, still stubbornly trying to ready myself for trading) I worked as a lowly clerk for a few of Klipp’s traders. Finally, after graduating, with backing from Gramma Spitznagel (my first and best investor) I leased a membership at the Chicago Board of Trade and took my place in the bond pit where, at age 22, I became its youngest trader. The deliverable instrument of the bond futures contract is the 30-year U.S. Treasury bond (or a nearby “cheapest to deliver”), the benchmark interest rate (along with the 10-year) on which long-term debt is based. In the early-1990s, the bond futures pit was the center of the financial universe, the most actively traded contract and the locus of open outcry in all the world. The pit was where anyone with longterm dollar-denominated interest rate risk in the future converged to hedge their rates, whether savers worried about forward rates falling or borrowers concerned about forward rates rising. Trading pits are configured like concentric rings (octagons, actually) that descend like a staircase, resembling an inverted tiered wedding cake. The very top, outer step of the bond pit was occupied by the biggest and baddest traders (as this was where the biggest brokers with the biggest order flow stood, as well as where the best sight lines were into

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the pit—an incalculable advantage). In my first month, I was decidedly not there. In fact, I was at the other extreme, at the very bottom of the pit where only the back month contracts sporadically traded. For the first month or so, my day started and ended with Klipp standing next to me, feeding me trades and testing to see how I managed them. Klipp made it perfectly clear: “You’re not here to make money, you’re here to learn how to trade. If you could walk into the pit to make money, you wouldn’t even be in here. You’d be in a long line all the way down LaSalle Street, still waiting to get in.” This was an imminently roundabout start down a roundabout path.

THE PRIVILEGES OF A TRADER Klipp’s methodology was exceedingly simple—almost dubiously so— conveyed as a parent would to a child, not as principles, but as privileges: “As a pit trader, you have two privileges and two privileges only: One, you can demand the edge—buy at the bid price, sell at offer price; two, you can give up that edge when you’ve made a mistake.” The “edge” of Klipp’s allotted privileges is that of the market makers, known as “locals” at the Chicago Board of Trade. (The bond pit was occupied by both locals, virtually all of whom, like me, traded independently for their own accounts, and brokers, whose job was to execute orders on their clients’ behalf.) What locals do is provide immediacy to those who demand it, meaning they offer prices (a bid price and an ask price) at which they are willing to transact immediately, and in so doing they provide immediate liquidity. In exchange, the locals require a price concession, reflected in their bid and ask prices, a profit they expect to monetize as demands for immediacy flow in from both sides, from buyers as well as sellers. Locals stand in the pit all day waiting for that flow, specifically to trade against an impatient counterparty. It’s not up to the locals to determine when they trade; rather, they wait and, if necessary, wait some more. The price concessions, the “rents” extracted from urgent counterparties (who pay for not having to wait), are the local’s ultimate edge. But, upon receiving such a price concession, the local’s game is not over; he has the advantage, but he must act yet again, either by stepping aside (taking his loss) or following the market back. He accumulates

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inventory (a position) by transacting against urgent order flow, with the intention of closing out of that inventory profitably once the urgency subsides; thus, advancing seems to be receding, and the local advances by retreating. But, naturally, between these two steps is the potential for great loss—the cost of waiting and holding inventory. So the sooner he gets out the better, but in so doing his aim is to transact better than his urgent counterparty, from whom he received his position in the first place. The late legendary bond local Charlie DeFrancesca (“Charlie D.”) put it best: “The question is: Can you be more efficient than the market?”28 Klipp liked to think about the local’s role in more standard business terms, such as the inventory markup of the wholesaler or the retailer, or, more generally, the price spreads that exist in different phases of production for any economic good (including futures contracts). Both involve exploiting intertemporal imbalances between raw material and output, providing immediacy to end users, and the intermediation of waiting, carrying intermediate inventory (including capital goods and other factors of production), and providing a final good at just the right time and place (and, as we will see in Chapter 5, the more roundabout this process, typically the greater these spreads). The second allotted privilege was “cruel,” as Klipp would say, because it meant immediately closing out a trade once it turned negative (a “mistake”), what he called “always taking a one-tick loss.” One could expect this to happen roughly half of the time, and much of the other half of the time (depending, of course, on how quickly any profits were grabbed, as we’ll discuss) the price would find its way back to show a loss even then as well. For instance, if the market was three bid, four offered (meaning 115 and 23/32nds bid, offered at 115 and 24/32nd), I had to buy at three or sell at four—“demand the edge”—without exception. If I managed to buy a one-lot (or one contract) at three, and then a big sell order came in and pushed the market down one tick to two bid, three offered, I was expected to immediately sell that one-lot to someone at two (“give up the edge,” or “step out,” preferably to a broker who would later return the favor), thus taking my one-tick loss (which amounted to $31.25 on one $100,000 bond contract). I was officially in Klipp’s Alpha School of Trading, as everyone called it, after the name of his firm, Alpha Futures. (We were the guys in the aqua jackets who loved to lose money.)

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Who could argue with this logic? If, as Klipp said, “There’s only one thing that can hurt a trader at the Chicago Board of Trade, and that’s a big loss,” then, for God’s sake, “never take a big loss.” As his own mentor said to him some 40 years before, “Any time you can take a loss, do it, and you will always be at the Chicago Board of Trade.” (To which Klipp always added with a smile, “Well, I’ve been losing money since 1954, but he was right, I’m still at the Chicago Board of Trade.”) Naturally, this meant taking many small losses. Hence you had to “love to lose money,” otherwise you’d just stop doing it. Impatience and intolerance for many such small losses, as well as urgency for immediate profits, Klipp believed, dealt a death blow to traders, an easy and common one. The well-known disposition effect in finance, an observation that goes back at least a century, states that people naturally fall victim to these tendencies, and thus do the opposite of Klipp’s approach: We sweat through large losses and take small profits quickly. Going for the immediate gain feels so right, while taking the immediate loss feels so wrong. The pressing need for consistent and immediate profits is hardwired into our brains; we humans have a shallow depth of field (as we will see in Chapter 6). And nothing is better at amplifying this natural humanness about us than trading too big and having excessive carrying costs. These are the great external magnifying lenses on the immediate. All is decisive when all is at stake, whether through an excessive loss (because of too much leverage)—a loss that you can’t afford to take immediately—or an insufficient gain (because of too much debt). No one trade need ever be decisive. As Klipp said, “One trade can ruin your day. One trade can ruin your week. One trade can ruin your month. One trade can ruin your year. One trade can ruin your career!” It is not surprising, then, that Klipp’s approach was not embraced by everyone, even by most; in fact, in many ways he was pit trading’s greatest dissident (despite his title, bestowed by the futures industry, of The Babe Ruth of the Chicago Board of Trade). Among his greatest critics was none other than Charlie D.—the misinterpretation of whose criticism surely cost many an aspiring Charlie D. his shirt. (There will only ever be one Charlie D.) It was nearly impossible to follow and practice consistently—“brutal” was Klipp’s term to describe the formidable challenge of looking beyond the immediate outcome—of retaining depth of field—a challenge that Klipp believed was essential to gaining an edge.

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This was as it should be; indeed, if everyone accepted Klipp’s Paradox, it would no longer be effective, no longer even be a paradox. From the Laozi, “The bright path seems dim / Going forward seems like retreat / The easy way seems hard / The highest Virtue seems empty.”29 Here are the favorite Daoist images of water and the valley, the Laozi’s “attitude of lowliness,”30 which water always seeks. This was Klipp’s roundabout approach, and that of his mentor and perhaps his before: Expect to lose first, the first loss is a good loss; from that comes greater gain later. Call it playing good defense, embracing loss, biding one’s time and using the present moment for later advantage, the advantage of then playing more effective offense. Or, as Klipp called it, “looking like a jerk, feeling like a jerk.” Waiting must precede opportune action, by definition. Exploiting others’ immediacy was the logic of the roundabout approach, the fundamental edge—the ultimate edge of trading and investing. In baseball the difference between minor leaguer and major leaguer is generally thought to be in hitting the curve ball, as opposed to just a linearly extrapolated fast ball, and so too is the difference in investing in playing the curve, the roundabout intertemporal bends which deviate from the straight course. My mantra has always been like that of Milwaukee Braves pitcher Lew Burdette, who once said, “I earn my living from the hungriness of hitters.”31 I earn my living from the hungriness of investors, from their decisiveness, their forcefulness, from their great urge for immediacy. And this immediacy was not just the bid-ask spread; it was even more so, as we will see, in the larger routs. Continues...

ROBINSON CRUSOE IN THE BOND PIT After about a month, Klipp released me into the wilds of the active bond contract, the upper steps.The discipline had to remain the same— I still had but two privileges—and, like a hawk, he kept an eye on me in the pit as well as on my daily trading statements, to make sure that it did. The king of the bond pit, nay of all pits, was (and will forever be) Lucian Thomas Baldwin III (trading badge “BAL”), known for the largest trading size of any local—thousands of contracts a day—and his ability to single-handedly bully what was then the half-trillion-dollar government bond market. While I was still a teenager, at a time when

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Bonds Are Not Forever The Crisis Facing Fixed Income Investors Simon A. Lack 978-1-118-65953-3 • Hardback • 240 pages • October 2013

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CHAPTER 1

FROM HIGH SCHOOL TO WALL STREET—THE BULL MARKET BEGINS Inflation Memories

It was February 1972, and at nine years old I found playing with my toy soldiers in the flickering candlelight an exciting change from the steady illumination of incandescent bulbs. My British platoon skillfully maneuvered behind the German lines, taking advantage of the shadows to surprise and quickly overwhelm the enemy. In those days the Germans were always the competition, whether on the battlefield or the English football pitch. The change in routine caused by the loss of electricity thrilled me as a young boy, but was not so exciting for my grandparents because it was a scheduled loss of power whose timing had been announced in the daily newspaper. February in Britain is dark at the best of times. After a long winter night, a person awakes to a dull, gray sky. By the time I began my career working in London’s financial markets, the British winter, while not nearly as cold as that of New York, felt rather like two months living at the bottom of a damp, dark pit, with only an occasional glimpse of daylight through a window. However, an English evening in July, when the days are long but never humid, can be the best place in the world. 1 113


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Britain in the early 1970s was at the mercy of the trade unions, and a coal miners’ strike was preventing fuel from reaching the power stations around the country. The proud people of a nation that still recalled the empire on which “the sun never set” found itself powerless at home, reduced to eighteenth-century means of illumination. Arguably, Britain was continuing its steady relative decline from the late nineteenth century, at which time the United States began to surpass Britain by measures such as iron and energy production, and industrial output (Kennedy, 1987). The steady rise in importance of other powers accelerated following World War II, when victory was achieved only at an enormous financial and material cost; confirmation of Britain’s reduced status came during the 1956 Suez Crisis when U.S. pressure forced an embarrassing climb down on a once dominant power.Yet diminished global influence didn’t need to translate into self-destructive actions at home. Nonetheless, in 1972, while the trade unions and the government argued over pay, a country once described as “built on coal” was unable to use enough of it to light its homes. There were many low points for Britain and its economy in the 1970s when I was growing up, including a bailout by the International Monetary Fund (IMF) in 1974. Looking back at those times from a distance of 40 years and 3,500 miles in America, the 1970s were the most turbulent economic times since the Depression in the 1930s. Britain had its own set of homemade wounds in the form of militant trade unions, a manufacturing base that was losing out to its European competitors (especially the Germans), and a welfare state whose safety net was so generous it often made paid employment more costly than indolence. Although Britain had its own partly self-inflicted problems, rising inflation in the 1970s and early 1980s wasn’t limited to the United Kingdom. President Ford even resorted to handing out pins labeled Whip Inflation Now (WIN), perhaps revealing the paucity of more robust ideas within his administration. For much of the developed world it was the greatest inflation in living memory. Today, it is recounted through bland numbers on a statistical release from the U.K. government. In 1972, when the miners were forcing Britain to her knees, inflation the United Kingdom was 7.6 percent (see Figure 1.1).

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From High School to Wall Street—The Bull Market Begins 3 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008

FIGURE 1.1 U.K. Inflation 1948–2012 Source: U.K. Government, Office for National Statistics.

Two years later, fueled in part by generous pay settlements won by the coal miners and other unions, it was 19.2 percent. A year later, in1975, U.K. inflation reached 24.9 percent, a level at which money loses half its value in just over three years. In one month (May 1975), prices jumped 4.2 percent, an annualized inflation rate of 63.8 percent! This is an abstract notion for most Westerners today. We read about inflation in Latin America, about hyperinflation in countries such as Zimbabwe, but few of us below the age of 60 have had to manage a household budget and make personal financial decisions under such circumstances. That includes me, but memories of my mother and grandparents worrying about “the cost of living,” about weekly price increases and the ongoing failure of income to keep up with expenses remain a part of my otherwise quite happy childhood. Running commentary at the dinner table about how the price of sugar, washing powder, petrol, or school uniforms had gone up since the last time we gathered were a staple part of the conversation. Of course, nobody knew when it would end, or really even what was causing it (although the reasons seem clear enough to today’s economic historians). People blamed the trade unions for selfishly

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negotiating pay increases not backed by improved productivity, the government for conceding to their demands, and the Organization of Petroleum Exporting Countries (OPEC) for sharply hiking the price of oil. All of these were to blame. What was worse was that at the time nobody knew if double-digit inflation or worse was a permanent part of the economy.

AS BAD AS IT GETS Hard economic times were not limited to Britain, though.The 1970s were tumultuous in America as well. While American trade unions were not nearly as powerful as their U.K. counterparts, photos of gasguzzling cars lined up waiting to refill their tanks became an iconic image of that time. Shortages of basic goods, often accompanied by inflation, were a global phenomenon. The lax monetary policies followed by central banks and governments combined with some features unique to each country. In Britain, a steady loss of competitiveness, on top of an overly generous welfare state, was ultimately reversed by Maggie Thatcher when she came to power in 1979. In the United States, blame for the economic turbulence of the 1970s typically traces back to the 1960s, with the costs of financing the Vietnam War coincident with an expansion in welfare under Lyndon Johnson’s “Great Society.” The subsequent loss of confidence in the U.S. dollar led to the breakdown of the Bretton Woods Accord when President Nixon suspended its free convertibility into gold in 1971. This ushered in the current era of “fiat money,” in which a currency’s value is only as good as the market’s confidence in its government’s policies. The 1970s and early 1980s saw two major oil price hikes, economic upheaval, and ultimately strong leaders in Margaret Thatcher and Ronald Reagan, determined to lead their respective countries along a better path to smaller government, sound money, and improved living standards. Britain and America share a great deal in terms of history and values. At that time, both countries were in need of decisive leadership to promote economic growth supported by competitiveness and sound money. Both found it.

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From High School to Wall Street—The Bull Market Begins 5

In 1980, U.K. monthly inflation was 15 percent (in just one month, April 1980, prices rose 3.4 percent), and shortly thereafter the greatest bull market in history began in bonds. It followed the longest global bear market in history, one that began in 1946 after World War II and lasted 35 years. To illustrate, if a constant maturity 2.5 percent 30-year bond had been available throughout this period, its price would have declined from 101 to 17, a drop of 83 percent (Homer and Sylla, 2005). More than an entire generation of bond investors had lived through a relentless destruction of the purchasing power of their savings. In the years leading up to 1981 investors had been demanding ever higher yields on their fixed income investments to provide protection against the rapid erosion of purchasing power. High borrowing costs were stifling any industry that required borrowed money to operate, which is to say virtually the entire economy. As financial markets began to sense that inflation and interest rates were peaking, they bid up the prices of bonds aggressively. The long road to low and stable inflation had begun, and with it a bull market in equities as well (propelled by falling borrowing costs, which were helping so many companies).

TRADING IN GILTS By coincidence, my career in financial markets began in London within a few weeks of that peak in interest rates and inflation. I had grown up during the most extended financial turmoil in living memory, with double-digit interest rates and savings that rapidly lost their real (i.e., inflation-adjusted) value. I began my career in finance within a month or two of the very worst of high interest rates and rampant inflation. It was the threshold of the gradual return to sound money, and it would be complemented by an inexorable rise in the value of all financial assets. At the same time, finance and financial markets were set to gain enormously in importance through greater employment and would contribute a substantially larger share of overall economic output. Liberalization of markets would lead to a dizzying array of financial instruments to be traded. This occurrence combined with the relentless fall in trading costs would support the

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steady increase in financial engineering and debt creation that culminated in the crash of 2008. None of this was even remotely plausible to someone recently out of high school and beginning his career in “The City.” Yet, in hindsight, my entry into the workplace was blessed with fortunate timing. The U.K. market for government bonds, or “gilts” as they are known in Britain, has as long a history as any in the world. Consolidated annuities (known as “consols” for short) are perpetual securities that were created in 1756 by consolidating a series of already issued perpetual annuities. They have no maturity date (although theoretically the U.K. government may redeem them). Their history is detailed in a 2005 book soporifically named A History of Interest Rates by Sidney Homer and Richard Sylla. It’s probably not flying off the shelves at Amazon. Nevertheless, for those interested in such things it is a comprehensive record of the cost of borrowing that goes back to biblical times in measuring the price of credit. Bond markets are not nearly as exciting as stocks. Bonds issued by governments don’t involve colorful CEOs, corporate takeovers, or profits warnings. Bonds are boring; in fact, bonds are meant to be boring. Investors don’t buy them for excitement—for thrills they buy stocks or go to the racetrack. Because bonds move far less than stocks and are rarely prone to the extremes of greed and fear so prevalent in equity markets, the people who traffic in them tend to be more staid as well. Equity traders have been known to accuse their colleagues in bonds of being communists. On days when the government releases weak economic data, government bond prices often rise (because their yields fall), and traders in most markets generally do better when prices are rising. Economic misery, which tends to restrain inflation, causes bond traders to leap for joy while equity markets and consumer sentiment both tumble. There’s an essential difference in outlook between the two markets. Equity traders are happiest when they are optimistic on the economic outlook because higher corporate profits tend to fuel rising stock prices. By contrast, bond traders are often cheerful when everybody is miserable. Rising unemployment, slowing retail sales, and falling house prices are all associated with falling interest rates and a bull market for bonds. Try watching

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From High School to Wall Street—The Bull Market Begins 7

the professionals on TV from any big bond firm (Pimco, for example) sincerely lament another weak economic report while their investments are most likely rising in price. Professed and genuine concern for the newly unemployed competes with the quiet satisfaction of a more highly valued bond portfolio. The U.K. gilt market (so named after the “gilt-edged” credit quality of the bonds traded there) of 1980 operated in a way that was scarcely different from the 1880s. The market consisted of brokers, who charged a commission and traded with the public as brokers do, and jobbers who were market makers and did not deal with the public at all. The market was structured with two large jobbers named Wedd Durlacher and Akroyd and Smithers, in effect surrounded by a far larger number of brokers. Brokers were allowed to trade only with jobbers and investors, not with one another. The jobbers could not trade with anybody except the brokers or (occasionally) with other jobbers. The jobbers held a monopoly on market making, but in return had given up the ability to face investors. The brokers had the exclusive right to deal with the general public, and in exchange were allowed to act only as agents (i.e., they couldn’t take positions themselves). Business took place on the large floor of the London Stock Exchange. Jobbers stood at their “pitch,” or assigned post, while brokers moved around the floor in search of the best deal for their client. A broker would ask a jobber to quote a price that was, in the best tradition of London markets, always “two-way” (i.e., bid and offer). Years later, when I was trading U.S. government bonds in New York, I always felt that the U.S. custom, whereby the client had to disclose whether they were buying or selling before obtaining a quote from the dealer, was providing a needless advantage at the expense of the client. A U.S. government bond dealer will show only one side of a two-way market—the client will ask for “a bid on 25,” for example, or request that the trader “offer 50.” Showing a two-way market keeps the dealer honest, in that if his bid/ask spread is wide, that’s an indication that his profit margin is possibly too high and may signal the client to go elsewhere. Other markets, such as foreign exchange, always required that the market maker quote a two-way price. The trader could try to guess whether the client was buying

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or selling, but if he shaded the price the wrong way, he ran the risk of the client’s trading on the other side (i.e., buying when the dealer thought he was a seller) and perhaps profiting off the dealer’s attempt to “read” him. The London Stock Exchange in 1980 was only a few years away from “Big Bang,” the 1986 deregulation of the overall market that would radically alter almost everything about how “The City,” as London’s financial center is called, operated. Back then, the entire place followed rigid work practices, from commissions, which were uniform across all firms, to career paths and how clients transacted their business. Finance had long provided jobs for those who were quick-witted and confident. London’s financial market place is physically not far from the East End of London, with its rowhouses of tenements barely changed from World War II. Multiple paths existed for the aspiring financier: education at a private school (perversely called a “public” school in the United Kingdom) followed by a university degree, then entry to a blue-blooded stockbroker in the gilt market.This was dubbed by some the “champagne and polo crowd,” evoking the cultural background of those whose leisure regularly includes the enjoyment of both.

THE OLD CLASS STRUCTURE Another path was from comprehensive (i.e., not elite) school, and probably not university, to a job in the equity markets or the money markets, where one’s peers would be the “gin and tonic and squash crowd,” denoting less cultured and cheaper relaxation. The open outcry, rough and tumble of a large physical market was a comfortable place for someone who might just as easily be competing to sell fruit and vegetables fewer than 10 miles away for vastly different compensation. London has become a much more culturally diverse place, with little patience for the staid old ways, and that’s no doubt a good thing. Still, the London Stock Exchange in 1980 in many ways mirrored the class system of the country. Britons could instantly place someone in their appropriate class as soon as words were spoken, and, while business could be transacted across class lines, social life was rarely so flexible.

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From High School to Wall Street—The Bull Market Begins 9

Forest School in Snaresbrook is close to London’s East End. The surrounding forests from which it draws its name quickly give way to gritty working-class neighborhoods as you head toward the center of the city. Before reaching the gleaming towers of London’s financial district, it’s necessary to pass through run-down areas such as Leyton, Hackney, and Bethnal Green, none of which could be confused with the leafy suburbs of the stockbroker belt. Historically, immigrants to the United Kingdom have often settled in the East End, from the Huguenots fleeing religious persecution in France in the seventeenth century to the South Asians today. Forest was and remains a public school with neighbors who can only dream of affording the tuition to send their children there, and yet the presence of so many minority students highlights the economic mobility that immigrants achieve. In many ways, my alma mater, Forest School, was typical—all boys, classes that ran six days a week, with a heavy emphasis on competition across all endeavors, both academic and sporting. When I was there in the 1970s, there were many boys that didn’t look “English,” to use the terminology of that time, because they weren’t white. Today’s coeducational student body is no less diverse, and yet more “English” because the country is itself more diverse. The closely packed houses of London’s East End have usually been home to workers struggling to move up a rung or two, and also home to a fair amount of crime. A student from Forest School, easily recognizable in his uniform, would head warily in that direction to a place where looking at someone the wrong way, or indeed looking at them at all, was to invite trouble. So this public school’s catchment area for students included parts of London that wouldn’t normally send their children to one. Nonetheless, the experience was typical of most public schools. Boys were assigned to “houses,” which were the basis for intense internal competition in everything from sports to drama. In fact, competition was ever present, whether it was in class rankings for subjects or an English football game with a neighboring school. Anything that mattered was subject to comparison with your peers. “Monitors” (selected students in their senior year) were the first layer of sometimes arbitrary discipline, empowered to administer corporal punishment if they judged it appropriate. It was its

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own somewhat insular and challenging world, with far less parental involvement than is the case in most schools today. School was a tight community, where problems were invariably resolved with little outside influence.You had to figure things out within the confines of the physical boundaries and the social ones. Therefore, I found the seven years I spent there hugely impactful, as those years often are. The school’s song, in Latin, was sung on key days during the year, and portraits of headmasters past adorned the walls of the dining hall where grace was said (in Latin) before boys could eat their (usually barely edible) lunch. The hierarchy and the traditions were all part of the education, in addition to the academic experience. Although fewer than 10 percent of the population shared this type of schooling, they represented a far bigger percentage of the U.K. workforce in law, medicine, senior levels of the government, and, of course, finance. On top of this unusual mixing of social classes, I took the less conventional route out of school and went straight to work in The City, passing up university out of the poorly informed, youthful confidence that my formal education was already sufficient. I soon found myself with the champagne and polo crowd in U.K. government bonds, known as the gilt market, in spite of the absence of a university degree on my resume. I was a “blue button,” so named after the blue badge with my employer’s name on it that placed me precisely at the bottom of the ladder. In many ways, the gilt market was like starting school again, with my firm taking the place of my schoolhouse and my blue button status ensuring that the yellow badges (members) and silver badges (partners) barely even acknowledged my existence, just as senior-year students in school barely tolerate the existence of those merely a few years younger. Gilts were the preserve of the “well-spoken” public schoolboys who had grown up in elite establishments steeped in practices many decades old. In a memorable holdover from much earlier times, the employees of one stockbroking firm called Mullins were all required to wear top hat and tails every day on the trading floor. Socially, they were the top of the pyramid, drawing their employees from only the most exclusive public schools.They were truly in the champagne and polo crowd.

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A NINETEENTH-CENTURY MARKET Mullins retained a special designation in that they were the only firm allowed to trade directly with the U.K. Treasury. In an archaic structure that epitomized the Old World style of business and fed many along the food chain, the U.K. government would issue its new gilts only to Mullins. Mullins would then turn around and sell these on to the jobbers, who would buy only what they knew they could sell back to the other stockbrokers, who would then sell them at very high commissions to the investing public. It was emblematic of the closed, anticompetitive methods of the time. The brokers from Mullins followed a long tradition of dressing somewhat like the students from Eton, perhaps Britain’s most elite public school and from which, no doubt, many of them had graduated. Their nineteenth-century dress code persisted until the late twentieth century. When the Big Bang in 1986 transformed commissions, structure, and customs, this particular tradition went, too, as Mullins was absorbed by investment bank S. G. Warburg and the gilt market abandoned the physical trading floor in favor of doing business over the phone. I don’t think it’s missed, although it’s extraordinary to think that even within my 30+ year career they were part of the landscape. In addition, just as moving from first year to sixth year in school can’t realistically be completed in fewer than five years, graduating to the next level as a stockbroker in the gilt market required as much as anything that you “do your time.” The rigidity of commissions and market practices required a similarly inflexible career path, in which talent or ambition would take second place to chronologically determined promotions. For me, my impatience with this way of business culminated with a discussion of my performance and my first pay raise. I entered the boardroom to meet with my boss, having put on my suit jacket, as was the custom for such a formal discussion. My diminutive annual salary of £2,750 was surely about to be rounded up to £3,000. To my dismay a mere £200 was added, confirming my lowly position at the base of the ladder in contrast to my own inestimable self-worth. Shortly afterward, I concluded that the gilt market’s time frame and mine were at odds, and I moved to

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the money markets, where my starting salary as a trainee broker was quickly agreed at £5,000. So I left the rigid social confines of the London Stock Exchange, where your accent would assign you to the equity market (working class, gin and tonic and squash) or the gilt market (upper class, champagne and polo, although in my time there I experienced neither). Instead, I entered the money markets, where social classes mingled, the business environment was more freewheeling, and ability might just get you a step ahead.

FINANCE STARTS TO GROW I was one individual making personal decisions that were dictated by the world I found but to whose shifting circumstances I did not give much thought. The United States and Britain were at the threshold of an advance in financial services that would substantially increase their impact on future economic growth. A 2012 paper by Robin Greenwood and David Scharfstein, both of Harvard Business School and the National Bureau of Economic Research (NBER), examines this shift in some detail (Greenwood and Scharfstein, 2012).The authors focus on a concept called gross domestic product (GDP) value added. Rather than measure the simple output (i.e., revenue) of an industry, they believe the more important measure is the value added.This makes sense since any business has inputs that it needs to generate its output. To use an example, a supermarket might take in $100,000 of revenue in a week and only spend $80,000 buying all the produce from various wholesalers. The $20,000 remaining goes to pay compensation to the workers in the supermarket and profit to the owners. It’s this $20,000 that is the GDP value added measure used by the authors, essentially salaries and bonuses to the workers in financial services and profits to the owners of the businesses. As such, it excludes all the other inputs or expenses, such as leased office space, information technology (IT), and others. These are someone else’s GDP value added. They are not directly created by the bankers, brokers, and asset managers in finance. Greenwood and Scharfstein found that financial services’ share of U.S. GDP measured in this way grew from 4.9 percent in 1980 to

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FIGURE 1.2 U.S. Financial Services Percentage of GDP Source: Bureau of Economic Analysis.

8.3 percent1 in 2006, where it peaked just prior to the mortgage crisis that began in 2007 (see Figure 1.2). In 1950, finance was only 2.8 percent of GDP, so although it had been growing as a proportion of GDP prior to 1980, the annual rate of growth doubled pre-1980 versus post-1980 (from 0.07 percent per annum to 0.13 percent per annum). Britain experienced a similar though less marked increase because its economy was already more biased toward finance than the United States at that time. Canada, Japan, and the Netherlands all saw an increase in finance within their economies, although it was by no means a worldwide phenomenon. In many European countries the opposite effect was observed, as other industries gained a bigger share of overall economic output. Germany, France, and Italy all saw modest falls in financial services’ share of GDP over this period, while in Norway and Sweden the share dropped by over a third. The authors don’t dwell much on the reasons behind these different outcomes. In looking at the data, it’s clear that those countries Current Bureau of Economic Analysis data show finance at 8.2 percent in 2006, presumably the result of a revision in the data since the Greenwood and Scharfstein paper was published.

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with a longer history and more dominant role in financial markets were the ones that witnessed the growth. During this time, there was a growing focus on the need to be global and to have scale in order to thrive. I worked during most of this period at one large American bank, which morphed from Manufacturers Hanover Trust to Chemical Bank to Chase Manhattan, before winding up as the behemoth that is JPMorgan today. Many smaller acquisitions took place along the way, and the constant strategic justification was the need to provide a global platform to our global clients. Furthermore, banking is also heavily reliant on IT and the development of the Internet from the mid-1990s improved communications dramatically, allowing more trading functions to be managed in a smaller number of major financial centers. Language and common culture no doubt also played a role, and with spoken English as well as U.K. law already the common currency across many areas of banking, the British Empire and its former members had a big lead. The fact that the United States was the largest economy, market, and only superpower is probably a factor, too. London already had a dominant position in this sector throughout Europe. These trends probably served to marginalize centers like Brussels, Paris, and Milan. New York never really had a close competitor within its time zone, although Chicago’s futures pits made it the home for exchange traded derivatives. It’s therefore likely that for these reasons and maybe others, the Anglo-Saxon countries allowed and encouraged bankers and asset managers to play a bigger role in their economies. It’s doubtful that the political leaders of the late 1970s and early 1980s sought this transformation, and the past 30 years have witnessed an evolution with many twists along the way, as the creative destruction that defines capitalism has created winners and losers. The way the French sneer at Anglo-Saxon hedge funds and their brand of capitalism may reflect different values that led France to inhibit similar growth in their domestic markets. Perhaps it also reflects disappointment that so many young French people choose to live and work in London, where the opportunities are often far greater. The GDP data from which this analysis is drawn identifies two areas within financial services that are responsible for most of the

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growth—securities and credit intermediation. Insurance is the third big component of financial services, although its growth over this time was unremarkable and fairly steady going back as far as 1940. The securities industry, which includes everything from trading and underwriting to asset management, increased its share of GDP value added from 0.4 percent in 1980 to 1.9 percent in 2006 before falling back modestly to 1.7 percent in 2007 (see Figure 1.3). This more than quadrupling of virtually all things related to investment securities in barely more than a single generation is probably unprecedented in history. The securities industry further breaks down into subcategories, of which asset management is by far the biggest, representing over half of all securities industry activity by 2007. Credit intermediation, which includes traditional banking such as taking deposits and making loans, also saw substantial growth albeit from a higher base. This increased from 2.6 percent of GDP value added in 1980 to 3.6 percent in 2006 before dropping back in 2007 to 3.4 percent, although by 2011 it had increased modestly back to 3.6 percent (Bureau of Economic Analysis, 2013). Banking went

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from being six times as big as the securities industry in 1980 to only twice as big almost 30 years later, although it, too, represented a bigger share of the economy.

IS FINANCE GOOD? So Wall Street and Banking (and sometimes the two are synonymous) had by 2006 reached over 8 percent of the entire U.S. economy. As we all discovered during the 2007-2008 Crisis, their actual impact was substantially greater than this, since their collapse led to the worst recession most of us have ever seen and the brink of financial catastrophe.These two industries affect the lives of so many more people than simply those employed within it. As well as employing more workers, finance has contributed to the increasing dispersion of incomes within most developed countries. Many finance jobs provide more than your average middle-class income that has stagnated for the past 10 years. Indeed, from 1980 to 2006, pay in finance rose cumulatively 70 percent more than in the rest of the economy (Philippon, 2008). The growth in the securities industry and in credit intermediation were related phenomena. Much of the growth in credit intermediation was fueled by residential mortgages. The long bull market in bonds created regular incentives for homeowners to refinance their mortgages to take advantage of lower rates. At the same time, public policy became geared toward increased home ownership, while the tax deductibility of interest on home mortgages combined with the increased percentage of loans underwritten by the federal government, all contributed to the increased percentage of families living in their own homes. Data from the U.S. Census Bureau shows that the home ownership percentage was remarkably stable from 1965 until the late 1990s, fluctuating between 63 percent and 66 percent. President Clinton made increasing home ownership one of his goals, stating to the National Association of Realtors in November 1994 with his typical eloquence that “most Americans should own their homes, for reasons that are economic and tangible, and reasons that are emotional and

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intangible, but go to the heart of what it means to harbor, to nourish, to expand the American Dream� (Morgensen, 2011). Clinton enlisted support from all the stakeholders including banks, securities firms, builders, and realtors, and his strategy was greatly facilitated by the corruptly led twin federal agencies FNMA and FHMC (Fannie Mae and Freddie Mac) (Morgensen, 2011). By the late 1990s the home ownership percentage had reached the top of its multidecade band of 66 percent (see Figure 1.4). By 2000 it was at 67 percent and in 2004 it reached 69 percent before moderating for a few years and then falling more sharply back to its long-term range as the housing bubble burst. Government policies were aided by increased securitization of mortgages, and the increased securitization also led to a bigger securities market with more assets to manage for the securities industry. In this way, the two fastest-growing areas in financial services were linked and to some degree fed off one another. Some compelling questions are prompted by the developments of the past 30 years. Society may well challenge the wisdom of promoting home ownership beyond what was, in hindsight, a stable, equilibrium level. Owner-occupied homes are widely believed to promote 70 69 68 67 66 65 64 63 62 1965

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stable communities with lower crime rates and higher incomes; however, the incentives to own your own home clearly resulted in many people buying homes they could not afford, with mortgages they should not have been given. While the policies that promoted this were no doubt well intentioned, the sad outcome of so many people losing their homes, and in many cases a hard-earned down payment, exposed the flawed nature of this approach. Household debt also grew along with Wall Street. Outstanding consumer credit jumped in the 1950s, as the end of World War II brought soldiers home and ushered in the beginning of the Baby Boom and increased household formation. It then fluctuated between 10 and 13 percent of GDP during the 1960s and 1970s (see Figure 1.5). Nevertheless, from 1980 to 2003, consumer credit grew steadily from 12.6 percent of GDP to 18.6 percent. Although during recessions it shrank, the overall trend was clearly higher. There’s little doubt that securitization aided the process as banks packaged debt into bonds and moved it off their balance sheets to investors globally. Government debt (federal, state, and local) also grew strongly from 1980. No doubt, the growth of finance helped this as well. As a percentage of GDP, government debt is close to the levels following

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World War II (see Figure 1.6). When combined with household debt, our total obligations are assuredly at a record. Another important question is whether the growth in financial services has created widespread benefits for anybody beyond those directly employed in the industry. Greenwood and Scharfstein conclude that a bigger asset management industry has led to higher equity prices than would otherwise be the case through greater investor diversification. Their logic is that investors hold generally more diversified portfolios of equities, thanks to the greater use of financial advisers and mutual funds. In theory, this improved diversification should lower the return required for investors to hold equities (because portfolios are now less risky through being more diversified). A lower required return for equity investors translates directly into a lower cost of equity capital for public companies. It’s a reasonable argument, albeit hard to prove empirically. Cheaper access to equity financing is most certainly good for the broader economy, since it makes it easier for companies to finance themselves and invest in new projects, with corresponding broadbased benefits throughout the economy. Yet they also note that asset management fees have stayed surprisingly high and that there seem to be few economies of scale that pass through to the investor in

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terms of lower fees. In some respects, they echo the findings in my 2011 book, The Hedge Fund Mirage:The Illusion of Big Money and Why It’s Too Good to Be True, in which I showed that hedge fund managers had kept all the profits made with their clients’ capital through exorbitant fees.This is an extreme case of the financial services industry retaining substantially all of the benefits of a potentially good thing (active asset management). It nonetheless begs the question of whether such behavior is simply rent seeking with little added societal value. Increasing dispersion of incomes and the stagnation of median household real wealth suggest that gains have been unevenly distributed. Politically, the median voter’s economic state is far more important than the average voter’s when the two are diverging, as is the case today. As average incomes are less reflective of the average person (due to “the 1 percent” doing so well and pulling up the average), a public policy response cannot be far behind.

INVESTING AFTER THE BUBBLE Perhaps the most interesting question is the one facing investors. We are probably at an inflection point in two important ways. The collapse in the real estate bubble with its consequently deeply unpopular bank bailouts has focused attention on the securities industry, its pay practices, and what the appropriate relationship should be between banks and the society they are intended to serve. At its core, Wall Street is supposed to facilitate the channeling of savings into productive types of capital formation, which will foster economic growth and job creation as well as investor returns above inflation. To many people, Wall Street has increasingly lost sight of this goal; one simple example is the growth of computerized, high-frequency trading (HFT). Managers of HFT strategies even value physical proximity to the New York Stock Exchange so as to gain vital milliseconds in the transmission of their orders and therefore a more profitable outcome. It’s hard to come up with a more obvious case of a perfectly useless activity that is clearly part of a zero-sum game on whose other side lie conventional investors seeking a return on their capital.

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Public policy is just beginning to grapple with all the issues of a financial system that may be larger than we need, a system that although highly competitive within itself doesn’t appear to pass on the benefits of that competition to consumers in the form of lower prices. Increased regulation and higher capital requirements are the two most obvious reactions, although in time society may add further constraints. The other inflection point is surely on the level of debt outstanding. For if there’s one common thread linking up the U.S. real estate crash, the subsequent Euro sovereign debt crisis, and the looming U.S. fiscal crisis over entitlements and taxes, it must be an excess of debt across individuals and their governments. Public corporations with no taxing ability or social safety net have broadly been the sector that has been best behaved, which is why cash held by corporations is at a record high. The enormous debts incurred by individuals and their governments, including future commitments of pensions and health care that don’t show up on conventional public reporting, represent perhaps the most important consideration for investors today. Whether the huge liabilities we have created result in a lost decade like Japan’s through deflation or are highly inflationary is, to me at least, not clear. Yet, we are likely entering a period of greater populism fueled by increased income disparity, and perhaps more popular support for debtors who are both more numerous and face darkening prospects through continually stagnant middle-class wages. This book tells the story of how we arrived here, which is to say at a place with far too much debt owed by governments and individuals and with no easy ways to deal with it.The debt is not going away, and barring some unimaginable technological leap, our economies are unlikely to grow their way out of trouble. The story has two parallel strands: one describes the economic forces and trends that have been operating, in some cases the direct result of public policy decisions, while in others in spite of them. The other strand provides a groundlevel view from one participant who, for most of this time, had little understanding of the larger forces at work, but was rather reacting to market forces in a micro way, choosing jobs and opportunities whose prospects seemed most promising. Only with the benefit of hindsight

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can I regard my own past in conjunction with the broad strokes of history and appreciate that I was responding to market forces as I saw them in terms of career moves I made and jobs I held. I gave little thought at the time to the invisible hand at work in the background. This was a period of increasing financial liberalization as markets deregulated, of increased borrowing greatly aided by securitization and a heavy public policy bias toward debt and real estate, and consequently the ability to consume today at the expense of tomorrow became easier for individuals as well as governments. It would be natural to hold strong views and to express them in reviewing how we arrived here. However, there are many varied solutions, and the politics are largely for others to pursue. As an investor, you take the world as you find it, not as it should be; and while understanding the past is important in terms of planning for the future, investors need to focus themselves on likely outcomes and their probabilities and consequences, and make decisions accordingly. Most of us could solve the developed world’s debt problems easily enough, given the absolute power to do so. Futile debates on how the world should be are far less interesting than coolly assessing how it may well turn out to be. This story uses economic statistics to present the big picture combined with one individual’s personal journey through the growth of financial deregulation, securities trading, and debt. By considering how we made the journey, the story seeks to answer the question most investors have—where should I invest for tomorrow? It will be no surprise given the book’s title that the forces of economic history and politics are likely to combine in ensuring that even though fixed income has been a great place for investors over the past 30 years, the next decade is likely to be disappointing and may even be ruinous for bond investors. Those avoiding the possible risk of falling equity markets by holding bonds are most likely accepting the guarantee of negative real returns (i.e., returns below inflation, resulting in a loss of purchasing power) on their savings and a transfer of real wealth to those who have borrowed too much. Bonds have been great, to be sure, but Bonds Are Not Forever.

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The Essays of Warren Buffett, 4th Edition Lessons for Investors and Managers Lawrence A. Cunningham 978-1-118-82115-2 • Paperback • 320 pages • December 2013

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I

Corporate Governance

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any annual meetings are a waste of time, both for shareholders and for management. Sometimes that is true because management is reluctant to open up on matters of business substance. More often a non-productive session is the fault of shareholder participants who are more concerned about their own moment on stage than they are about the affairs of the corporation. What should be a forum for business discussion becomes a forum for theatrics, spleenventing and advocacy of issues. (The deal is irresistible: for the price of one share you get to tell a captive audience your ideas as to how the world should be run.) Under such circumstances, the quality of the meeting often deteriorates from year to year as the antics of those interested in themselves discourage attendance by those interested in the business. Berkshire’s meetings are a different story.The number of shareholders attending grows a bit each year and we have yet to experience a silly

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question or an ego-inspired commentary.1 Instead, we get a wide variety of thoughtful questions about the business. Because the annual meeting is the time and place for these, Charlie and I are happy to answer them all, no matter how long it takes. (We cannot, however, respond to written or phoned questions at other times of the year; one-personat-a-time reporting is a poor use of management time in a company with [thousands of] shareholders.) The only business matters that are off limits at the annual meeting are those about which candor might cost our company real money. Our activities in securities would be the main example.2

A. Full and Fair Disclosure3 At Berkshire, full reporting means giving you the information that we would wish you to give to us if our positions were reversed.What Charlie and I would want under that circumstance would be all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business. We would expect both a lot of financial details and a discussion of any significant data we would need to interpret what was presented. When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA make us shudder— does management think the tooth fairy pays for capital expenditures?4 We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something. And we don’t want to read messages that a public relations department or consultant has turned out. Instead, we expect a company’s CEO to explain in his or her own words what’s happening. For us, fair reporting means getting information to our 300,000 “partners” simultaneously, or as close to that mark as possible. We therefore

1 [Subsequent letters sometimes report on the turnout at prior annual meetings. The turnout went from 12 at the 1975 meeting to approximately 7,500 at the 1997 meeting to over 15,000 in the early 2000s and to 35,000 in 2008, with steady increases since 1984.] 2 [Introductory essay, 1984.] 3 [Divided by hash lines: 2000; 2002.] 4 [See the essay Owner Earnings and the Cash Flow Fallacy in Part VI.E.]

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put our annual and quarterly financials on the Internet between the close of the market on a Friday and the following morning. By our doing that, shareholders and other interested investors have timely access to these important releases and also have a reasonable amount of time to digest the information they include before the markets open on Monday. We applaud the work that Arthur Levitt, Jr., until recently Chairman of the SEC, has done in cracking down on the corporate practice of “selective disclosure” that had spread like cancer in recent years. Indeed, it had become virtually standard practice for major corporations to “guide” analysts or large holders to earnings expectations that were intended either to be on the nose or a tiny bit below what the company truly expected to earn. Through the selectively dispersed hints, winks and nods that companies engaged in, speculatively-minded institutions and advisors were given an information edge over investment-oriented individuals. This was corrupt behavior, unfortunately embraced by both Wall Street and corporate America. Thanks to Chairman Levitt, whose general efforts on behalf of investors were both tireless and effective, corporations are now required to treat all of their owners equally. The fact that this reform came about because of coercion rather than conscience should be a matter of shame for CEOs and their investor relations departments. One further thought while I’m on my soapbox: Charlie and I think it is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble. It’s fine for a CEO to have his own internal goals and, in our view, it’s even appropriate for the CEO to publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble. That’s true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 to 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than

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10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years. The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to “make the numbers.” These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more “heroic.”These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.) Charlie and I tend to be leery of companies run by CEOs who woo investors with fancy predictions. A few of these managers will prove prophetic—but others will turn out to be congenital optimists, or even charlatans. Unfortunately, it’s not easy for investors to know in advance which species they are dealing with.

Three suggestions for investors: First, beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out.When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen. Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would

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lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense—a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality? Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me. Finally, be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers). Charlie and I not only don’t know today what our businesses will earn next year—we don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future—and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.

B. Boards and Managers5 [The performance of CEOs of investee companies], which we have observed at close range, contrasts vividly with that of many CEOs, which we have fortunately observed from a safe distance. Sometimes these CEOs clearly do not belong in their jobs; their positions, nevertheless, are usually secure. The supreme irony of business management is that it is far easier for an inadequate CEO to keep his job than it is for an inadequate subordinate. If a secretary, say, is hired for a job that requires typing ability of at least 80 words a minute and turns out to be capable of only 50 words a minute, she will lose her job in no time. There is a logical standard for this job; performance is easily measured; and if you can’t make the grade, you’re out. Similarly, if new sales people fail to generate 5 [Divided by hash lines: 1988; 1993; 2002; 2004; 2003; 1986; 1998; 2005.]

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sufficient business quickly enough, they will be let go. Excuses will not be accepted as a substitute for orders. However,a CEO who doesn’t perform is frequently carried indefinitely. One reason is that performance standards for his job seldom exist. When they do, they are often fuzzy or they may be waived or explained away, even when the performance shortfalls are major and repeated. At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands. Another important, but seldom recognized, distinction between the boss and the foot soldier is that the CEO has no immediate superior whose performance is itself getting measured. The sales manager who retains a bunch of lemons in his sales force will soon be in hot water himself. It is in his immediate self-interest to promptly weed out his hiring mistakes. Otherwise, he himself may be weeded out. An office manager who has hired inept secretaries faces the same imperative. But the CEO’s boss is a Board of Directors that seldom measures itself and is infrequently held to account for substandard corporate performance. If the Board makes a mistake in hiring, and perpetuates that mistake, so what? Even if the company is taken over because of the mistake, the deal will probably bestow substantial benefits on the outgoing Board members. (The bigger they are, the softer they fall.) Finally, relations between the Board and the CEO are expected to be congenial. At board meetings, criticism of the CEO’s performance is often viewed as the social equivalent of belching. No such inhibitions restrain the office manager from critically evaluating the substandard typist. These points should not be interpreted as a blanket condemnation of CEOs or Boards of Directors: Most are able and hardworking, and a number are truly outstanding. But the management failings that Charlie and I have seen make us thankful that we are linked with the managers of our three permanent holdings. They love their businesses, they think like owners, and they exude integrity and ability.

At our annual meetings, someone usually asks “What happens to this place if you get hit by a truck?” I’m glad they are still asking the question

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in this form. It won’t be too long before the query becomes: “What happens to this place if you don’t get hit by a truck?” Such questions, in any event, raise a reason for me to discuss corporate governance, a hot topic during the past year. In general, I believe that directors have stiffened their spines recently and that shareholders are now being treated somewhat more like true owners than was the case not long ago. Commentators on corporate governance, however, seldom make any distinction among three fundamentally different manager/owner situations that exist in publicly-held companies.Though the legal responsibility of directors is identical throughout, their ability to effect change differs in each of the cases. Attention usually falls on the first case, because it prevails on the corporate scene. Since Berkshire falls into the second category, however, and will someday fall into the third, we will discuss all three variations. The first, and by far most common, board situation is one in which a corporation has no controlling shareholder. In that case, I believe directors should behave as if there is a single absentee owner, whose longterm interest they should try to further in all proper ways. Unfortunately, “long-term” gives directors a lot of wiggle room. If they lack either integrity or the ability to think independently, directors can do great violence to shareholders while still claiming to be acting in their longterm interest. But assume the board is functioning well and must deal with a management that is mediocre or worse. Directors then have the responsibility for changing that management, just as an intelligent owner would do if he were present. And if able but greedy managers over-reach and try to dip too deeply into the shareholders’ pockets, directors must slap their hands. In this plain-vanilla case, a director who sees something he doesn’t like should attempt to persuade the other directors of his view. If he is successful, the board will have the muscle to make the appropriate change. Suppose, though, that the unhappy director can’t get other directors to agree with him. He should then feel free to make his views known to the absentee owners. Directors seldom do that, of course. The temperament of many directors would in fact be incompatible with critical behavior of that sort. But I see nothing improper in such actions, assuming the issues are serious. Naturally, the complaining director can expect a vigorous rebuttal from the unpersuaded directors, a

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prospect that should discourage the dissenter from pursuing trivial or non-rational causes. For the boards just discussed, I believe the directors ought to be relatively few in number—say, ten or less—and ought to come mostly from the outside. The outside board members should establish standards for the CEO’s performance and should also periodically meet, without his being present, to evaluate his performance against those standards. The requisites for board membership should be business savvy, interest in the job, and owner-orientation. Too often, directors are selected simply because they are prominent or add diversity to the board. That practice is a mistake. Furthermore, mistakes in selecting directors are particularly serious because appointments are so hard to undo: The pleasant but vacuous director need never worry about job security. The second case is that existing at Berkshire, where the controlling owner is also the manager. At some companies, this arrangement is facilitated by the existence of two classes of stock endowed with disproportionate voting power. In these situations, it’s obvious that the board does not act as an agent between owners and management and that the directors cannot effect change except through persuasion. Therefore, if the owner/manager is mediocre or worse—or is over-reaching—there is little a director can do about it except object. If the directors having no connections to the owner/manager make a unified argument, it may well have some effect. More likely it will not. If change does not come, and the matter is sufficiently serious, the outside directors should resign. Their resignation will signal their doubts about management, and it will emphasize that no outsider is in a position to correct the owner/manager’s shortcomings. The third governance case occurs when there is a controlling owner who is not involved in management. This case, examples of which are Hershey Foods and Dow Jones, puts the outside directors in a potentially useful position. If they become unhappy with either the competence or integrity of the manager, they can go directly to the owner (who may also be on the board) and report their dissatisfaction. This situation is ideal for an outside director, since he need make his case only to a single, presumably interested owner, who can forthwith effect change if the argument is persuasive. Even so, the dissatisfied director has only that

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single course of action. If he remains unsatisfied about a critical matter, he has no choice but to resign. Logically, the third case should be the most effective in insuring firstclass management. In the second case the owner is not going to fire himself, and in the first case, directors often find it very difficult to deal with mediocrity or mild over-reaching. Unless the unhappy directors can win over a majority of the board—an awkward social and logistical task, particularly if management’s behavior is merely odious, not egregious— their hands are effectively tied. In practice, directors trapped in situations of this kind usually convince themselves that by staying around they can do at least some good. Meanwhile, management proceeds unfettered. In the third case, the owner is neither judging himself nor burdened with the problem of garnering a majority. He can also insure that outside directors are selected who will bring useful qualities to the board. These directors, in turn, will know that the good advice they give will reach the right ears, rather than being stifled by a recalcitrant management. If the controlling owner is intelligent and self-confident, he will make decisions in respect to management that are meritocratic and pro-shareholder. Moreover—and this is critically important—he can readily correct any mistake he makes. At Berkshire we operate in the second mode now and will for as long as I remain functional. My health, let me add, is excellent. For better or worse, you are likely to have me as an owner/manager for some time. All in all, we’re prepared for “the truck.”

Both the ability and fidelity of managers have long needed monitoring. Indeed, nearly 2,000 years ago, Jesus Christ addressed this subject, speaking (Luke 16:2) approvingly of “a certain rich man” who told his manager, “Give an account of thy stewardship; for thou mayest no longer be steward.” Accountability and stewardship withered in the last decade, becoming qualities deemed of little importance by those caught up in the Great Bubble. As stock prices went up, the behavioral norms of managers went down. By the late ‘90s, as a result, CEOs who traveled the high road did not encounter heavy traffic.

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Most CEOs, it should be noted, are men and women you would be happy to have as trustees for your children’s assets or as next-door neighbors. Too many of these people, however, have in recent years behaved badly at the office, fudging numbers and drawing obscene pay for mediocre business achievements. Why have intelligent and decent directors failed so miserably? The answer lies not in inadequate laws—it’s always been clear that directors are obligated to represent the interests of shareholders— but rather in what I’d call “boardroom atmosphere.” It’s almost impossible, for example, in a boardroom populated by well-mannered people, to raise the question of whether the CEO should be replaced. It’s equally awkward to question a proposed acquisition that has been endorsed by the CEO, particularly when his inside staff and outside advisors are present and unanimously support his decision. (They wouldn’t be in the room if they didn’t.) Finally, when the compensation committee—armed, as always, with support from a high-paid consultant—reports on a mega-grant of options to the CEO, it would be like belching at the dinner table for a director to suggest that the committee reconsider. These “social” difficulties argue for outside directors regularly meeting without the CEO—a reform that is being instituted and that I enthusiastically endorse. I doubt, however, that most of the other new governance rules and recommendations will provide benefits commensurate with the monetary and other costs they impose. The current cry is for “independent” directors. It is certainly true that it is desirable to have directors who think and speak independently—but they must also be business-savvy, interested and shareholder oriented [as noted in the previous essay]. Over a span of 40 years, I have been on 19 public-company boards (excluding Berkshire’s) and have interacted with perhaps 250 directors. Most of them were “independent” as defined by today’s rules. But the great majority of these directors lacked at least one of the three qualities I value. As a result, their contribution to shareholder well-being was minimal at best and, too often, negative. These people, decent and intelligent though they were, simply did not know enough about business and/or care enough about shareholders to question foolish acquisitions or egregious compensation. My own

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behavior, I must ruefully add, frequently fell short as well: Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders. In those cases, collegiality trumped independence. So that we may further see the failings of “independence,” let’s look at a 62-year case study covering thousands of companies. Since 1940, federal law has mandated that a large proportion of the directors of investment companies (most of these mutual funds) be independent.The requirement was originally 40% and now it is 50%. In any case, the typical fund has long operated with a majority of directors who qualify as independent. These directors and the entire board have many perfunctory duties, but in actuality have only two important responsibilities: obtaining the best possible investment manager and negotiating with that manager for the lowest possible fee. When you are seeking investment help yourself, those two goals are the only ones that count, and directors acting for other investors should have exactly the same priorities. Yet when it comes to independent directors pursuing either goal, their record has been absolutely pathetic. Many thousands of investment-company boards meet annually to carry out the vital job of selecting who will manage the savings of the millions of owners they represent. Year after year the directors of Fund A select manager A, Fund B directors select manager B, etc. . . . in a zombie-like process that makes a mockery of stewardship. Very occasionally, a board will revolt. But for the most part, a monkey will type out a Shakespeare play before an “independent” mutual-fund director will suggest that his fund look at other managers, even if the incumbent manager has persistently delivered substandard performance. When they are handling their own money, of course, directors will look to alternative advisors— but it never enters their minds to do so when they are acting as fiduciaries for others. The hypocrisy permeating the system is vividly exposed when a fund management company—call it “A”—is sold for a huge sum to Manager “B”. Now the “independent” directors experience a “counterrevelation” and decide that Manager B is the best that can be found— even though B was available (and ignored) in previous years. Not so incidentally, B also could formerly have been hired at a far lower rate

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than is possible now that it has bought Manager A. That’s because B has laid out a fortune to acquire A, and B must now recoup that cost through fees paid by the A shareholders who were “delivered” as part of the deal. (For a terrific discussion of the mutual fund business, read John Bogle’s Common Sense on Mutual Funds.) Investment company directors have failed as well in negotiating management fees. If you or I were empowered, I can assure you that we could easily negotiate materially lower management fees with the incumbent managers of most mutual funds. And, believe me, if directors were promised a portion of any fee savings they realized, the skies would be filled with falling fees. Under the current system, though, reductions mean nothing to “independent” directors while meaning everything to managers. So guess who wins? Having the right money manager, of course, is far more important to a fund than reducing the manager’s fee. Both tasks are nonetheless the job of directors. And in stepping up to these all-important responsibilities, tens of thousands of “independent” directors, over more than six decades, have failed miserably. (They’ve succeeded, however, in taking care of themselves; their fees from serving on multiple boards of a single “family” of funds often run well into six figures.) When the manager cares deeply and the directors don’t, what’s needed is a powerful countervailing force—and that’s the missing element in today’s corporate governance. Getting rid of mediocre CEOs and eliminating overreaching by the able ones requires action by owners— big owners. The logistics aren’t that tough: The ownership of stock has grown increasingly concentrated in recent decades, and today it would be easy for institutional managers to exert their will on problem situations. Twenty, or even fewer, of the largest institutions, acting together, could effectively reform corporate governance at a given company, simply by withholding their votes for directors who were tolerating odious behavior. In my view, this kind of concerted action is the only way that corporate stewardship can be meaningfully improved.

Several institutional shareholders and their advisors decided I lacked “independence” in my role as a director of Coca-Cola. One group

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wanted me removed from the board and another simply wanted me booted from the audit committee. My first impulse was to secretly fund the group behind the second idea. Why anyone would wish to be on an audit committee is beyond me. But since directors must be assigned to one committee or another, and since no CEO wants me on his compensation committee, it’s often been my lot to get an audit committee assignment. As it turned out, the institutions that opposed me failed and I was re-elected to the audit job. (I fought off the urge to ask for a recount.) Some institutions questioned my “independence” because, among other things, McLane and Dairy Queen buy lots of Coke products. (Do they want us to favor Pepsi?) But independence is defined in Webster’s as “not subject to control by others.” I’m puzzled how anyone could conclude that our Coke purchases would “control” my decision-making when the counterweight is the wellbeing of $8 billion of Coke stock held by Berkshire. Assuming I’m even marginally rational, elementary arithmetic should make it clear that my heart and mind belong to the owners of Coke, not to its management. I can’t resist mentioning that Jesus understood the calibration of independence far more clearly than do the protesting institutions. In Matthew 6:21 He observed: “For where your treasure is, there will your heart be also.” Even to an institutional investor, $8 billion should qualify as “treasure” that dwarfs any profits Berkshire might earn on its routine transactions with Coke. Measured by the biblical standard, the Berkshire board is a model: (a) every director is a member of a family owning at least $4 million of stock; (b) none of these shares were acquired from Berkshire via options or grants; (c) no directors receive committee, consulting or board fees from the company that are more than a tiny portion of their annual income; and (d) although we have a standard corporate indemnity arrangement, we carry no liability insurance for directors. At Berkshire, board members travel the same road as shareholders. Charlie and I have seen much behavior confirming the Bible’s “treasure” point. In our view, based on our considerable boardroom experience, the least independent directors are likely to be those who receive an important fraction of their annual income from the fees they receive for board service (and who hope as well to be recommended for

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election to other boards and thereby to boost their income further).Yet these are the very board members most often classed as “independent.” Most directors of this type are decent people and do a first-class job. But they wouldn’t be human if they weren’t tempted to thwart actions that would threaten their livelihood. Some may go on to succumb to such temptations. Let’s look at an example based upon circumstantial evidence. I have first-hand knowledge of a recent acquisition proposal (not from Berkshire) that was favored by management, blessed by the company’s investment banker and slated to go forward at a price above the level at which the stock had sold for some years (or now sells for). In addition, a number of directors favored the transaction and wanted it proposed to shareholders. Several of their brethren, however, each of whom received board and committee fees totaling about $100,000 annually, scuttled the proposal, which meant that shareholders never learned of this multi-billion offer. Non-management directors owned little stock except for shares they had received from the company.Their open-market purchases in recent years had meanwhile been nominal, even though the stock had sold far below the acquisition price proposed. In other words, these directors didn’t want the shareholders to be offered X even though they had consistently declined the opportunity to buy stock for their own account at a fraction of X. I don’t know which directors opposed letting shareholders see the offer. But I do know that $100,000 is an important portion of the annual income of some of those deemed “independent,” clearly meeting the Matthew 6:21 definition of “treasure.” If the deal had gone through, these fees would have ended. Neither the shareholders nor I will ever know what motivated the dissenters. Indeed they themselves will not likely know, given that self-interest inevitably blurs introspection. We do know one thing, though: At the same meeting at which the deal was rejected, the board voted itself a significant increase in directors’ fees.

We now have eleven directors and each of them, combined with members of their families, owns more than $4 million of Berkshire stock. Moreover, all have held major stakes in Berkshire for many years. In the

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case of six of the eleven, family ownership amounts to at least hundreds of millions and dates back at least three decades. All eleven directors purchased their holdings in the market just as you did; we’ve never passed out options or restricted shares. Charlie and I love such honest-to-God ownership. After all, who ever washes a rental car? In addition, director fees at Berkshire are nominal (as my son, Howard, periodically reminds me). Thus, the upside from Berkshire for all eleven is proportionately the same as the upside for any Berkshire shareholder. And it always will be. The downside for Berkshire directors is actually worse than yours because we carry no directors and officers liability insurance. Therefore, if something really catastrophic happens on our directors’ watch, they are exposed to losses that will far exceed yours. The bottom line for our directors: You win, they win big; you lose, they lose big. Our approach might be called owner-capitalism.We know of no better way to engender true independence. In addition to being independent, directors should have business savvy, a shareholder orientation and a genuine interest in the company. The rarest of these qualities is business savvy—and if it is lacking, the other two are of little help. Many people who are smart, articulate and admired have no real understanding of business. That’s no sin; they may shine elsewhere. But they don’t belong on corporate boards. Continues...

Charlie and I really have only two jobs. One is to attract and keep outstanding managers to run our various operations.6 This hasn’t been all that difficult. Usually the managers came with the companies we bought, having demonstrated their talents throughout careers that spanned a wide variety of business circumstances. They were managerial stars long before they knew us, and our main contribution has been to not get in their way. This approach seems elementary: if my job were to manage a golf team—and if Jack Nicklaus or Arnold Palmer were willing to play for me— neither would get a lot of directives from me about how to swing. 6 [The other is capital allocation, discussed in Parts II and VI.]

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The Trader’s Guide to the Euro Area Economic Indicators, the ECB and the Euro Crisis David J. Powell 978-1-118-44005-6 • Hardback • 212 pages • September 2013

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CHAPTER 2

Gross Domestic Product GDP is the most commonly cited comprehensive indicator of economic activity. It is the total market value of the goods and services produced within a nation or, in the case of the euro area, a monetary union. It can also be described as the total income of the geographic area. The first word of the term – gross – indicates that depreciation of equipment and factories used in the production process is excluded from the calculation.1 For example, the decline in the value of an aging computer is ignored in this measure of national output. The second word of the term – domestic – indicates the inclusion of all production within the region’s borders irrespective of the country of origin of the producer.2 For example, if a Mercedes is produced in a plant constructed by the German company in the U.S., the car is included in U.S. GDP and excluded from German GDP. If the car is produced in Germany and shipped to the U.S., it is included in German GDP and excluded from U.S. GDP. Three methods of measuring GDP exist: expenditure, output and income. In theory, all three methods should produce the same figure. In practice, measurement problems normally lead to discrepancies. The Expenditure Approach

The expenditure approach is based on the final or end use of the produced goods and services. This method has historically been used most frequently by national statistical agencies. In a report from 1996 of 18 member countries, the OECD calculated that all of them reported GDP using the expenditure Principal European Economic Indicators: A Statistical Guide. Eurostat, 2009. Ibid.

1

2

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approach. Sixteen of them also tallied the figure using the output method and 10 used the income approach as well.3 These numbers have since risen to 18, 17 and 16, respectively.4 The accounting identity used to calculate GDP under the expenditure approach states that GDP equals consumption plus investment plus net exports. Consumption is broken down into private consumption and government consumption and investment consists of gross fixed capital investment and the change in inventories. The sum of consumption and investment equals domestic demand. Net exports equals exports minus imports. Consumption (= Private Consumption + Government Consumption)  + Investment (= Gross Fixed Capital Investment + Change in Inventories)  = Domestic Demand + Net Exports (= Exports − Imports)  = Gross Domestic Product Private consumption is spending on goods and services by non-governmental entities such as individuals and households. It is the largest category of GDP for most developed economies. For example, it was about 71% of GDP of the U.S.; 64% of that of the U.K. and 57% of that of Germany in 2011. Eurostat also includes a group called NPISH in its calculation of private consumption (Table 2.1). It is an acronym for non-profit institutions serving households. It includes charities, churches, political parties and trade unions. Government consumption represents the purchase of goods and services by general government. It made up about 20% of GDP of the U.S.; 20% of that of Germany; and 22% of that of the U.K. in 2011. Investment is the spending used to increase future consumption. The category breaks down into gross fixed capital formation and inventories. Gross fixed capital formation represents the acquisition of fixed assets minus the disposal of those items. In this case, “gross” refers to the exclusion of depreciation costs. Fixed assets are defined by Eurostat as “tangible or intangible assets produced as outputs from the processes of production that are themselves used repeatedly, or continuously, in processes of production for more than one year.”5 An example of a tangible asset from this category is a factory and one of an intangible asset is a patent. Quarterly National Accounts: Sources and Methods Used by OECD Member Countries. OECD, 1996. {http://www.oecd.org/std/na/1909562.pdf } 4 E-mail to David Powell from the OECD, March 18, 2013. 5 Gross Fixed Capital Formation. Eurostat. {http://circa.europa.eu/irc/dsis/nfaccount/info/data/ esa95/en/een00137.htm} 3

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154

1.8

JP

Source: Eurostat

0.3

US

0.1 1.3

1.0 0.5

0.3 1.1

0.4 0.4

0.7

0.5

Q4

1.2

0.6

Q1

Q2

2011

0.2 0.4

Q1

0.1

0.2

0.4

1.0

Q3

2011 Q4

Q1

2012

0.3

0.6

2.6

1.1 1.5

1.3 3.3 −0.4

2.0

0.4 7.9 −3.6

1.5

1.5 −0.2 1.4 0.1

Q1 Q2

3.4 1.2 3.4

1.1 1.5 1.1

1.0

1.2

2.2 1.6

0.8 0.7

0.7 1.3 0.5 −1.4 −0.2 0.9 0.5 1.0 0.6 −1.0 −0.2 0.9

Q4

2012

Imports 2011 Q4 Q1 Q2 Q3

2012

Exports 2011

Q2 Q3

Gross Fixed Capital Formation

0.1 −0.4 −0.5 −1.3 −0.8 0.2 −0.1 −0.3 −0.7 −0.9

Q2

2012

0.4 −0.6 −0.7 −0.3 −0.3

0.0 0.1

Q2 Q3

2012 Q4

Q4 Q1

2011 Q3

Q3

2012

Government final comsumption expenditure

EA17 0.1 −0.3 0.0 −0.2 0.2 −0.5 −0.2 −0.2 −0.2 EU27 0.2 −0.3 0.0 −0.1 0.0 −0.3 −0.1 −0.2 −0.3

2011

GDP

PERCENTAGE CHANGE OVER THE PREVIOUS QUARTER – SEASONALLY ADJUSTED – CHAIN-LINKED VOLUMES

t/t-1

Household & NPISH final consumption expenditure

GDP AND EXPENDITURE COMPONENTS

T1

TABLE 2.1 Euro-Area GDP and Expenditure Components


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The Trader’s Guide to the Euro Area

The remainder of investment spending consists of inventory accumulation. Inventories are used to meet future demand. Investment, under the framework of national accounting, is undertaken mostly by businesses. The purchase of new homes is the only part of personal spending that falls into this category. Government spending generally falls into the category of consumption.6 The category of net exports is the difference between exports and imports. It represents the portion of aggregate domestic production that is beyond the goods and services needed for domestic consumption. The breakdown by category of expenditure allows for an analysis of the type of spending that drives economic growth. Investment – gross fixed capital formation and inventories – tends to be the most cyclical category of spending. That is because businesses will likely delay plans for expansion or reduce their stocks of inventories as long as their managers perceive the outlook for demand to be uncertain or weak. The recession in the euro area from 2008 to 2009 provided a good example. GDP contracted for five quarters – from the second quarter of 2008 through the second quarter of 2009. The economy contracted by 1.2% per quarter, on average, during that period. The contraction in investment spending was responsible for 1 percentage point of that average quarterly decline. Specifically, 0.7 of a percentage point was due to the decline in gross fixed capital formation and 0.3 of a percentage point to the change in inventories. The subsequent recovery provided a similar picture. The economy expanded for nine consecutive quarters – from the third quarter of 2009 through the third quarter of 2011 – after the recession ended. The contribution to economic growth from investment spending was greater than that of any other source of domestic demand (Figure 2.1). On average, the economy expanded by 0.4% per quarter during that period. Half of that growth – 0.2 of a percentage point – came from investment spending. The contribution to growth from household consumption was 0.1 of a percentage point and that from government spending was close to flat as austerity programs were implemented. The contribution from net exports – 0.2 of a percentage point – explains the other major source of growth. The figures fail to add up perfectly due to rounding. During the recovery, the majority of the growth in investment spending came from inventory accumulation, though the decline in inventories played a smaller role than the decline of gross fixed capital formation during 6 The Economist Guide to Economic Indicators: Making Sense of Economics, seventh edition. Hoboken, NJ: John Wiley & Sons, Inc., 2011.

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9

Gross Domestic Product FIGURE 2.1 Contributions to euro-area GDP growth from Q3 2009 to Q3 2011.

Household Consumption Government Consumption Investment Net Exports

Source: Bloomberg, Eurostat

the recession. “Recessions and recoveries are (mostly) inventory cycles. While inventory investment typically only accounts for a tiny fraction of GDP, swings in inventories account for a large share of the cyclical swing in GDP,” according to Ethan Harris, co-head of economic research at Bank of America– Merrill Lynch.7 He contends “inventories do not cause cycles in the economy, rather they amplify or ‘accelerate’ swings in the economy.” They tend to lower output during recessions and increase output in the early stages of recoveries. An outlook for inventory growth can be formed by looking at the monthly economic sentiment indicator of the European Commission in conjunction with the state of the economy. The industry and the retail trade surveys both contain questions about stocks (Figures 2.2 and 2.3). Respectively, they are: Q4

Do you consider your current stock of finished products to be . . . ?

Q2

Do you consider the volume of stock currently held to be . . . ?

+ too large (above normal) = adequate (normal for the season) − too small (below normal) + too large (above normal) = adequate (normal for the season) − too small (below normal)

7 Harris, Ethan “The Opposite of ‘Stagflation’.” The Market Economist. Bank of America– Merrill Lynch, September 18, 2009.

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FIGURE 2.2 Inventory component of industrial confidence indicator.

25.0 20.0 15.0 10.0 5.0 0.0 Do you consider your current stock of finished products to be…? −5.0 01-01-00

01-01-02

01-01-04

01-01-06

01-01-08

01-01-10

01-01-12

Source: Bloomberg FIGURE 2.3 Inventory component of retail trade confidence indicator.

30.0 25.0 20.0 15.0 10.0 5.0 Do you consider the volume of stock currently held to be…? 0.0 01-01-00

01-01-02

01-01-04

01-01-06

01-01-08

01-01-10

01-01-12

Source: Bloomberg

The Output Method

The output method measures the gross value added in an economy. In other words, it measures the value of all goods and services produced minus the value of all goods and services used in their production. The second category is subtracted from the first to avoid double accounting.

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Gross Domestic Product

The reading is normally broken down by industry of the economy. For example, Eurostat provides a breakdown into the following industries (Table 2.2): 1. 2. 3. 4. 5. 6.

Agriculture, Fishing and Forestry. Industry (Mining, Manufacturing, Electricity, Water and Waste). Manufacturing. Construction. Trade, Transport, Accommodation, and Food Service Activities. Information and Communication.

The Income Method

The third method of GDP calculation is based on income earned through the production of all the goods and services in an economy. It measures the incomes obtained from wages and salaries, rent, interest, corporate profits and proprietors’ income.8 GDP excludes transfer payments such as government benefits. GNP vs. GDP

Gross national product measures the incomes of the residents of a country, regardless of where they were earned. For example, the net income that is transferred to its German owners from a Mercedes factory in the U.S. would be included in the GNP of Germany and excluded from that of the U.S. Central bankers and economic policy makers tend to focus on GDP, though private economists refer to GNP on occasion. For example, Paul Krugman has often argued that economists should focus on GNP in the case of Ireland.9 Ireland is an exception to the rule that the difference between GNP and GDP is normally negligible.10 The difference between these two figures

Auerbach, Alan J. and Kotlikoff, Laurence J. Macroeconomics: An Integrated Approach, second edition. Cambridge, MA: The MIT Press, 1998. 9 Krugman, Paul “Ireland Triumphs!” The New York Times, September 30, 2011.

8

The Economist Guide to Economic Indicators: Making Sense of Economics, seventh edition. Hoboken, NJ: John Wiley & Sons, Inc., 2011.

10

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12 TABLE 2.2

The Trader’s Guide to the Euro Area Euro-Area GDP and Gross Value Added by Industry

T4a

GDP AND GROSS VALUE

t/t-1

PERCENTAGE CHANGE OVER THE PREVIOUS QUARTER –

NACE Rev.2 Description:

Agriculture, forestry and fishing

GDP

Division:

A 2011

EA17 EU27

Industry (mining, manufacturing, electricity, water and waste)

2012

2011

B, C, D and E 2012

2011

2012

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

0.1 0.2

−0.3 −0.3

0.0 0.0

−0.2 −0.1

0.7 0.3

−0.1 −0.8

1.7 0.8

−0.4 −0.4

0.0 0.0

−1.6 −1.3

0.1 0.2

−0.3 −0.3

Source: Eurostat

is about 25% for Ireland, 2% for the U.S. and 2% for Germany.11 This is probably due to the large number of multinational corporations operating in Ireland as a result of its low level of corporate taxation. Release Schedule

Eurostat publishes three releases for GDP. The first two GDP releases are accompanied by a press statement. The third release is only a database update. All three releases publish the data in the form of growth over the previous quarter and over the previous year. They are normally referred to as quarterover-quarter and year-over-year rates of growth. The latter is a smoothing technique, which removes short-term influences on the quarterly numbers and is a good measure of the recent trend. The figure for Germany is calculated using Gross National Income (GNI). The glossary of statistical terms of the OECD indicates that GNI and GNP are the same. It says, “Gross national income is identical to gross national product as previously used in national accounts generally.” Some countries report small differences. For example, the Central Statistics Office of Ireland indicates that GNP totaled 130,202 million euros and GNI totaled 131,295 million euros in 2010.

11

159


13

Gross Domestic Product

ADDED BY INDUSTRY SEASONALLY ADJUSTED – CHAIN-LINKED VOLUMES of which: Manufacturing C 2011 Q3

Q4

−0.2 −1.4 −0.2 −1.1

2012 Q1

Q2

Construction

Trade, transport, accommodation and food service activities

Information and communication

F

G, H and I

J

2011 Q3

Q4

2012 Q1

Q2

0.0 −0.5 −0.7 −0.1 −1.0 −0.7 0.1 −0.5 −0.3 −0.1 −2.4 −1.2

2011 Q3

Q4

0.1 0.1

−0.2 −0.2

2012 Q1

Q2

0.0 −0.4 0.2 −0.2

2011

2012

Q3

Q4

Q1

Q2

0.3 0.6

0.1 0.1

−0.1 −0.1

−0.1 −0.3

The first release, which is called the flash estimate, is published about 45 days after the end of the reporting period (Table 2.3). It only provides headline figures for the euro area, the EU and individual countries of those regions for the latest quarter. The second estimate appears about 65 days after the reporting period. It provides a breakdown from the expenditure and from the value-added points of view. A third and final release appears about 100 days after the end of the reporting period. All current and past figures are open to revision, starting with the second release. The first release only contains the GDP data with the effect of inflation removed. The broad term “real growth” is used to describe that adjustment. It can be applied to all aggregates, including those for income, which do not have directly observable volumes.12 Specifically, the first release of GDP is expressed in terms of chain-linked volumes with a reference year of 2000. “Volume growth,” which is a narrower term than “real growth,” is used for items with a physical quantity that can theoretically be measured directly.

National Accounts Frequently Asked Questions. Eurostat. {http://epp.eurostat.ec.europa.eu/ portal/page/portal/national_accounts/documents/FAQ_NA_1.pdf }

12

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The Trader’s Guide to the Euro Area

TABLE 2.3 Quarterly National Accounts Release Policy

In the current release policy for the calculation of European aggregates there are four releases during a quarter Q. The three first releases (T + 45, T + 65 and T + 75) are database releases that are combined with a news release. The T + 100 release is only a database release. The following table summarises the release coverage:

Flash GDP volume GDP (+) Output A6 (+) Main expenditure (+) GFCF AN_F6 (+) Exports/imports (+) Income Compensation A6 National income Employment A6

ESA

T + 45

T + 65

T + 75

T + 100

0101 0102 0102 0102 0103 0103 0107 0111

Q* only ----------

-Up to Q Up to Q* Up to Q* -------

----Up to Q* Up to Q* Up to Q* Up to Q-1 Up to Q-1 Up to Q*

-Up to Q Up to Q Up to Q Up to Q Up to Q Up to Q Up to Q* Up to Q* Up to Q

+ estimation includes current prices, chain-linked volumes and previous year’s prices. * and bold: first release of figures for the new quarter. Up to Q: whole time series up to the new quarter is revised. Up to Q-1: whole time series up to the previous quarter is revised (aligned with higher level data), data for Q not available yet. Shaded: Data is included and commented on in the news release. Note that all “Up to” releases include also revisions of the underlying annual figures. Source: Eurostat

The releases after the flash estimate contain data on nominal GDP as well. That figure is GDP expressed at current prices. The first GDP release for the euro area is published much later than that for the U.K. or the U.S. As mentioned previously, it is announced 45 days after the end of the reporting period. In the latter two countries, the figures are published 25 days after the end of the quarter. Countries that delay the publication of economic statistics often argue that a trade-off exists between timing and accuracy. The difference in accuracy between the GDP statistics for the euro area and those of the U.S. appears small. The flash GDP estimate for the euro area was unchanged relative to the second estimate for 40 of the last 46 quarters, as of August 2012, according to Eurostat, which began reporting a flash estimate in May 2003. In the other six of those 46 quarters, the two figures differed by plus or minus 0.1 of a percentage point.13 The absolute difference 13 Eurostat News Release: Flash Estimate for the Second Quarter of 2012. Eurostat, August 14, 2012.

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15

Gross Domestic Product

between the advance (first) and the preliminary (second) estimates of U.S. GDP has been 0.5 of a percentage point on an annualized basis from 1983 to 2008, according to the Bureau of Economic Analysis of the U.S. Department of Commerce.14 That equals about 0.125 of a percentage point on a quarterover-quarter basis.

Trend Growth

The long-term path of GDP growth is normally assumed to be in line with the historic trend rate of growth. The easiest way of determining that figure is by taking a long-term average of output growth. Recent data may be most useful for the euro area as a result of the structural changes that have taken place since the birth of the monetary union. The 10-year average for the euro area is 1.1%, using data from 2002 to 2011. It is 1.6% for the U.K. and for the U.S. These figures are below the long-term potential growth estimates of policy makers. The ECB has cited 2% to 2.5% as the trend rate of growth for the euro-area economy.15 The Federal Reserve has estimated 2.2% to 3% as the equivalent figure for the U.S.16 These figures are likely to be revised down as the level of economic growth experiences a structural decline in the aftermath of the global financial crisis. The ECB has attributed the higher rate of potential growth in the U.S. – relative to the euro area – to demographic developments and the rate of productivity growth.17 These demographic developments refer to the growth in the population, which is the pool of labor for production. Annual population growth in the euro area has averaged 0.5% over the 10-year period from 2002 to 2011. That figure for the U.S. has been 1.1%.

14 National Income and Product Accounts: Gross Domestic Product, 2nd Quarter 2012 (Advance Estimate). Bureau of Economic Analysis, July 27, 2012. 15 “Output, Demand and the Labour Market.” ECB Monthly Bulletin. Frankfurt: European Central Bank, July 2009. 16 Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, September 2012. Board of Governors of the Federal Reserve System, September 13, 2012. 17 “Patterns of Euro Area and U.S. Macroeconomic Cycles – What Has Been Different This Time?” ECB Monthly Bulletin. Frankfurt: European Central Bank, May 2011.

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The Business Cycle

Deviations in GDP growth from that long-term trend occur as part of the business cycle. Arthur Burns, former chairman of the Board of Governors of the Federal Reserve System and president of the National Bureau of Economic Research, and Wesley Mitchell, a founder of the NBER, proposed a definition for the business cycle: “Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximating their own.”18

The NBER in Cambridge, Massachusetts is the official arbitrator of recessions in the U.S. It defines a recession as a “significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”19 It doesn’t use the popular definition of recession – two consecutive quarters of negative GDP growth. The NBER has identified 33 recessions in the U.S. since the middle of the 19th century (Table 2.4). The Centre for Economic Policy Research in London is the European equivalent of the NBER. In 2002, the CEPR created a Business Cycle Dating Committee for the euro area. It has established four recessions for the euro area since 1970 (Table 2.5). The CEPR, like the NBER, announces the end of a recession long after it occurs. For example, it declared the ending point of the 2008–2009 downturn to be in the second quarter of the latter year more than a year later – on October 4, 2010.

18 Burns, Arthur F. and Mitchell, Wesley C. Measuring Business Cycles. Cambridge, Mass.: NBER, 1946. 19 US Business Cycle Expansions and Contractions. The National Bureau of Economic Research. {http://www.nber.org/cycles.html}

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BUSINESS CYCLE REFERENCE DATES Peak

Trough

Quarterly dates are in parentheses

June 1857 (II) October 1860 (III) April 1865 (I) June 1869 (II) October 1873 (III) March 1882 (I) March 1887 (II) July 1890 (III) January 1893 (I) December 1895 (IV) June 1899 (III) September 1902 (IV) May 1907 (II) January 1910 (I) January 1913 (I) August 1918 (III) January 1920 (I) May 1923 (II) October 1926 (III) August 1929 (III) May 1937 (II)

December 1854 (IV) December 1858 (IV) June 1861 (III)

DURATION IN MONTHS Contraction Expansion Peak to trough

Cycle

Previous Trough from Peak from trough to previous previous this peak trough peak

--

--

--

--

18

30

48

--

8

22

30

40

December 1867 (I) December 1870 (IV) March 1879 (I)

32 18

46 18

78 36

54 50

65

34

99

52

May 1885 (II) April 1888 (I) May 1891 (II) June 1894 (II) June 1897 (II)

38 13 10 17 18

36 22 27 20 18

74 35 37 37 36

101 60 40 30 35

December 1900 (IV) August 1904 (III)

18

24

42

42

23

21

44

39

June 1908 (II) January 1912 (IV)

13 24

33 19

46 43

56 32

December 1914 (IV) March 1919 (I)

23

12

35

36

7

44

57

67

July 1921 (III) July 1924 (III) November 1927 (IV)

18 14 13

10 22 27

28 36 40

17 40 41

March 1933 (I)

43

21

64

34

June 1938 (II)

13

50

63

93 (Continued )

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TABLE 2.4 Continued

BUSINESS CYCLE REFERENCE DATES Peak

Trough

Quarterly dates are in parentheses February 1945 (I) November 1948 (IV) July 1953 (II) August 1957 (III) April 1960 (II) December 1969 (IV) November 1973 (IV) January 1980 (I) July 1981 (III) July 1990 (III) March 2001 (I) December 2007 (IV)

DURATION IN MONTHS Contraction Expansion Peak to trough

Cycle

Previous Trough from Peak from trough to previous previous this peak trough peak

October 1945 (IV)

8

80

88

93

October 1949 (IV)

11

37

48

45

May 1954 (II) April 1958 (II)

10 8

45 39

55 47

56 49

February 1961 (I) November 1970 (IV)

10 11

24 106

34 117

32 116

March 1975 (I)

16

36

52

47

July 1980 (III)

6

58

64

74

16 8 8 18

12 92 120 73

28 100 128 91

18 108 128 81

November 1982 (IV) March 1991(I) November 2001 (IV) June 2009 (II)

Source: NBER

TABLE 2.5 Peaks and Troughs of Euro-Area

Business Cycles PEAK

TROUGH

1974Q3 1980Q1 1992Q1 2008Q1 2011Q3

1975Q1 1982Q3 1993Q3 2009Q2 -

Source: CEPR Business Cycle Dating Committee {www .cepr.org}. Reproduced by permission of the CEPR.

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Policy makers have normally responded to deviations in GDP growth from the long-term trend. They attempt to slow the rate of growth if inflationary pressures start to build and to stimulate the economy during periods of recession. The economy can be stimulated or restricted through three primary channels: the exchange rate, fiscal policy and monetary policy. Central banks have historically only controlled monetary policy directly through changes in short-term policy rates and indirectly through changes of the exchange rate, though some of the unconventional measures implemented by monetary authorities in recent years have been used to influence longer-term interest rates and could be interpreted as measures of fiscal policy. Monetary Conditions Index

A monetary conditions index can provide a reading of the level of stimulus provided by the main policy rate and the exchange rate relative to the past. The effects of these variables can be gauged by measuring changes in the real three-month interest rate and the real effective exchange rate, an inflationadjusted and trade-weighted measure of a country’s currency. The weighting of each component should be a function of the openness of the economy to imports and exports. The weightings of the exchange and interest rates can be determined by calculating the openness of the economy to trade.20 Mathematically, the indices can be expressed as MCI1 = α(r1 − r0) + β((e1/e0) − 1) + 100 where r is the three-month interest rate deflated by the consumer price index; e is the real effective exchange rate as calculated by the International Monetary Fund; β = ((imports plus exports)/2)/nominal GDP); and α = 1 − β. Effects of Monetary Policy on GDP

Monetary policy works with long and variable lags, as Milton Friedman famously said. The OECD’s global macroeconomic model signals that the effect of a change in monetary policy may be felt over about five years. The

Verdelhan, Adrien “Construction d’un indicateur des conditions monétaires pour la zone euro.” Bulletin de la Banque de France, No. 58, October 1998.

20

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TABLE 2.6 Sustained Increase in Euro-Area Interest Rates (100 Basis Points)

Percentage Deviations from Baseline Years after Shock Year 1 UNITED STATES GDP level Inflation Current account (% GDP) Government net lending (% GDP) Japan GDP level Inflation Current account (% GDP) Government net lending (% GDP) Euro GDP level Inflation Current account (% GDP) Government net lending (% GDP) GDP level Other OECD Europe Other OECD Total OECD China Other non-OECD Asia Non-OECD Europe Other non-OECD Total non-OECD World

Year 2

Year 3

Year 4

Year 5

0.0 0.0 0.1 0.0

0.0 0.0 0.1 0.0

0.0 0.0 0.1 0.0

−0.1 0.0 0.1 0.0

−0.1 0.0 0.1 0.0

0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0

0.0 0.0 −0.1 0.0

−0.1 0.0 −0.1 0.0

−0.1 0.0 −0.1 0.0

0.0 0.0 0.1 0.0

−0.1 0.0 0.2 −0.1

−0.3 −0.1 0.3 −0.2

−0.5 −0.1 0.4 −0.2

−0.7 −0.2 0.5 −0.2

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

−0.1 0.0 −0.1 −0.1 −0.1 −0.1 0.0 −0.1 −0.1

−0.2 −0.1 −0.2 −0.1 −0.1 −0.1 0.0 −0.1 −0.2

−0.3 −0.1 −0.3 −0.1 0.0 −0.1 0.0 −0.1 −0.2

Source: OECD. Reproduced by permission of the OECD.

model suggests that a sustained increase in “policy determined nominal shortterm interest rates” of the euro area by 100 basis points has no effect on the level of GDP during the first year after the shock (Table 2.6). It then estimates that the policy change will reduce the level of output by a cumulative 0.1% during the second year, 0.3% during the third year, 0.5% during the fourth year and 0.7% during the fifth year.21 The ECB supports the view that monetary policy has no effect on longterm real GDP growth. In other words, the central bank states that its actions Hervé, K. et al. “The OECD’s New Global Model”, OECD Economics Department Working Papers, No. 768, OECD Publishing, 2010. {http://dx.doi.org/10.1787/5kmftp85kr8p-en}

21

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21

Gross Domestic Product

can only amplify or dampen the effects of the business cycle without affecting trend growth. The staff economists claim that this is consistent with the “large body of theoretical and empirical literature on money neutrality.”22 Their view is not held universally by economists. Effects of the Exchange Rate on GDP

A change in the exchange rate, often induced by monetary policy developments, also has an effect on GDP. The OECD’s global macroeconomic model suggests that a 10% depreciation of the nominal effective exchange rate of the euro boosts the level of GDP of the euro area by a cumulative 0.7% in the first year after the drop, 1.3% by the second year, 1.7% by the third year, 1.8% by the fourth year and 1.6% by the fifth year (Table 2.7). In other words, after five years, a 10% decline in the trade-weighted currency would have an effect on GDP that is close to reducing short-term interest rates by 200 basis points. The model assumes that the exchange rate stays at the new level throughout the simulation period. The OECD’s economists state that the effects of currency appreciation are broadly symmetric to those of currency depreciation. The stimulus to GDP growth would likely be greater for the euro area during the debt crisis, as pointed out by Laurence Boone and Huw Worthington.23 That’s because the OECD assumes the central bank will raise interest rates in response to the currency depreciation to counteract the inflationary pressures. By contrast, the ECB eventually reduced its main policy rate to a record low level. The effect of a depreciation of the euro is also likely to vary from country to country. Céline Allard, Mario Catalan, Luc Everaert and Silvia Sgherri of the IMF found that the goods exports of Germany are the least sensitive to changes in the country’s real effective exchange rate out of those from the monetary union’s four largest national economies. The estimated exchange rate elasticity for goods – the ratio of the percentage change of goods exports to the percentage change of the exchange rate – for Germany stands at minus 0.32. In other words, as the country’s real

“Recent Findings on Monetary Policy Transmission in the Euro Area.” ECB Monthly Bulletin. Frankfurt: European Central Bank, October 2002. 23 Boone, Laurence and Worthington, Huw European Government Monitor: Is Further Tightening Desirable? Barclays Capital, September 1, 2010. 22

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TABLE 2.7 10% Euro Depreciation

Percentage Deviations from Baseline Years after Shock

UNITED STATES GDP level Inflation Interest rates (basis points) Current account (% GDP) Japan GDP level Inflation Interest rates (basis points) Current accout (% GDP) Euro GDP level Inflation Interest rates (basis points) Current account (% GDP) GDP level Other OECD Europe Other OECD Total OECD China Other non-OECD Asia Non-OECD Europe Other non-OECD Total non-OECD World

Year 1

Year 2

−0.1 −0.1 −10 0.1

−0.2 −0.1 −20 0.0

0.0 −0.1 −10 −0.1

Year 3

Year 4

Year 5

−0.2 −0.1 −30 0.0

−0.3 −0.2 −45 0.0

−0.3 −0.3 −50 −0.1

−0.1 −0.1 −20 −0.2

−0.2 −0.1 −20 −0.3

−0.3 −0.1 −35 −0.4

−0.4 −0.2 −50 −0.4

0.7 0.3 85 0.3

1.3 0.7 165 0.2

1.7 1.0 220 0.5

1.8 0.9 210 0.8

1.6 0.9 200 1.0

−0.2 −0.3 0.1 −0.1 0.2 0.7 0.5 0.3 0.2

−03 −0.4 0.2 −0.1 0.0 0.7 0.5 0.3 0.2

−0.4 −0.4 0.2 −0.2 −0.2 0.5 0.2 0.1 0.2

−0.5 −0.4 0.2 −0.4 −0.2 0.2 0.1 −0.1 0.1

−0.5 −0.3 0.1 −0.4 −0.2 −0.1 0.0 −0.1 0.1

Source: OECD. Reproduced by permission of the OECD.

effective exchange rate – based on unit labor costs in the manufacturing sector – increases by 1%, the export of goods declines by 0.32%. The equivalent figure is minus 0.7 for Italy, minus 0.8 for France and minus 1.5 for Spain.24 Economists from the Bundesbank attribute the muted effect of currency movements on the volume of German exports to their price inelasticity. This implies that German exports – probably as a result of their high quality – are Allard, Céline, Catalan, Mario, Everaert, Luc and Sgherri, Silvia Explaining Differences in External Sector Performance Among Large Euro Area Countries. International Monetary Fund, October 12, 2005.

24

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23

Gross Domestic Product

not easily substituted with other products. They wrote, “this relatively small influence is due partly to the fact that the share of relatively price-inelastic goods in the range of German exports is quite high. Exports to non-euro-area countries, in particular, respond relatively weakly to price competitiveness.” They concluded, “the German economy’s export activity fundamentally depends much more on the growth of export markets and attractiveness of exporters’ product profile than merely on exchange rate changes.”25 As a general rule, economists believe the level of growth of a country’s export activity is more highly dependent on the rate of GDP growth in the economies of a country’s largest trading partners than the value of the domestic currency vis à vis the currencies of those trading partners. In addition, the composition of German exports creates a natural hedge, the Bundesbank study concluded. Because many of the country’s products are manufactured goods, which require imported materials for production, the appreciation of the euro reduces the price of those intermediate inputs, cushioning the bottom line of corporate balance sheets. That natural hedge probably exists to a lesser extent for other euro-area countries with different export compositions. Exchange-Rate Deflators

Economists look mostly at the real effective exchange rate of a country rather than the nominal effective exchange rate as a measure of price competitiveness in international markets. The use of that inflation-adjusted measure requires a measure of inflation as a deflator. Most economists seem to agree that unit labor costs are the best deflator, at least in theory. That is because they are the most relevant costs for international trade. The debate assumes that goods are priced by adding a mark-up to the cost of production.26 The higher unit labor costs, the higher the final price of the product and the higher the real exchange rate. The appreciation of the real exchange rate lowers international demand for a country’s goods.

“Macroeconomic Effects of Changes in Real Exchange Rates.” Deutsche Bundesbank Monthly Report. Deutsche Bundesbank, March 2008. 26 Chinn, Menzie D. “Effective Exchange Rates” in The Princeton Encyclopaedia of the World Economy. Editors in chief, Kenneth A. Reinert and Ramkishen S. Rajan; Associate editors, Amy Jocelyn Glass and Lewis S. Davis. Princeton: Princeton University Press, 2009. 25

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The major disadvantage of using unit labor costs as a deflator is that neither a consistent nor a timely measure of those costs is available for many countries.27 Another disadvantage of this deflator is that it ignores all input costs apart from labor. Other deflators also have advantages and disadvantages. The advantage of the CPI is the inclusion of the prices of both goods and services. The disadvantages of this measure are the inclusion of the impacts of subsidies and taxes and the prices of non-traded goods and services and the exclusion of non-consumer goods. The advantage of the producer price index is the exclusion of many services that are non-traded. The disadvantage of this measure is that comparable figures across a wide variety of countries are unavailable. The advantage of the wholesale price index is that it may be less affected by subsidies and taxes than the CPI because it tracks prices in various stages of the production process. The disadvantages are that it includes non-traded goods and excludes the costs of services.28 The CPI has become the most commonly used deflator. These indices are often comparable around the world and are published on a timely basis.29 The IMF tends to use the CPI as a deflator for real effective exchange rates. The staff economists have also primarily used CPI-based measures of the real effective exchange rate in their reports on the bailouts of the euro-area countries.30 The choice of a deflator can significantly affect the level of the real effective exchange rate. In a 2005 study, Menzie Chinn found that, “after accounting for productivity changes, the (U.S.) dollar at the end of 2001 is less than 20 percent weaker than its 1985 peak using the CPI deflated rate, while the unit labor deflated series is 40 percent weaker.”31 Similarly, in a 2011 study, IMF economists Tamim Bayoumi, Richard Harmsen and Jarkko Turunen stated, “While Italy’s competitiveness does

Ibid. This list is drawn mostly from an IMF paper by Tamim Bayoumi, Richard Harmsen and Jarkko Turunen titled “Euro Area Export Performance and Competitiveness.” It covers some of the major advantages and disadvantages of the various price indices, though it is not comprehensive.

27 28

Ellis, Luci Measuring the Real Exchange Rate: Pitfalls and Practicalities. Reserve Bank of Australia, August 2001.

29

30 See: Greece: IMF Country Report No. 12/57: Request for Extended Arrangement Under the Extended Fund Facility – Staff Report. International Monetary Fund, March 2012. 31 Chinn, Menzie D. A Primer on Real Effective Exchange Rates: Determinants, Overvaluation, Trade Flows and Competitive Devaluation. National Bureau of Economic Research, July 2005.

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appear to have eroded, the size of this effect is, frankly, anyone’s guess – while the CPI- and WPI-based measures (of the real effective exchange rate) show only modest appreciation since 1995, the ULC- and XUV- (export unit valued) based indicators have appreciated by about 50 to 110 percent, respectively.”32 The long lag between the end of a particular month or quarter and the publication of the GDP data leads economists, market participants and policy makers to watch other data releases that are coincident indicators closely. They provide a more timely reading of the state of the economy.

Bayoumi, Tamim, Harmsen, Richard and Turunen, Jarkko Euro Area Export Performance and Competitiveness. International Monetary Fund, June 2011. Reproduced by permission of the International Monetary Fund.

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Secret Millionaires Club Warren Buffett’s 26 Secrets to Success in the Business of Life A. Heyward 978-1-118-49459-2 • Hardback • 160 pages • September 2013

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SECRET

#1 SECRET Try to learn #1 fr mistakes—be om your learn from th tter yet, e mistakes o f others!

Don’t Be Afraid to Make Mistakes

H

i again. I’m glad you want to learn more about Secret Millionaires Club! In fact, the first lesson is all about learning!

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Secret Millionaires Club

When you own a business or manage a company, the last thing you want to do is make a mistake. You can lose customers and lose money by making too many mistakes. But sometimes slip-ups happen and a successful business manager learns from his or her mistakes. It’s the same thing in life. Learn from your mistakes— better yet; learn from the mistakes of others!

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3

When school started last year, Radley, Starty, Lisa, Elena, and Jones had no idea that after learning this one simple secret, they would end up forming one of the most interesting and exciting clubs around: Secret Millionaires Club!

I met the four teenagers—and Radley ’s robot—on the first day of school because I was giving a pep talk to all the students. My message to all the kids was simple: “Even when you make mistakes, keep your eyes ahead—on the future. In fact, see your future. Be your future!”

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Secret Millionaires Club

Unfortunately, the school principal followed my speech with some bad news. Because of a lack of money, the eighthgrade ďŹ eld trip to New York City had to be cancelled.

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Don’t Be Afraid to Make Mistakes

5

Radley, Elena, Lisa, and Jones were upset, but at the exact same moment, they each came up with an idea for a fundraiser. They even made it a bit of a competition among themselves. Who could raise the most money and be the first to save the field trip?

But, try as they might, each of their moneymaking ideas failed. The four were so discouraged, they were about to give up, until I suggested that they work together and pool their ideas. “Just toss out what didn’t work,” I said, “and focus on what did work!”

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Secret Millionaires Club

Radley, Starty, Jones, Elena, and Lisa combined their ideas and came up with a neighborhood popsicle delivery service that raised enough money to pay for the New York field trip! As an added bonus, they ended up meeting a friend of mine: the famous rapper Jay-Z! When they returned home the kids were so excited that they had helped solve their school’s money problems, they wanted to form a club—Secret Millionaires Club!

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Don’t Be Afraid to Make Mistakes

And together, we’ve been helping people around town and around the world ever since! As I always like to say: “The more you learn, the more you’ll earn,” so remember:

SECRET #1 Try to learn from your mistakes—better yet, learn from the mistakes of others!

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Celebrate 100 Centenarian Secrets to Success in Business and Life Steve Franklin & Lynn Peters Adler 978-1-118-52564-7 • Hardback • 228 pages • August 2013

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CHAPTER

1

Today’s Centenarians—Celebrities and National Treasures A Century of Wisdom THE CELEBRITIES OF AGING: CENTENARIANS IN THE SPOTLIGHT THE AGE OF CENTENARIANS: A MILLION OR MORE BY 2050? THE WISDOM OF CENTENARIANS: AUTHENTIC—EXPERIENCE, NOT THEORY NATIONAL TREASURES: UNIQUE—INDIVIDUALLY AND COLLECTIVELY CAMEOS OF TODAY’S CENTENARIANS A CENTURY OF PROGRESS: THEIR CENTURY

1

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2 Celebrate 100

P

eople who have lived 100 years or more are here to share their experiences, having done and seen it all. They are also our living links to history and our role models for the future of aging. Their engaging spirit can help to shape the attitude of younger generations, especially Baby Boomers, who are looking toward their future years.

“My golden years are like sparkling diamonds,” says Elsa Brehm Hoffmann, 104. To celebrate her 100th birthday, Elsa bought a brand new car, “eggplant color, because it was a little different.” After giving herself a birthday gala for 150 friends and family, she took off on a two-week Caribbean cruise. On board she met another centenarian, John Donnelly, and his wife, Marian, who were celebrating their seventh wedding anniversary and his 102nd birthday. Meanwhile, Jack Borden, 101, was hard at work at his law firm in Texas, still handling a full caseload and loving every minute of it. Centenarians are shattering the long-held stereotypes of life in later years, which is thought to be static, boring, and marked by disinterest in contemporary life. Today, we see active centenarians enjoying interests that are associated with much younger people, prompting us to think better of our future—30, 50, or 70 years from now. As with Elsa, John, and Jack, much of what we see in centenarians’ lives is surprising—for instance, the increasing number of people who are living independently at 100 and over, and the number of centenarians still driving competently. We see centenarians living full lives: dancing, falling in love, traveling, playing in a band, taking courses, giving lectures; using cell phones, computers for e-mail, browsing the Web, socializing on Facebook and Twitter; working, volunteering, and lunching with friends. We like what we see, but how do we get there, and what “secrets” do we need to know? The centenarians with whom you are about to become acquainted share an indomitable spirit. They tell us what has worked for them to live successfully into advanced age and they share their “secrets” of business and life. Indeed, centenarians are the true experts on living long and living well, and on what it takes to do so. Others can study

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3

them and turn them into statistics, but only they know what it is like and what it means to live for 100 years; only they can vivify the experience of reaching the century mark and beyond. Centenarians are here to share their hard-earned wisdom born of their experiences, and show us why it is worth the effort to strive to have the means to live a good life in old age.

“Think of it as mountain climbing,” explains Dr. Will Clark, 104, as he sits holding the hand of his wife, Lois. “Why do people climb mountains? Because they’re there. Because they can. Some people will be lost along the way, and it’s never going to be easy; but for those who reach the top, there’s no better view. So why give up on life? Why sell yourself short? There’s so much you can learn and do and enjoy. Life can be very fulfilling if you make it so. But you’ve got to want to do it.” Centenarians such as Dr. and Mrs. Clark exemplify the positive attitude and other characteristics active centenarians have in common, the traits that have helped them to reach the century mark and enjoy a good quality of life at 100 and beyond. Lois, 101, says, “It’s not just how long you live that matters, but how well. People forget that, I think.”

“People ask all the time about how to live to 100,” Dr. Clark adds. “I tell them it’s easy: all you have to do is survive your 70s, 80s, and 90s, and that’s the hard part!” This “Centenarian Spirit” will become familiar to you as you learn of the lives and lifestyles of the Clarks, Elsa, John, Jack, and many others in the following pages. You will see it in action: A love of life, which includes a sense of humor and a healthy dose of self-esteem; a positive yet realistic attitude; a strong religious or spiritual belief;

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4 Celebrate 100 personal courage, because a lot of things can go wrong as we get older, such as those that require medical intervention. And, most important, a remarkable ability to renegotiate life at every turn—to compensate—to accept the losses and changes that come with aging and not let it stop them.

“Keep good, keep busy, keep thinking about tomorrow,” advises Carl Azar, 100. Carl’s thought could be the centenarian motto.

THE CELEBRITIES OF AGING: CENTENARIANS IN THE SPOTLIGHT Centenarians are the celebrities of aging. They draw the most attention and capture the spotlight; they are the trendsetters. Centenarians are influencing society in ways once not imaginable. Longevity itself is one of the greatest developments of the twentieth century. Now, well into the twenty-first, growing numbers of elders are going far beyond the once touted ideal of “aging gracefully” to a new standard of “aging excellently!” And Baby Boomers are eyeing this with glee. Today’s centenarians are changing the very thought of what’s possible in our later years. “It was once standard journalism for local papers to report on the event of a person in the community who had reached the remarkable age of 100, giving a chronological biography of the person’s life, often mentioning the person’s close family members,” says Mildred Heath, 101, a longtime newspaper reporter. “It was standard fare. Nothing unusual, just what the person used to do. Today, there is more interesting copy because people who have lived to 100 and beyond are very often continuing to do things and to be involved with their communities, clubs, churches, and families. In the old days, a local resident who took a trip out of town for vacation or to visit relatives was noteworthy, and a little article made the weekly paper. Today, centenarians are

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Today’s Centenarians—Celebrities and National Treasures among those traveling to visit family and often just for pleasure. It’s really quite an extraordinary difference.” Centenarians are sought out now because of their active lifestyles, not only for print media but also television features and specials, often centering around longevity. In the spring of 2008, for example, the ABC Barbara Walters Special, “Living to 150—Can You Do It?” aired on network television. In one segment, it featured five centenarians, four of whom are included in Celebrate 100: Elsa Hoffmann; Lillian Cox; Karl Hartzell, PhD; and Rosie Ross. The fi fth centenarian, Dorothy Young, was a performer who lived in New Jersey, and was the last living assistant to the magician Harry Houdini. The others traveled from their homes in Florida and Arizona to New York to be interviewed by Ms. Walters, who mentioned the Special in her book, Audition, as being one of her favorites in her long career. She related especially to Lillian Cox, she said, because of Lillian’s resilience. After the taping, the group traveled by limousine to (then) Tavern on the Green, their choice, for carriage rides through Central Park and a lovely dinner. “The afterparty was almost as exciting as the main event,” Elsa observed. “But it was a thrill to be interviewed by Ms. Walters, and to be on national television. A few weeks later, a film crew attended my birthday gala and footage was included.” In December of the following year, Ruth Proskauer Smith, 102, and Captain Jose Grant, 101, appeared on a network TV special, “GO! New York.” Ruth, a native New Yorker, was featured because of her active lifestyle and civic involvement in her later years. For two decades she has led a weekly seminar at the City College of New York about the Supreme Court for a group of retired professionals. As an intrepid New Yorker, she travels from her home at the Dakota by subway each week. Ruth’s father was a prominent New York judge and lawyer, and confidant and speechwriter of Alfred E. Smith, four-time governor of New York and unsuccessful candidate for president. Governor Smith gave Ruth her first lesson in public speaking, when, while a student at Radcliffe College, she was called upon at the last minute to introduce him at a large political event. “I was so nervous,” she says, “and I didn’t want to do it. But he assured me to speak my mind and I would do fine. So I did, and have been doing it— successfully—ever since.”

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6 Celebrate 100 Joseph “Jose” Grant was included because of his continuing role in aviation and the jewelry business he founded in Stamford, Connecticut, after retiring as a Captain from TWA. He started flying as a barnstormer in the 20s and went on to become the private pilot for the King of Saudi Arabia in the 40s, and then joined TWA. He still frequently pilots his son’s private plane. Captain Grant returned to Saudi Arabia at the age of 99 and again at 101, to renew his acquaintance with the Saudi Royal Family; he helped to found their national airline in the late 40s. Recently, at 101, during the Oshkosh Air Show, actor Harrison Ford remarked “Jose was more like Indiana Jones than I was.” Jose’s advice to viewers of the show was: “Enjoy your life!” Fitness magazine (Spring 2011) included four centenarians in an article encouraging healthy diet and exercise as a way to age well. Beatrice McLellan, 100, was  disappointed she was not included, despite “pumping iron.” New Yorker Ruth Korbin, 101, was featured in an article in the November 2012 issue of Pilates Style magazine as possibly the oldest Pilates student at 101. Ruth looks beautiful and stylish in the two-page spread. She began Pilates when she was 85. Dr. Frank Shearer, 101, of Washington state, a retired family physician, made the cover of National Geographic and a host of other print media because of his continued passion for water skiing and horseback riding (he was shown, also, in the background segment of the ABC Barbara Walters Special). Verla Morris was featured in March 2012 in a syndicated newspaper article covering the release of the 1940 census data. Verla, an avid amateur genealogist and computer whiz and all-around active new centenarian, was interviewed for her opinion on the relevance of the release of the census data, which some people oppose as an invasion of privacy. “I think it’s a good thing,” she told the reporter, and went on to explain why she thought so, from her perspective; she was actually included in the data. “If I can be of help to someone, encouraging them to get off the couch and get out and move, then I’m glad to do it,” Frank Shearer says. Garnett Beckman, 101, is always pleased to “help,” as she puts it. She has a lovely speaking voice and does a lot of radio interviews. Elsa feels the same motivation as Frank and Garnett, but also admits to enjoying the limelight. “I had to wait until I was 100 to become a celebrity,” she

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says, “and I love it!” Lillian does, too, although she’s a bit coy about expressing it. “That’s part of my Southern charm, darlin’,” she says with a smile. Rosie, 102, is miffed that he’s not the only centenarian musician being featured in the media, but he’s enjoying all the attention he’s receiving. Rosie has played a regular Friday night gig to a packed house at a supper club in Prescott, Arizona, for the past 20 years. “Total strangers come up and give me a kiss after a set and thank me for the good time they’re having. I’ve always liked the ladies. This is fun!” When asked how long he intends to continue, Rosie says, “As long as people want to hear Clyde McCoy’s ‘Sugar Blues,’ or ‘You Made Me Love You,’ I’ll live to play it for them.” The major media interest in including centenarians as role models is substantive. These aren’t just social gatherings or birthday parties being covered. Elsa was again featured in a U.S. News and World Report article entitled “A Long Life: 7 People, Sailing Past 90 with Lots Left to Do.” Garnett has appeared in a Christian Science Monitor article, “Redefining Longevity” (April 2010). These are just a few examples of what is possible in our later years if we not only live long, but age well; active centenarians no longer behave like people who are 100 years old. They say they are not feeling it, either. This is good news for Boomers—and everyone—that well over two thirds of our centenarians report that they feel significantly younger than their chronological age. Many say they feel 80 or less and a few mentioned they feel mentally between 25 and 30.

“The secret is to not act your age,” Marvin Kneudson, 100, offers. The centenarians in Celebrate 100 will tell you it’s worth the effort to try to remain healthy and stay active. The fields of medicine, genetics, and technology are working overtime to come up with ways to make this feeling widely available. Astrid Thoeing, 103, who is still working full time at her family insurance business in New Jersey as the office manager, says the trick is to not think you’re old. “I don’t feel old and I don’t think old.” Leonard “Rosie” Ross

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“Everybody wants to live to 100, but no one wants to feel old,” agreed centenarian twin sisters Lois Fisher and Eloise Rogers.

THE AGE OF CENTENARIANS: A MILLION OR MORE BY 2050? Depending on the data source referenced, there are estimated to be between 55,000 to 80,000 current centenarians in the United States, with predictions ranging from 600,000 to over 1 million by 2050. Over the past 20 years, the ratio of those in the United States 100 and over rose from 1 in every 10,000 people to 1 in every 6,000 people. As a result, centenarians are considered to be one of the fastest, if not the fastest, growing segments of our population. Eight out of ten centenarians are women. To put this in perspective, consider that in 2012, a newborn has a 29.9 percent chance of living to be 100; someone born in 1912 had only a 0.7 percent chance of reaching the century mark. And with medical and genetic advances growing at a rapid pace, good health in later years is becoming more the norm than the exception.

Supercentenarians Those living to very advanced age—110 and over—have been on the rise as well, thus gaining their own subset as “supercentenarians.” Currently, there are an estimated 70 verified supercentenarians in the United States. No one has yet defeated the verified world record holder, Madame Jeanne Calment, of France, who lived to 122 years, 164 days. It was our privilege to interview several supercentenarians, including the oldest, Besse Cooper, 116, who became the world’s oldest living person in 2011. She turned 116 in August 2012, only the eighth person in the world to verifiably reach this remarkable age. Walter Breuning became the world’s oldest living man at 114.

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The ever delightful Dr. Leila Denmark, also 114, has been a friend since turning 100. Beatrice Farve, 113, was, at the time we met her, the second-oldest person in the United States. She was still selling Avon products until she turned 100 and drove her car until age 106.

THE WISDOM OF CENTENARIANS: AUTHENTIC—EXPERIENCE, NOT THEORY What is best about centenarian wisdom and advice is that it is authentic: No theory— tried and true—they have lived it. Each has his or her own experience to share. They have learned about coping with life through every imaginable economic, political, social, and technological change. Their advice is timeless because the basics do not change: having enough money to live, buying a home, raising children, investing for the future. Some of their advice may be new to us and our way of thinking and differ from the way we handle our financial matters now, but timeless in the positive effect it can have on our future. We talked to people with such disparate backgrounds as Irving Kahn, who at 107 was still working on Wall Street, to Porter Edwards, 105, who had lived all his life in South Georgia, and had earned the money to pay for the 40-acre farm on which he still lived alone by planting and picking crops.

“If I didn’t have cash to pay for it, I didn’t buy it,” says Porter Edwards, 105. Surprisingly, the amount of money people had amassed, or not, had no effect on their outlook. Again, it really boils down to the basics: do not spend more than you earn, make saving and investing an integral part of living; avoid getting in over your head with debt; don’t waste money paying interest on credit cards; and plan for your future— because you just might live to be 100. “Don’t discount the possibility of living a long life,” advises Lillian Cox of Tallahassee, Florida. “I did, and it was my biggest financial mistake.” Lillian sold her

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10 Celebrate 100 successful business at age 65 because she assumed that she wouldn’t live past age 70. Her advice is relevant to today’s generation of Boomers who are charging into their 60s in record numbers, and who are facing many difficult decisions. Lillian’s resourcefulness has allowed her to continue to maintain her own home and to live a fulfilling life; she’s now 106. “But still, once money is gone, it’s gone.” One important aspect of money that is often overlooked is the amount of stress it can cause on a person’s health and life. Centenarians had a lot to say about that. They also offered advice on work and choosing one’s career: if you can, do what you love, and you will be successful.

“If you’re not pleased, change. Do something you enjoy,” Joe Stonis, 100, advises. Gordy Miller of San Francisco, the world’s oldest sailor, confided that sailing was the thing he enjoyed and said he only worked so he could afford to sail. It was still his passion when we visited him at age 100. While centenarians as a group were conservative about how they handled their finances, they were not so about career and work advice and felt strongly about making the most of one’s work life and career path.

“If you don’t like it, you’d better get out of it,” advises Mabel McCleary, 104. The overwhelming majority of centenarians experienced meaning, purpose, and fulfillment in their work, whether it was in business or corporate America, a factory or a farm, or as an entrepreneur, salesman, or homemaker. They felt it was important because so much of one’s life is spent working.

A Good Life In addition to the questions about money and work, which we fully cover in Chapters 3 and 4, we go on to ask questions about how we can live longer and fuller lives. After all,

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active centenarians demonstrate that a good quality of life is attainable in later years. Along these lines, we asked, “How would you define the word rich?” There were various answers, of course, that ran from being a millionaire to having the love of family.

“Being rich for me is living to 100! I feel like I’ve won a prize,” declared Gloria Posata, a new centenarian. For Rosie Ross, the answer came easily: “Having enough extra money to buy a new trumpet,” the musician said. It’s the first thing Rosie did when he arrived in New York City for the Barbara Walters Special. Often, our centenarians equated being rich with having good health: “I don’t care about being a millionaire. I am a millionaire now—I’m healthy,” says Bernando LaPallo, 107.

“If you have your health, you have everything,” says Rosella Mathieu, 100. Many centenarians agree and emphasize that one of the most important things a person can do in his or her life is to take good care of their health. In Chapter 2 we explore lifestyle choices people can make on their way to becoming a centenarian and take a look at what’s on the horizon in genetics and medicine that will help us all live longer, healthier, and better lives. But for now, we need to focus on the things we can control.

NATIONAL TREASURES: UNIQUE—INDIVIDUALLY AND COLLECTIVELY As our eldest citizens, centenarians are our national treasures. There is no one else like them. Individually and collectively, they represent the wisdom, wit, and spirit of America’s last 100 years and more. This status and their contributions to the building of America as we know it are being recognized on local, state, and national levels.

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12 Celebrate 100 Manuel Vicente Osorio became a naturalized citizen on the day before his 101st birthday. He was the first Arizonan and the 11th person in the country to become a naturalized citizen at 100 years old or older.

“It was one of the proudest moments in my life; it was my lifelong dream to become an American citizen,” says Manuel. In 2012, Arizona and New Mexico each celebrated the 100th anniversary of its admission to statehood. Arizona used the celebration of centenarians as a centerpiece of its anniversary activities by hosting luncheons throughout the state honoring centenarians in their local areas. In Phoenix, on Statehood Day, February 14, the Arizona Centennial Celebration was kicked off Manuel Vicente Osorio with a luncheon honoring the 66 centenarians in attendance. The Centenarian Spirit was on full display. We met Art Fortier as we stepped off the elevator at the Sheraton Hotel ballroom in downtown Phoenix. For a few minutes we were not sure if he was one of the honored guests or one of the attending family members. Dapper in a dark blue suit, crisp white shirt, and red tie, Art was grinning from ear to ear. “It’s great to be here,” he said, as we made our way through the crowd to the registration desk. It was only when he was given a boutonnière that we were certain he was a centenarian. Finding that we were not seated with any of the centenarians, we set off to visit the other tables where centenarians and their families were gathering. To our delight, we soon found several centenarians we had interviewed for this book three years earlier. We spotted Maynard White and his daughter, Diane; Maynard was engrossed in conversation with Ralph Wilson, the centenarian seated to his left, comparing the current economic problems with those of the Depression era. We learned from Louis Reitz that he was still living in his own home, playing the organ in his living room, and riding his

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bicycle around the retirement community. Lucille Myers was still living in her apartment and volunteering at the senior center. Teddy Schalow, a former switchboard operator at the Waldorf Astoria hotel in New York City, and its oldest retiree, demanded to know, “Where have you been?” We said we had been in the East and recently had lunch at the Waldorf. “How is the place?” she asked. “That was some bash they threw for me at the hotel on my 100th birthday.” We were surprised when soon-to-be-100 Verla Morris gave us her e-mail address instead of her telephone number and said, “Keep in touch.” Another centenarian maneuvered skillfully between the tables on her scooter. If anyone ever doubted that active centenarians could and would keep pace with life and technology, they are wrong. And if anyone ever thought that they would outgrow their enthusiasm for life, love, and enjoyment as they aged, here was living proof they were mistaken. Walking hand in hand through the throng, one couple stood out—he in a bright red sport jacket and she in a red skirt with a festive white blouse. “Happy Valentine’s Day,” she said to everyone they passed. “Happy Statehood Day,” we said when we caught up with them. We mistakenly assumed the gentleman was the centenarian until his bubbly wife interrupted, saying, “I’m the centenarian! I robbed the cradle—he’s 95,” and off they went. Back at our table, we enjoyed watching the video presentation of centenarians who were not at the event. One had been a Navaho Code Talker during World War II. It was interesting to hear, in his own words, how he and other Native American recruits developed the method of battlefield communication so instrumental in America’s success in the Pacific. As the program was nearing its end, we stood along a side wall, looking out over the crowd as they sang the centennial song, “I Love You, Arizona,” each waving a small Arizona state flag in time to the music. In front of us was a centenarian flanked by her daughter and granddaughter, who had flown in from New York especially to attend the event with her grandmother. As the centenarian raised her arm to wave the flag, the sleeve of her jacket slipped back, revealing a series of faded numbers on her forearm—the tragic markings of a Holocaust survivor.

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14 Celebrate 100 We were reminded, as we watched her, of Austrian psychiatrist Viktor Frankl’s renowned work, Man's Search for Meaning (Simon & Schuster, Inc., New York, 1959, 1962, 1984), in which he, also a survivor of the Holocaust, argues that life is unconditionally meaningful and that one’s sense of purpose is adaptable. “We create meaning through choices and actions as we move through life,” he writes. “Meaning unfolds along with the changes in the life cycle. . . . Life can be meaningful by being an example to others.” It is instructive to recognize how much this generation of centenarians has lived through and witnessed. They are a diverse group of distinctive individuals, not only because of the lives they have lived, but also how they are living and continuing to recreate their lives at 100 and beyond. They are impressive, not only in their numbers, but in their health, vitality, activities, and interests. Every centenarian brings special knowledge from his or her life. This collective experience presents a kaleidoscope of America’s history over the past 100-plus years, made up of the same events, but each represented by a slightly different story. The richness of this experience is mirrored in every centenarian throughout the country, and is the hallmark of Celebrate 100.

Continues... CAMEOS OF TODAY ’S CENTENARIANS

Elsa Brehm Hoffmann, Entrepreneur Elsa has never let age stop her from accomplishing her goals. At 18, she brought the love of her life home to meet her parents, assuming that since he was from the same close-knit German immigrant community, they would readily give their approval for them to marry. Bill, 10 years her senior, had just started his own roofing business in Yonkers, New York. After he left, her mother voiced her disapproval, citing the tar under his fingernails as making him unacceptable. “Ma—that’s money!” Elsa exclaimed. They married, and Elsa worked with her husband to build a successful business, using the skills she had learned working for her father in the office of his bakery supply business. When their four children were grown, the couple began to spend the winters in

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C H A P T E R

This “Recovery” Is 100 Percent Fake WH Y T H E A F T E R S H OC K HAS N OT BE E N CA N C E LE D

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s we write this second edition of The Aftershock Investor in mid2013, U.S. stock markets have hit new highs, real estate prices are rising, and the economic cheerleaders are declaring once again that all is well or will be soon. The economy is in recovery and the coming Aftershock, our critics say, has been canceled. How wonderful that would be if it were only true. But nothing has happened to change our minds about our earlier forecasts. In fact, current events fall in line pretty well with our previous analysis and predictions, dating back to our earliest books, America’s Bubble Economy in 2006 and the first edition of Aftershock in 2009. From the beginning, we said that in order to keep the stock, real estate, private debt, and consumer spending bubbles going, the government would inflate two more bubbles—the dollar and the federal debt bubbles—through massive money printing and massive money borrowing. That is the only way to keep this temporary bubble party going, and the government is doing all it can to keep pumping helium into the balloons so they don’t fully fall. With the national debt now nearly $17 trillion and the Federal Reserve flooding the economy with $85 billion in newly printed money every month (at the time of this writing), our predictions are looking pretty spot-on.

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We never said the stock market wouldn’t rise—in fact, it may go even higher. We never said the economy couldn’t temporarily stabilize or that home prices couldn’t rise a bit in some areas in the short term. We said this is a bubble economy and that the government will do anything it could to keep the bubbles going—and that is exactly what they are doing. But please don’t confuse a temporary, artificially created recovery with the real thing. Any recovery that is created by massive government stimulus and can be maintained only with continued massive government stimulus is a fake recovery. Why? Because the fundamental economic realities have not changed, and even massive government stimulus cannot permanently override the fundamentals. The fact is that since the late 1970s we have been living in a bubble economy (see Chapter 2 for why we say so), and bubbles don’t last forever. We saw the beginning of the pop with the partial decline of the real estate bubble in 2007, which helped kick off the global financial crisis of late 2008. Since then, we’ve seen a mammoth effort to partially reinflate and maintain the sagging bubbles with an enormous amount of money printing and money borrowing. This huge stimulus has been only marginally successful, as evidenced by the fact that the stock and real estate markets have not really grown much, just returned to their pre-2008 crash levels, at best. This highly expensive, bubble-maintaining stimulus may work for a while—maybe even years—but it won’t work forever. In the long run, the massive stimulus will eventually have to end, and it will have made our problems even worse in the future. So contrary to popular belief, this “recovery” is 100 percent fake and the Aftershock has not been canceled.

Isn’t a Fake Recovery Better than No Recovery at All? That seems true, but it really isn’t. The massive money printing and borrowing that is creating this fake recovery and delaying the Aftershock will only make the coming crash all the worse later. That’s why we say it’s nothing to cheer about. A fake recovery may feel good now—like postponing a trip to the dentist with a strong painkiller—but it will only bring us much more pain later.

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Not only will the temporary painkiller eventually wear off, but the medicine itself will later become a poison as the massive money printing eventually causes dangerous future inflation. Why is that so dangerous? Because rising inflation will cause rising interest rates, and rising interest rates will cause markets to crash even harder than they would have had we not printed so much money. And, of course, just like postponing a trip to the dentist, putting off dealing with our underlying problems only increases our future pain because it postpones the fundamental changes we desperately need to make in order to create a real economic recovery. What we need is not more government borrowing and more dollars created out of thin air to keep the party going. What we need is a true economic recovery based on fundamental changes that will boost real productivity (the subject of future books). Real productivity growth would generate real economic growth and real, nonbubble wealth that would not be vulnerable to bubble pops.

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The problem is that those changes are difficult. No one wants to hear that we have to make tough choices and endure a lot of pain now to create real economic growth later. It’s much easier to let the government borrow and print for now, and kick all the rest of it down the road to deal with later. Politicians might talk about fiscal and monetary responsibility, but the short-term consequences of stopping the current bubble-supporting machine would put their jobs in jeopardy. This is why we have been predicting since 2006 that our bubble economy will continue to be maintained until that maintenance is no longer possible. We will throw everything at it until we can throw no more. While marginally effective in the short term, eventually this strategy will fail. Until then, no one wants to pop the temporary bubble party. Inflation or Deflation? Nobel Prize–winning economist Milton Friedman in the 1970s famously said: “Inflation is always and everywhere a monetary phenomenon.” In fact, inflation and deflation are both “monetary phenomena,” meaning they both result from changes in the money supply. Inflation results from increasing the money supply faster than the economy grows, devaluing the dollar and causing goods and services to cost more. Deflation results from decreasing the money supply relative to the economy, pushing up the value of the dollar and causing goods and services to cost less. The Great Depression gave us deflation, not inflation. Too few dollars relative to the economic needs of the time caused the value of the dollar to rise, and the cost of goods and services to fall. By sharp contrast, we are printing enormous amounts of new money, increasing the monetary base much faster than the economy is growing, which will bring us future inflation, not deflation. (Please see www.aftershockpublishing.com for more info on inflation versus deflation.) Those who point to falling prices or the threat of future falling prices, and call it deflation, are making a fundamental mistake. Separate from inflation or deflation, prices also rise and fall because of changes in supply and demand. For example, when an asset bubble pops (such as real estate), falling home prices are not due to deflation; home prices fall because there are more sellers than buyers. Just before and during the Aftershock, multiple popping bubbles will cause many asset prices (in inflation-adjusted dollars) to fall. That is not deflation; that is a price drop due to a bubble pop!

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If the Aftershock Has Not Been Canceled, Why Hasn’t It Happened Yet? While we stand by our past and current predictions for the coming Aftershock, we admit that predicting exactly when the bubbles will fully burst is difficult. What we can do is look at the fundamentals of this economy, and they continue to look worse and worse as time passes. So while we cannot easily predict the timing of the coming Aftershock, there is no doubt that it will happen. It cannot be permanently avoided, only delayed. To understand why the Aftershock hasn’t happened yet, let’s take a closer look at what is keeping this fake recovery going and how long we think it might last.

The Key to Creating and Maintaining the Fake Recovery: Massive Money Printing Massive money printing is quickly becoming the key support of our multibubble economy. We are not talking about creating a modest amount of extra money to keep up with a growing economy, like we used to do. We are talking about a truly staggering amount of new money printing, more than we’ve ever done in U.S. history or for that matter the history of the world. If you think we are exaggerating, consider this: since the creation of the U.S. Federal Reserve almost 100 years ago, we have printed roughly $800 billion; now the Fed is printing more new money than that in just one year (see Figure 1.1) Since the financial crisis of 2008, the Fed has increased the monetary base from about $800 billion to more than $3 trillion. By making money so abundant and therefore cheap to borrow, money printing allows the government to run high deficits. And money printing keeps the stock market from collapsing and the bond and real estate markets doing great. A government can boost the economy by running a large deficit. But eventually it will have to pay higher yields on its bonds as investors become more and more skeptical of the government’s ability to pay its increasingly large debt obligations. The solution: money printing. The central bank uses printed money to buy government bonds in large quantities, thus creating an artificial demand for those bonds and keeping yields low. 201


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Figure 1.1

Massive New Money Printing

We will print more new money in 2013 than we created in total since the Federal Reserve was formed almost 100 years ago. Source: Federal Reserve.

The artificial demand for government bonds carries over to the rest of the bond market as well, where yields are often defined by the markup over the rate on sovereign bonds. The low interest rates in the bond market carry over into the mortgage market as well, keeping demand up for easy home loans and propping up the real estate market. Low yields on bonds leave many investors chasing bigger gains. And what better place to increase their return on investment than the stock market? There’s plenty of capital to put into stocks, too. After all, when the Fed prints money to buy bonds, it has to buy those bonds from somebody, and then they have to do something with it. Much of that newly printed money goes right from investors’ bank accounts into the stock market, raising demand for stocks and boosting the overall stock market. The rising stock market further encourages the real estate market and general consumer spending, creating the fake recovery we have today. So if money printing enables the government to run large deficits with little consequence and it boosts the stock, bond, and real estate markets as well, what’s the downside? The answer is future inflation. More dollars in circulation means they are less valuable (lower buying power). A dollar losing its buying power means 202


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higher interest rates. Higher interest rates in a bubble economy mean collapsing markets and an exploding government debt problem. Rising inflation is something a bubble economy cannot afford. But the Fed has been printing money since late 2008, and inflation hasn’t reached significant levels—at least not according to the Consumer Price Index (CPI). Well, first of all, there is a lag factor between money printing and future inflation. Second, the official inflation statistics leave something to be desired, as we’ll discuss below. We’ll talk more about inflation later in the book, but it’s worth noting here just how unrestrained the Fed’s money printing operations have become and the fact that future inflation is now inevitable. It’s only a matter of when. When the first edition of this book was published in September 2012, the Fed had already completed two rounds of quantitative easing (QE1 and QE2), making the U.S. money supply roughly triple what it was in 2008. Soon after the book was published, the Fed announced yet a third round of quantitative easing (QE3). But this time, perhaps losing confidence in the economy’s fundamentals, the Fed put no limits on its money printing operations, saying only that it would commit to at least $40 billion a month in bond purchases until unemployment figures had reached a satisfactory level. It didn’t take long before that $40 billion commitment became a staggering $85 billion a month, with no end in sight. That’s a lot of artificial stimulus from the government to keep the markets up. It’s working so far, as long as the money printing continues. But does anyone really think that endlessly creating dollars out of thin air is a path to real future prosperity? It’s almost silly to believe in such a fantasy and yet the psychological drive to accept this as a safe and effective cure for our problems generally overrides logic. Investors love the easy-money fantasy that money printing supports and they want it go on forever. We are not saying that if we stopped the stimulus today, all would be fine. Just the opposite, ending the stimulus entirely would quickly throw the economy into severe recession. But our economic problems are not due to a lack of stimulus, therefore the stimulus, no matter how massive, will not save us, it will only delay the inevitable economic pain and will make it all the worse when it happens later. This is a falling bubble economy (see Chapter 2 for details) and the money printing and money borrowing stimulus is simply delaying its further fall. But the more stimulus we throw at it now, the harder the crash will be later because inflation and interest rates will be that much higher. 203


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In a Supporting Role: Cheerleading Cheerleaders root for the home team. They won’t tell you the quarterback has a weak arm, or that the offensive line is outmatched, or that the head coach is inexperienced. Their job is to be positive and cheer on the home team! In recent decades we’ve seen the financial world take on a “home crowd” type of atmosphere, with financial pundits and economists assuming roles as cheerleaders rather than analysts. They won’t tell you about the fundamental problems in the economy. They’ll only assure you that everything is bound to get better, that

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recovery is right around the corner, or that it’s already here. Never mind all the people out there looking for decent wages. The cheerleading mindset is a big reason we ended up with a bubble economy in the first place. Brokerage firms needed to sell stocks in order to make money. Fundamentals didn’t matter, as long as everyone plays along. They cultivated a deep belief that prices were always going to go up, up, up. Remember how optimistic all the experts were before the subprime mortgage crisis? The cheerleading mindset persists, as the analysts hype every little positive and ignore or downplay every negative. We can’t possibly have inflation. It doesn’t matter how much money the Fed prints. The unemployment rate is falling. It doesn’t matter how many people are out of work. Home sales are on the rise. It doesn’t matter how low they are compared to a few years ago. Oh, but if gold prices drop, that’s a “correction” on a fundamentally bad investment.

Ammo for the Cheerleaders: Inflation and Unemployment Numbers Still Appear Low One of the reasons our critics like to point out to show we are wrong is the current absence of rising inflation, which is a key part of our predictions for the coming Aftershock. They say, if we need inflation to push interest rates up and kick off the Aftershock and we have no inflation, then clearly the Aftershock has been canceled. We disagree. To a large extent, the reason we haven’t seen significant inflation yet in spite of massive money printing is that, as we’ll explain in more detail in Chapter 5, there are some “lag factors” that create a delay between when money is printed and when inflation sets in. But also keep in mind that we have seen some inflation. While inflation may not be 10 or 20 percent yet, the government’s sub– 3 percent figures are difficult to believe. Anyone who buys food or puts gas in their car knows that prices of many things have gone up in the past few years. So why doesn’t the government’s measure of inflation seem to more fully reflect this? One important reason has to do with the way the government measures inflation, which they purposely changed in the last couple of decades in order to downplay the inflation rate. While

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manipulation of economic statistics is expected and accepted as an everyday occurrence in some other countries, the United States is not known for regularly manipulating our statistics. However, that doesn’t mean it doesn’t happen, albeit in subtle ways. One of the easiest and most convenient statistics to manipulate is the inflation rate, and the United States is almost certainly massaging its chief measure of inflation, the CPI. This figure can easily be manipulated by making changes to the basket of goods and services measured over time and making subjective judgments about product substitution—for example, how a 2013 car model compares to a 2003 model. We are not at all surprised that the government is taking steps to hide the real inflation rate. The stakes are very high, and the people generating the inflation statistics want the figure to appear as low as possible. Aside from the danger that inflation leads to higher interest rates that can hurt the markets, inflation also puts a big strain on the government budget. The government has to make higher and higher payments for any inflation-indexed programs, including pensions and social security, and higher interest rates mean the government has to offer higher rates to finance its debt. Worse yet, inflation eats away at gross domestic product (GDP) growth figures. If inflation reaches 4 or 5—let alone 10 or 20— percent, any growth in GDP has to be adjusted accordingly. With our economy right now officially only growing by about 2 percent annually (and likely the real number is less than that), it’s very much in the government’s interest to report a low CPI inflation figure. That has no doubt played a role in the shifting standards for measuring CPI over the last couple decades. The unreliability of government statistics makes it difficult for us to say exactly what inflation really is right now. But we don’t see any reason to believe that the government’s “new and improved” measure of inflation is more accurate than the measure they used 30 years ago. The evidence suggests that the changes to CPI were made out of self-interest, not a concern for accuracy. Combine the inflation rate with the unemployment rate and you get the misery index. Generally speaking, the higher this number is, the more economic and social woes we face. So unemployment is another figure the government has a keen interest in understating. And while employment statistics are not as easy to manipulate as CPI, that doesn’t mean we should take them all at face value.

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More jobs were lost from 2007 to 2009 (almost 9 million), than during the previous four recessions combined. So employment statistics are important numbers for the media and the cheerleaders. To be counted in the official “unemployment rate” a person has to be out of work entirely and actively seeking a job. This means those who have given up searching and whose unemployment benefits have lapsed—referred to as the discouraged unemployed—are not counted in the popular unemployment rate that gets reported so much in the news. Also not counted in the popular unemployment rate are those working part time when they would rather work full time, or who are working well below their education and skill levels. In July 2013, Gallup reported that more than 17 percent of the workforce characterizes itself as “underemployed.” Many previous full-time workers have been forced to take part-time work while they continue to look for better employment. When the media and cheerleaders tell us to feel good about the creation of new jobs, they rarely if ever mention that roughly 80 percent of those new jobs are only part time (see Figure 1.2).

Figure 1.2

More Workers Forced into Part-Time Jobs

A growing number of people who would like to have full-time jobs have had to take part-time jobs instead. Many more workers have had their previously full-time hours reduced to part-time. Source: BLS/Haver Analytics.

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So while the typical unemployment rate reported in the media has recently held steady around 7 or 8 percent, it doesn’t tell the whole story. For that, we need to look at what is called the U6 unemployment rate, which conveniently the government and the media avoid discussing too much. The U6 rate, which includes discouraged unemployed and those working part time when they rather work full time, is officially 14.5 percent. The actually number is likely higher. It has become an increasingly common phenomenon to see the official unemployment rate figure remain flat or even go down slightly while the number of people dropping out of the work force goes up. In fact, according to the Bureau of Labor Statistics, the number of working-age Americans who have now dropped out of the workforce is about 3 to 4 million. The majority of these folks are under 50 years old, so they aren’t retiring. They are just giving up. There are typically some working-age Americans out of the workforce—such as full-time parents—but this is an exceptionally high number. Recently, the employment-to-population ratio (in which “population” counts anyone 16 years of age and older) is down to 58.5 percent, when it had hovered around 63 percent for much of the previous decade. And if you think job growth is bad, wage growth is in even worse shape. In fact, according to government statistics, real wage growth (adjusted for inflation) is worse now than it was during the Great Depression. Even with two people in the family working instead of one, the growth of household incomes has been essentially flat in the past few years (see Figure 1.3). Between the underreported unemployment figures and the lack of income growth, much of the pain in the economy is quiet pain—meaning that it doesn’t get much media coverage and few people are discussing it. But its impacts are widespread. Perhaps some of our readers know people who have lost their jobs and are looking for work, or who have dropped out of the workforce entirely, with little or no hope of finding a job. Or you might know some who have seen their wages or income fall, or their business suffer. And in spite of these realities we all see right in front us, the government will still claim we are in a “recovery,” trying to distract us with frivolous numbers that don’t tell the true story. If this really were a recovery, we’d be seeing more jobs by now.

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Figure 1.3

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Household Incomes Are Languishing

Median household incomes, adjusted for inflation, have declined and not recovered much since the financial crisis of 2008. Source: Sentier Research and the Wall Street Journal.

Money Printing = No Inflation = No Taxes! We Are Fooling Ourselves—and We Know It One of the craziest ideas that the cheerleaders promote can be summarized as “Don’t worry, massive money printing is always perfectly safe!” Really? If it’s really so safe, why are we only doing it on an “asneeded” basis? Why not do it all the time, not just in a crisis? If it’s really so safe, why ever stop? And if it is really so safe, why not do a whole lot more of it? After all, if massive money printing doesn’t cause future inflation, why are they so afraid of doing more? Surely, if $85 billion of new money per money is good, then $100 billion per month would be even better, right? What the heck, if there’s no downside to massive money printing, why not go for $200 billion per month? Think of how much that would boost the markets and the economy. It would be great! Why aren’t we doing that right now? In fact, why do we need to pay any taxes at all? Let’s just print all the money we will ever need, whenever we need it!

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But you’ll notice we don’t actually do that, do we? How come? Because everyone knows that it can’t work. If we didn’t know, we’d be doing it, so obviously, we know. People know that massive money printing comes with a nasty future price tag (inflation). If it didn’t, why should we limit it and why should we ever stop? Like smoking crack, we know darn well that this is a dangerous drug; we just can’t kick our addiction to its short-term high. How much crack can we smoke before we scare ourselves by the sheer quantity? Well, if we start out slowly and get ourselves used to it, our love of the short-term high can convince us that we are always printing the “just right” amount of new money. When we first started with limited quantitative easing (QE1) in early 2009, the idea of printing $85 billion/month without an end date would have seemed irresponsible. But by raising the amount of money printing gradually over time to create and maintain the fake recovery, each new round of QE was welcomed as perfectly safe and perfectly sized. Now $85 billion/ month seems “just right.” In fact, any talk of even slightly reducing the money printing makes the stock market drop 100 points. We are addicted and we know it. And we are fooling ourselves and we know it.

Still Not Sure This Recovery Is 100 Percent Fake? We’ve explained why this recovery is entirely fake and the coming Aftershock has not been canceled, but maybe you’re still not convinced. Maybe you think the economy really is turning around, that employment will pick up once it catches up with the stock market, that China will carry the rest of world out of this malaise, or that the fantasy of cheap energy will save us. If we haven’t made the case yet that the fundamentals of the economy are not improving, and in fact are only getting worse, here are a few more facts to wake you up.

If This Recovery Is Real, Why Is Government Borrowing Outpacing GDP Growth? While many people seem to cheer every little positive sign of growth in the economy (and ignore or downplay any negative

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news), what’s really astonishing is just how little growth in the economy we’ve seen in spite of all the government intervention. Between 2008 and 2013, the cumulative increase in GDP in the United States increased by $2.8 trillion. Over the same period, government borrowing increased $4.7 trillion. In other words, government borrowing is outpacing GDP growth three to one (see Figure 1.4). That’s a whole lot of borrowing for just a little bit of growth. Such huge borrowing relative to GDP shows just how fragile the U.S. economy really is. Pro-intervention pundits and academics like to think of government intervention as a parent holding up a young child’s bicycle, ready to pull the hand away as soon as the child can stay upright. In truth, the government is more like pushover parents who keep giving their children barrels of money well into their adult years, seeing less and less return on their investment as the kids become increasingly dependent. If the parents cut them off, they’d be out on the streets immediately. It’s the same for this economy. If you took away the huge money borrowing, we’d be thrown into an instant recession. At this point, the massive money printing and massive money borrowing are keeping the economy on life support.

Figure 1.4

GDP Growth versus Total Government Debt

We are borrowing three times more than the economy is growing.

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After Five Years of Emergency CPR, the Patient Is Not Recovering If the global financial crisis of 2008 was like a heart attack for the U.S. economy, then the massive stimulus (massive money printing and borrowing) needed to jump start this patient has keep the patient alive, but it’s certainly hasn’t restored full health. Even after five years of massive stimulus, we are still getting nowhere. If GDP is growing by 1 to 2 percent (the equivalent of $150 to $200 billion), even assuming that deficit spending is reduced to $800 to $900 billion this year, we are in fact buying very little GDP growth with a huge amount of debt—we are borrowing three to four times the amount of GDP growth we get for the borrowing (see Figure 1.5). In other words, we are stimulating nothing. It is all just fake bubble maintenance and no real growth. The only recovery has been in asset prices, not the economy. Only the assets are going up, while the economy is not. The jobs are just not there. In fact, there are more people on food stamps now than are working. Five years of CPR may be keeping some vital signs going, but the patient is not recovering. And with so much money printing and borrowing weighing heavily on our future, this patient will be sicker than before.

Figure 1.5 GDP Growth versus Current Government Borrowing We are borrowing at a rate of three or four times our current growth rate. Apparently, we are not getting much of a bang for our borrowed buck.

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If This Recovery Is Real, Why Are Stock Prices Growing Faster than Company Earnings? Lately, we can always rely on the stock market for optimism. And while anyone can appreciate some healthy optimism, the kind of blind optimism we’re seeing in the stock market right now helps no one. A big reason for the stock market’s record numbers recently has to do with investors’ outlandish expectations for future earnings. According to FactSet, industry analysts expect record earnings for the Standard & Poor’s (S&P) 500 in the last two quarters of 2013. In fact, projections for the fourth quarter of 2013 are more than 15 percent above the fourth quarter of 2012. That would be an impressive rise for any period, and a great reason for people to want to own stock in these companies. An actual 15 percent year-over-year growth rate in earnings would have been especially impressive. But it didn’t happen. In addition, revenues are also pretty poor, with only 1 percent or less for the S&P 500. Apparently, the market is expecting an enormous jump in revenues (which drive company earnings and stock prices) in the second half of 2013. This kind of freakish optimism isn’t just calling the glass half full. This is like saying the glass is overflowing when there’s barely a drop of water! The fact is that company earnings are not growing at the rate that stock prices are growing; therefore, you are paying more for the same earnings you could buy for less before. That’s nothing to cheer about.

If This Recovery Is Real, Why Is the Global Economy Slowing? One reason for slow earnings growth in the United States might be the situation around the world. For multinational corporations, like those that make up the S&P 500 and Dow Jones Industrial Average, a significant portion of their revenues come from overseas operations. And the news from overseas has been pretty bleak. In Europe, the north is in recession, while the south is in depression. Unemployment numbers in Spain, Italy, and Greece

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are staggering. In the north, even Germany is suffering from a slowdown, with big companies like Daimler abandoning their profit forecasts due to falling demand. France and the United Kingdom, Europe’s second- and third-largest economies, are flirting with recession. And the Netherlands, a traditionally strong economy, is on the verge of economic crisis. China, the engine many thought would pull the rest of the world out of this mess, is experiencing a slowdown in growth even by its own admission. The truth is likely even worse than the Chinese government lets on, as the enormous construction bubble that was built up in response to the 2008 financial crisis is becoming increasingly unsustainable. A 60 Minutes report in March 2013 showed entire cities being built—high-rise luxury condominiums, expansive malls—with no one living in them. So much for the world’s growth engine. China’s slowdown is taking a toll on the rest of the world, too. Brazil’s impressive growth has slowed to a crawl (and possibly contraction if inflation is properly accounted for). Turkey, another country that seemed to be flying above the global earthquake, saw just 2 percent growth in 2012—down from about 9 percent in 2010 and 2011. Japan’s government, unsatisfied with the country’s sluggish economic activity, recently announced a money-printing campaign that would make even Ben Bernanke blush—printing $75 billion a month in an economy a little more than a third of the size of the United States. And while there’s been a lot of talk about “emerging markets,” it’s becoming increasingly apparent that those markets were fueled largely by China’s rise, and thus are suffering now that China is struggling to keep pace with its earlier gains. This is important because the global slowdown has a direct impact on the U.S. economy and U.S. stocks, particularly those that collectively make up the S&P 500. That’s because in this global economy, no country is an island. Some countries may fare better than others, but trends around the world operate as a large feedback loop. When the United States falters, the rest of the world slows down. When demand in Europe drops, exports in China drop. When China slows down, Europe sinks further, and other economies can’t keep up their previous pace. Everyone depends on everyone else. We can turn our heads away from bad news all we want, but eventually there will be nowhere to hide. Continues... 214


An Embarrassment of Riches Tapping Into the World’s Greatest Legacy of Wealth Alexander Green 978-1-118-60882-1 • Hardback • 256 pages • December 2013

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INTRODUCTION

Everyone thinks about money. Few think about it more than I do. That’s not because I’m selfish, greedy, and materialistic. (Okay, maybe a little.) At various times over the past three decades, I’ve worked as a research analyst, stockbroker, investment adviser, portfolio manager, and financial writer. Today, I am the investment director of the Oxford Club, a private investment club dedicated to helping investors achieve and maintain financial independence. And we’ve had some success. The independent Hulbert Financial Digest has ranked the investment letter I direct—The Oxford Communique—among the best-performing newsletters in the nation for over than a decade now. Wealth, of course, is a subject that interests almost everyone. Money makes things happen; it gives us choices. Since few want to live circumscribed lives, the pursuit of wealth is universal. Money allows us to achieve our dreams, whether you define that as education, opportunity, independence, luxury, security, or peace of mind. It’s freedom, power, and opportunity rolled into one. As a result, there is a huge market for financial advice—and I’m fortunate to have a few hundred thousand readers who tune in regularly. Almost every day I can be found—either online or in print—weighing in on stocks, bonds, funds, interest rates, currencies, or commodities. xiii

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These aren’t my primary interests, however. What really fascinates me is where human beings find meaning and purpose during their brief journey on this little blue ball. For example, what is the real advantage of all your saving and investing? As I see it, there are three primary benefits: 1.

2.

3.

If you have money, you don’t have to worry about it. This isn’t guaranteed, of course. I’ve known plenty of highnet-worth individuals who agonized over their finances and worried about losing the nest egg they’d taken a lifetime to build. Still, if you have money and manage it conservatively, your worries should be few. Fretting about your investment returns is a lot less stressful than wondering how you’re going to make this month’s rent. Money gives you freedom to pursue your passions. You can spend your days engaged in activities that you find absorbing and satisfying, that you feel you’re good at—or you feel like you’re doing good. This doesn’t just happen in retirement, incidentally. A measure of financial freedom gives you the ability to swap into a new job that may be less lucrative but more fulfilling. Money buys you time with family and friends. Your most valuable resource is your time, not your bank statement. And nothing contributes to personal happiness more than seeing family and friends regularly. Money gives you the wherewithal to go out to dinner with buddies, take a vacation with the kids, or go to the concert with your significant other. In my view, money is put to the best use when it is spent making memories, not loading up on more stuff.

However, financial security remains elusive for many Americans. The 2013 Retirement Confidence Survey (RCS), the longest-running survey of its kind, revealed that the percentage of workers who feel confident they have enough for a comfortable retirement is near record lows. Most Americans have too little in retirement savings and remain pessimistic about the future. In a recent poll by Yahoo! 217


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Finance, 41 percent said, “The American Dream is lost.” Only 45 percent believe their kids will be better off than they are. Other surveys show that a significant percentage of us believe life is tough, the future is dim, and the country is decidedly on the wrong track. This is understandable in some ways. Aside from any personal challenges confronting you—financial or otherwise—our society faces serious problems, including war, disease, corruption, poverty, nuclear proliferation, terrorism, and political dysfunction in Washington. No wonder Americans are in a foul mood, especially if this dour perspective—one cycled 24/7 by the national media— is an accurate representation of the state of the nation. But it isn’t. The media delivers the world through a highly distorted lens, emphasizing tragedies, accidents, and problems. A recent study showed that more than 90 percent of the articles in the Washington Post had a negative slant. Television is even gloomier—and far more sensational. It’s not hard to understand why. News media companies exist to generate profits. To do that, they need advertisers. To attract advertisers, they need viewers. And to grab viewers, they scare the pants off them, setting their amygdalas alight with news of terrorist attacks, sensational crimes, natural disasters, and other unsettling developments. And we don’t just hear about accidents and natural disasters; we see immediate live footage that is recycled continually throughout the day. From a media standpoint, bad news is good news. If a factory closes, that’s a story. If a factory opens, it’s not. Of course, no one wants to hear about the planes that didn’t crash and the buildings that didn’t burn. But the news media creates a powerful impression that all over the country terrible things are happening, that modern life is filled with tragic developments and impending dangers. Yet this almost certainly doesn’t reflect your own day-to-day world. Honestly, is your life filled with life-threatening perils, violence, and extreme need? Or is it one of relative comfort, convenience, and affluence? 218


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A realistic look at your life begins with realizing the truth about your circumstances and the world we live in. Throughout most of human history, physical survival was the overriding problem confronting people. The bulk of each day was spent seeking food, water, shelter, warmth, and safety. Men and women lived lives that were, in Thomas Hobbes’s famous phrase, “solitary, poor, nasty, brutish, and short.” Nobody worried about retirement because almost no one lived to be old. By 25, just about everyone was dead, usually of unnatural causes. We battled the elements and hunted and scavenged to survive. As a species, we existed on the brink of starvation in a world filled with danger. Even 200 years ago, well after the advent of agriculture, the vast majority of the world’s population experienced the present standard of living of Bangladesh. Today we have a great bias, a widely accepted belief in the steady nature of progress. Yet for most of human history, there was none. More has been invented in the past 100 years than the previous 1,000. Most of human history has been one prolonged era of non-progress. Gains in living standards were imperceptible. And the human population grew slowly—or not at all—because death rates often exceeded birth rates. Things improved with the Industrial Revolution. But people worked much harder then than we do today. In 1850, the average workweek was sixty-four hours. In 1900, it was fifty-three. Today, it is thirty-five hours. On the whole, Americans work less, have more purchasing power, enjoy goods and services in almost unlimited supply, and have much more leisure time. One hundred years ago, 6 percent of manufacturing workers took vacations; today, it’s over 90 percent. One hundred years ago, the average housekeeper spent 12 hours a day on laundry, cooking, cleaning, and sewing; today’s it’s about 3 hours. A century ago, most workers performed backbreaking labor in farming, forestry, construction, or mining. But just a small fraction of the population performs physically demanding work today. That leaves the majority of us free to offer restaurant meals, financial services, jazz concerts, or aromatherapy. Your ancestors a few 219


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generations removed would marvel at contemporary life: unlimited food at affordable prices . . . plagues that killed millions—polio, smallpox, measles, rickets—all but eradicated . . . cancer, heart disease, and stroke incidence in decline .  .  . the advent of instantaneous global communication and same-day travel to distant cities . . . mass home ownership with central heat and air and limitless modern conveniences . . . senior citizens cared for financially and medically, ending the fear of impoverished old age. Thanks to advances in medicine and public safety, we are enjoying the greatest human accomplishment of all time: the near doubling of the average life span over the past 100 years. (At the beginning of the twentieth century, the average American lived just 42 years.) Life expectancy in the West is growing by three months per year. That means you’re gaining six hours of life expectancy a day without even exercising. Consequently, the number of years we spend in retirement is increasing, too. Living standards today are the highest they have ever been, including for the middle class and for the poor. Yes, the median family net worth suffered a hit following the financial crisis of 2008, falling well below the peak of $126,400 in 2007. But with home prices bouncing back and the stock market more than doubling from its lows, prosperity is on the rise again. The Federal Reserve reported in early 2013 that American families’ wealth had reached an all-time high of $70.4 trillion. Most of us are seeing our essential needs met and our higherpriority wants, as well. You may be in the midst of difficult personal circumstances, of course. You may have lost your job, your house, or a loved one. Appreciating this legacy of wealth doesn’t require blindness to the tragic aspects of life or the suffering of others. Unlike Dr. Pangloss, I don’t believe that everything is for the best in this best of all possible worlds. There are depressing or bittersweet aspects to every life, as there always have been for all people at all times and in all places. Yet if you were born into the affluent West, you live in a world that is vastly richer, easier, and more comfortable than your forebears’. No doubt you have family problems, or financial troubles or health issues. But people have always dealt with predicaments like 220


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these but in a milieu much more difficult than our own. A bit of context makes you realize that your life today is almost certainly better than it was for 99.9 percent of your ancestors. Pessimists grudgingly admit that life may be getting better in some respects, but it is also getting more expensive. And, indeed, inflation is a thief that robs us all. But inflation has been remarkably tame over the last three decades and the real measure of something’s worth is the number of hours it takes to acquire it. From this standpoint—again—we have never been richer. The four most basic human economic needs—food, clothing, fuel, and shelter—have been getting steadily cheaper for years. Housing, for instance, has rarely been a better bargain, and not just because the real estate bubble burst a few years ago. It took 16 weeks to earn the price of 100 square feet of housing in 1956. Today, it takes fourteen weeks and the housing is better quality. Plus, our homes are filled with all sorts of modern conveniences: dishwashers, ovens, microwaves, coffee makers, and lounge chairs that give massages. Most of our grandparents and great grandparents worked long, hard hours to raise lots of kids—thanks to the absence of birth control—in small homes with tiny kitchens and little closet space. The average American home had 1,700 square feet in 1973. Today, it has more than 2,500 square feet, and 40 percent more closet space than in 1978. Today, Americans live in spacious homes with family rooms, pools, and patios, filled with all kinds of desirable things that our grandparents either couldn’t have imagined or believed only rich people could own. It is easy to take things for granted today. Consider light, for example. To get an hour of artificial light from a sesame-oil lamp in Babylon in 1750 B.C. would have cost you more than 50 hours of work. The same amount of illumination from a tallow candle in the 1800s required 6 hours’ labor. Fifteen minutes of work was the trade-off for an hour from a kerosene lamp in the 1880s. Yet for an hour of electric light today, the average American labors half a second. Or take transportation. For millions of years, we got somewhere only by putting one foot in front of the other. Six thousand years 221


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ago, we domesticated the horse. (For most of human history, nothing traveled faster than a horse and, as far as we knew, nothing ever would.) In the 1800s, going from New York to Chicago on a stagecoach took two weeks’ time and a month’s wages. Industrialist Henry Ford made the automobile affordable to the masses a century ago, in any color that you wanted as long as it was black Today, it takes far less discretionary income for us to buy a car, and—aside from having the power of over 200 horses—the vehicles come with side airbags, antilock brakes, GPS guidance systems, high-powered audio systems, and voice-activated SYNC. Or consider home entertainment. It just keeps getting better and cheaper. A 50-inch flat screen TV cost more than $10,000 just over a decade ago. Today, you can pick one up at Wal-Mart for less than $500. In 2001, you could spend $600 for a splashy new 1.3-megapixel digital camera that weighed a pound and a half. Today, you can buy a 16-megapixel camera that weighs 3.8 ounces for less than 100 bucks. When DVD players first debuted, they cost several hundred dollars. Today, a good one costs less than $50. Of course, why trouble yourself to buy or rent DVDs when you can easily and cost-efficiently stream content to your home entertainment center without even getting off the couch? Technology is revolutionizing our lives. Thirty years ago, most people didn’t have a personal computer. Twenty years ago, the majority didn’t have a cell phone. Ten years ago, most didn’t have a high-speed Internet connection. We can’t even imagine all the technological advances that lie just ahead. In 1987, a megabyte of memory cost $5,000. The Mac II that sat on my desk—with a single megabyte of memory and running at 16 megahertz (which Apple in its typically breathless marketing described as “blindingly fast”)—cost nearly $6,000. Today, a much smaller and faster machine costs about a tenth as much. As for memory, you can buy a terabyte drive today for less than 60 bucks. It has never been cheaper to store, exchange, and improve ideas. In addition to the vast improvement in your material circumstances, you have inherited a tremendously rich cultural legacy: masterpieces of art, music, literature, sculpture, and architecture. And these things have never been more accessible. 222


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Visit any major city and you can marvel at paintings and sculptures that the world’s richest men and women cannot own, even if they could afford them. The local library offers all of history’s greatest books—with no waiting list. Many can be downloaded for free. Internet radio offers commercial-free music at no cost. And for a few dollars, you can own (and instantly download) high-quality, digital recordings of the world’s greatest music performed by the finest symphony orchestras. Digital music is more environmentally friendly, too. Albums, cassettes, and CDs are made of plastic and metal, the raw ingredients of which have to be extracted from the ground and molded into shape. Unlike digital music, these require packaging. (Older readers will remember early compact disc packaging with jewel cases, plastic wrap, and long cardboard boxes.) And it takes pollution-belching trucks to deliver CDs, records, and tapes to your home. Today, with the exception of greenhouse gases, all forms of pollution are in decline. In so many ways, you are better off than royalty of yore. Louis XIV lived at Versailles and had cooks and maids and servants waiting on him hand and foot. That sounds great. But he couldn’t have imagined our modern conveniences. He lived in a drafty building without central heat in the winter or air-conditioning in the summer. And what if he got an abscessed tooth or a ruptured appendix? Who would he see? His dinner choices couldn’t approach the cornucopia that greets you in a typical supermarket. If he wanted to dine out, he couldn’t choose from Italian, Chinese, or Indian cuisine. And today, you can walk into a gas station mini-mart and buy a better wine than he drank. His Majesty had his own tailors, yes. But he could never have imagined visiting a modern shopping mall or browsing the Internet to order excellent, affordable garments made of silk, linen, cotton, or wool from all over the world. Nor could Louis XIV travel from one town to the next at 70 mph. Or speak to friends or family members in another land. He couldn’t fly off to the other side of the world in a matter of hours to enjoy the best climate or an exotic locale for the equivalent of less than $1,000. 223


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Some things, of course, are getting steadily more expensive in real terms. Health care is one of them. But which would you prefer—today’s more costly, state-of-the-art health care or what you would have received at a lesser cost in, say, 1975? There has been a stunning reduction in infectious diseases. Heart disease and stroke incidence are in decline. A recent study from the Centers for Disease Control and Prevention reports that overall rates of new cancer diagnosis have dropped steadily since the mid-1990s. (Yet the American Cancer Society reports that 7 in 10 Americans believe cancer rates are going up.) Today, you can sign up for a hip replacement. Forty years ago you would have gotten a wheelchair. Or maybe you need cataract surgery. A few decades ago you would have gotten a seeing-eye dog. And today’s surgery is far less traumatic. Arthroscopic, laparoscopic, endoscopic, drug-eluting stents—these are all commonplace and engineered to get you up and around in no time. In their book, Abundance, technology gurus Peter Diamandis and Steven Kotler describe how rapidly things are improving in our society: Food is cheaper and more plentiful than ever (groceries cost 13 times less today than in 1870). Poverty has declined more in the past 50 years than the previous 500. In fact, adjusted for inflation, incomes have tripled in the past 50 years. Even Americans living under the poverty line today have access to a telephone, toilet, television, running water, air-conditioning, and a car. Go back 150 years and the richest robber barons could have never dreamed of such wealth. Nor are these changes restricted to the developed world. In Africa today a Masai warrior on a cellphone has better mobile communications than the President of the United States did 25 years ago; if he's on a smart phone with Google, he has access to more information than the President did just 15 years ago, with a feast of standard features: watch, stereo, camera, videocamera, voice recorder, GPS tracker, video teleconferencing equipment, a vast library of books, films, games, music. Just 20 years ago these same goods and services would have cost over $1 million . . . Right now all information-based technologies are on exponential growth curves: They're doubling in power for the same price every 12 to

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24 months. This is why an $8 million supercomputer from two decades ago now sits in your pocket and costs less than $200. This same rate of change is also showing up in networks, sensors, cloud computing, 3-D printing, genetics, artificial intelligence, robotics and dozens more industries.

Free markets deliver an enormous bounty based on specialization and exchange. One small example: Our forebears couldn’t have conceived today’s typical salad bar because they couldn’t imagine a global transportation network capable of bringing green beans from Mexico, apples from Poland, and cashews from Vietnam together in the same meal. The world’s poorest are being pulled up, too. Fifty years ago more than half the world’s population struggled with getting enough daily calories. Yet predictions that population growth would cause massive food shortages and starvation proved wrong. Genetically modified seeds allow farmers to produce better-quality crops while using fewer pesticides, herbicides, and fertilizers. The sustainability of the land has improved as a result. America’s farmers now grow five times as much corn as they did in the 1930s—on 20 percent less land. The yield per acre has grown sixfold in the past 70 years. The poor are actually experiencing the most dramatic rise in living standards. According to UNICEF, the global infant mortality rate is the lowest it has ever been, at 51 deaths per 1,000 live births. Child labor, while still too high, is a tenth of what it was five decades ago. The daily calorie intake in the developing world is up dramatically. There are roughly seven billion people in the world, but virtually everywhere health is improving and life expectancy is up. At the current rate of decline, the number of people in the world living in “absolute poverty” will be statistically insignificant by 2035. The spread of microfinance and cell phone technology in many developing countries, for example, is creating countless opportunities and greater prosperity. The overwhelming majority of us are far better fed, sheltered, entertained, and protected against disease than our grandparents. Plus, the majority of our ancestors enjoyed virtually none of the 225


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political freedoms we take for granted in the West today: freedom of speech, freedom of assembly, freedom of religion, freedom from conscription, freedom to choose our leaders or to pursue our economic self-interest. Educational attainment has never been higher. Eighty-eight percent of Americans are high school graduates. Over 57 percent have some college. And 40 percent have a bachelor’s degree. Yes, the cost of higher education has been growing faster than the rate of inflation, but there are signs this is changing, too. Online universities are revolutionizing higher education. And almost two-thirds of colleges now offer full online degree programs, nearly doubled what it was 10 years ago. And if knowledge rather than a degree is your goal, high quality courses—from Kahn Academy to Coursera—are available online and absolutely free. IQ scores are rising as well. In fact, the average has risen by 15 points in the last 50 years in the United States. That means a person with an average IQ of 100 today would score 115 on a test from the 1960s. Throughout most of American history, many groups were systematically marginalized. But formal discrimination against women and minorities has ended. Gays and lesbians are next. Polls show the majority of Americans now favor full and equal rights for homosexual couples. Walter Isaacson, former managing editor of Time, once noted that if you had to describe the twentieth century’s geopolitics in one sentence, it could be a short one: Freedom won. Free minds and free markets prevailed over fascism and communism. The world is getting steadily safer, too. Although you wouldn’t know it listening to your local TV station, Crime is in a long-term cycle of decline. This is the most peaceable era in the history of our species. The number of people who have died as a result of war, civil war, and terrorism is down 50 percent this decade from the 1990s. It is down 75 percent from the preceding five decades. And this greater stability has allowed the creation of a single global economic system, in which countries around the world are participating and flourishing. 226


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There is too much conflict, especially in the Middle East and parts of Africa. But this is newsworthy, in part, because it is increasingly rare. In his essay “A History of Violence,” Harvard psychologist Steven Pinker writes: Cruelty as entertainment, human sacrifice to indulge superstition, slavery as a labor-saving device, conquest as the mission statement of government, genocide as a means of acquiring real estate, torture and mutilation as routine punishment, the death penalty for misdemeanors and differences of opinion, assassination as the mechanism of political succession, rape as the spoils of war, pogroms as outlets for frustration, homicide as the major form of conflict resolution—all were unexceptionable features of life for most of human history. But, today, they are rare to nonexistent in the West, far less common elsewhere than they used to be, and widely condemned when they are brought to light.”

Never before has the risk of death by violence been smaller for most of humanity. Yes, there are armed conflicts around the globe, but the richest countries are not in geopolitical competition with one another, fighting proxy wars, or engaging in arms races. This is huge. There is a fundamental difference between growing up knowing your existence is precarious and growing up feeling that your survival is secure. This leads not just to material security but to a feeling of subjective well-being. I don’t mean to downplay our current challenges, including one of the most predictable crises in the nation’s history: huge and growing state and federal deficits.Yet you’ll notice that the extreme forecasts always begin with the words “If nothing is done . . .” Yet something will be done. Only the most hardened cynics believe that politics will ultimately trump the national welfare. The solutions are not politically easy, but they exist. Simpson-Bowles and other bipartisan commissions have already delineated the steps necessary to reach fiscal sanity. State governors like Chris Christie and Andrew Cuomo have started tackling deeply entrenched problems, such as pension shortfalls, that threaten to destroy state budgets. There is political polarization and plenty of heated rhetoric, but reform at the national level is coming. Yes, it is overdue, but 227


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this is hardly new. Winston Churchill was right when he observed that Americans can always be counted on to do the right thing after they have exhausted all the other possibilities. In sum, the world you live in is rich by almost every measure. Your circumstances are not just fortuitous but extraordinary. We should all recognize this and remember it. Human beings have never had it so good, our lives bountiful beyond measure. Yet Americans don’t report being any more satisfied today than they did in the 1940s when we were in the fight of our lives against Hitler, Mussolini, and Hirohito. It’s not uncommon to hear people grumble because they couldn’t get a high-speed Internet connection on the plane, or that web pages are taking too long to load on their smart phone, or the supermarket is out of their favorite gourmet pet food. As essayist Randall Jarrell observed: “People who live in a Golden Age usually go around complaining how yellow everything looks.” There is a serious downside to all this gloom and doom. For starters, despite the many positive developments in society, diagnoses of clinical depression are up tenfold in the last 50 years. Some of this is due to the increasingly willingness of those afflicted to seek treatment. But surely environmental factors contribute as well. And what could be more depressing than the daily drumbeat of pessimism—and an almost complete absence of positive news— from major media sources? Even among those who enjoy robust mental health, all this negativity—in addition to distorting our perspective—is, to put it mildly, “a bummer.” I also see serious ramifications in my bailiwick, the investment arena. Entrepreneurs who don’t feel optimistic about the future don’t start new businesses or expand existing ones. Investors don’t risk their money in the stock market—and thereby decrease their chances of meeting their investment goals. That delays retirement or diminishes your future standard of living. Over the last 15 years, we have had real booms and busts. But they have also been peppered with false alarms:Y2K, acid rain, natural resource depletion, mineral shortages, the bird flu epidemic, government shutdown threats, and “sequestration.”Yet if you adopt 228


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an optimistic attitude you may be branded naïve or out of touch. As the Austrian economist Friedrich Hayek said, “Implicit confidence in the beneficence of progress has come to be regarded as the sign of a shallow mind.” Most people—even scientists and sociologists—fail to recognize the incredible power of dynamic change. Human beings, technology, and capital markets now operate as a collective problem-solving machine. When a resource becomes scarce, for example, it drives up the price. That encourages both conservation and the development of alternatives and efficiencies. When whales grew scarce, for example, petroleum was used instead as a source of oil. (Warren Meyer has suggested that a poster of John D. Rockefeller should be on the wall of every Greenpeace office.) And when oil prices spiked recently, factories, utilities, and truck manufacturers switched from oil to natural gas. We tend to underestimate the power of human ingenuity and the powerful incentives that society provides for problem solvers. We focus on the daily white noise of setbacks, problems and negative developments and completely miss the real story. The essays that follow are meant to help you tap into our rich social, political, economic, scientific, technological, and cultural legacy. The subjects are diverse. But underlying them all is a call to greater awareness and gratitude—and an appreciation of the benefits these bring into your life. In countless ways—both large and small—we live in the wealthiest society in the history of the planet. The essays that follow are one optimist’s attempt to prove it.

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